ACCC 372 - The effects of Changes in Foreign Exchange Rates

Learning Outcomes

• Explain and apply the scope of IAS 21.
• Define key concepts regarding foreign exchange and apply them in practical situations.
• Distinguish between the functional currency and the presentation currency of an entity.
• Initially recognize a transaction in a foreign currency.
• Subsequently measure balances in a foreign currency.
• Correctly account for foreign exchange differences.
• Integrate the above learning outcomes with other learning outcomes in this module.

IAS 21: The Effects of Changes in Foreign Exchange Rates

• Objective
• Scope (paragraphs 3-7)
• Definitions (paragraph 8)
• Elaboration of definitions (paragraphs 9-16, excluding 11, 14, 15, 15A)
• Summary of approach required by this standard (paragraphs 17-19)
• Reporting foreign currency transactions in the functional currency
  • Initial recognition (paragraphs 20-22)
  • Reporting at the end of subsequent reporting periods (paragraphs 23-26)
  • Recognition of exchange differences (paragraphs 27-34)
• Change in functional currency (paragraphs 35-37) - Completely excluded
• Use of a presentation currency other than the functional currency (paragraphs 38-43) - Completely excluded
• Translation of a foreign operation (paragraphs 44-47) - Completely excluded
• Disposal of a partial disposal of a foreign operation (paragraphs 48-49) - Completely excluded
• Tax effects of all exchange differences (paragraph 50) - Completely excluded
• Disclosure (paragraphs 51-57) - Level 1

Vertical Mapping on e-fundi Overview of Gripping GAAP textbook

• Introduction EXCLUDED: SIC 7 Introduction of the Euro
• Foreign currency transactions
  • Overview
  • Monetary and non-monetary items
  • How exchange rates are quoted
    • Example 1: Exchange rates
  • Dates
    • Determining the transaction date
    • Determining the settlement date
    • Determining the reporting date (if applicable)
    • Example 2: Dates: transaction, settlement, and reporting dates
  • Initial recognition and measurement: monetary and non-monetary items
  • Subsequent measurement: monetary items
    • Overview
    • Translation at the end of the reporting period: monetary items
    • Translation at settlement date: monetary items
  • Exchange differences: monetary items
    • Overview
    • Example 3: Exchange differences – monetary item: debtor
    • Import and export transactions
      • Transaction and settlement on the same day (cash transaction)
        • Example 4: Import transaction: settled on the same day (cash transaction)
        • Example 5: Export transaction: settled on the same day (cash transaction)
      • Settlement deferred (credit transactions)
        • Settlement of a credit transaction before year-end
          • Example 6: Import: credit transaction settled before year-end
          • Example 7: Export: credit transaction settled before year-end
        • Settlement of a credit transaction after year-end
          • Example 8: Import: credit transaction settled after year-end
          • Example 9: Export: credit transaction settled after year-end
          • Example 10: Import: credit transaction: another example
    • Foreign loans
      • Example 11: Foreign loan received
      • Example 12: Foreign loan granted
  • Subsequent measurement: non-monetary items
    • Example 13: Non-monetary item: measurement of plant purchased from a foreign supplier
    • Example 14: Non-monetary item: measurement of inventory owned by a foreign branch ACCC371: Excluding example 14 & 15
    • Example 15: Non-monetary item: measurement of plant owned by a foreign branch ACCC371: Excluding example 14 & 15
  • Exchange differences: non-monetary items
    • Example 16: Revaluation of PPE owned by a foreign branch EXCLUDED
• Presentation and Functional Currencies
  • General
  • Determining the functional currency
  • Accounting for a change in functional currency EXCLUDED
  • Using a presentation currency other than the functional currency EXCLUDED
    • Explanation of the foreign currency translation reserve
    • Example 17: Foreign currency translation reserve EXCLUDED
• Presentation and Disclosure LEVEL 1
• Summary

Relevance of IAS 21

• Very relevant due to globalization and daily foreign transactions.
• Exchange rates fluctuate daily.
• Integrates with all asset standards, revenue, inventory, and financial instruments.

Definitions

• Closing rate: The spot exchange rate at the end of the reporting period.
• Exchange difference: The difference resulting from translating a given number of units of one currency into another currency at different exchange rates.
• Exchange rate: The ratio of exchange for two currencies.
• Fair value: The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.
• Foreign currency: A currency other than the functional currency of the entity.
• Functional currency: The currency of the primary economic environment in which the entity operates.
• Monetary items: Units of currency held, and assets and liabilities to be received or paid in a fixed or determinable number of units of currency.
• Presentation currency: The currency in which the financial statements are presented.
• Spot exchange rate: The exchange rate available for immediate delivery.

Guidance Provided by IAS 21

• Identification of an entity’s functional currency.
• Accounting for transactions in a foreign currency.
  • Purchases of inventory/supplies (PPE, IA, IP) from a foreign supplier denominated in a foreign currency.
  • Sales of inventory or PPE to a foreign customer with the sales price quoted in a foreign currency.
• How to account for a foreign operation (Subsidiary, Associate, JV in a foreign country) – next year.
• How to translate from a functional currency to a presentation currency (for investors, holding company or financial providers in another country) – next year.

Identification of an Entity’s Functional Currency (IAS 21.9-10)

• Currency of the primary economic environment in which the entity operates.
• In which currency does the entity primarily generate and expend cash.
• Factors to determine:
  • Primary indicators:
    • The currency that mainly influences the sales price of goods and services.
    • The currency of the country whose competitive forces and regulation mainly determine the selling price of goods and services.
  • The currency that mainly influences labor, materials, and other costs.
  • Additional indicators:
    • The currency in which the entity receives financing.
    • The currency in which receipts from operating activities are usually retained.
  • If still not clear, management uses professional judgment.

Functional Currency vs. Presentation Currency

• Functional Currency
  • Not a free choice.
  • The currency of the entity’s PRIMARY ECONOMIC ENVIRONMENT.
  • Does not change unless there is a change in the underlying transactions, events, and circumstance.
• Presentation Currency
  • Currency that the financial statements are presented.
  • Free choice.
  • An entity can have a number of presentation currencies.

Class Example 1 – Functional Currency

• Company A, a South African gold mine, pays workers in Rand, and overheads are primarily incurred in Rand.
• The majority of gold mined is exported, and all gold prices are quoted in US dollars.
• Company A is mainly financed by its American parent company, and the majority of their customers pay in dollars.
• What is Company A’s functional currency?

Solution

• Par 9 Factors:
  • The selling price of gold is primarily influenced by US dollars.
  • The cost price of mining the gold is primarily influenced by RSA Rand (labor, overheads).
  • Therefore, a contradiction.
• Which one?
• Par 10 Factors:
  • Cash flows from financing activities are primarily influenced by US dollars because loans from the parent company are denominated in US dollars.
  • Cash flows from operating activities (receipts from debtors) primarily occur in US dollars.
• Conclusion: The majority of factors, therefore, indicate that the functional currency is the US DOLLAR.

Accounting for Transactions in a Foreign Currency – Important Definitions and Examples

• Foreign currency transaction: Transaction that is entered into and settled in a foreign currency.
• Examples:
  • Buying and selling goods/services in a foreign country.
  • Borrowing and lending of funds in a foreign country.
  • Acquisitions or disposals of assets in foreign countries.
• This foreign denominated transaction should be included within the financial statements in the entity’s own functional currency.
• To do this, we follow guidance in terms of IAS 21:
  1. How should the transaction be translated to the entity’s functional currency?
  2. On what date should the transaction be translated into the entity’s functional currency?
• Accounted for in terms of IAS 21.

Accounting for Transactions in a Foreign Currency – Important Definitions and Examples

• Monetary item:
  • Units of currency held.
  • Right to receive or obligation to pay a fixed determinable number of currency units.
  • Examples:
    • Cash
    • Account receivable/payable
    • Provisions to be settled in cash
  • Restated on subsequent measurement.
• Non-monetary item:
  • Not monetary items.
  • Examples:
    • PPE
    • Intangible Assets
    • Investment Property
    • Inventory
    • Prepaid expenses
  • Not restated on subsequent measurement.

Accounting for Transactions in a Foreign Currency – Important Definitions and Examples

• Different rates (3 types):
  • Spot rates: Rate on a specific date (exchange rate for immediate delivery).
  • Closing rate: Spot rate at financial year end.
  • Forward exchange rate ≠ ACCC 372: The forecasted exchange rate when purchasing a forward exchange contract.
• NB!!! Choose the correct rate within a question.

Accounting for Transactions in a Foreign Currency – Important Definitions and Examples

• Quotation of exchange rates = Price of one currency in another currency
• Direct vs Indirect Quotation
  • e.g. $5 000
• Buying Rate vs Selling Rate
  • Direct quotation: $1 = R14.28
    • Use multiplication to obtain the rand value
    • 5 000 \times 14.28 = R71 400
  • Indirect quotation: R1 = $0,07
    • Use division to obtain the rand value
    • 5 000 / 0,07 = R71 429
• Export transaction DEBTOR
  • Entity has received forex from the debtor and will sell the forex to the bank
• Import transaction CREDITOR
  • Entity is required to buy forex from the bank to settle the foreign debt
• BUY RATE SELL RATE BUY RATE SELL RATE
  Bank buys foreign currency ($) from the entity Bank sells the local currency (R) to the entity Bank buys the local currency (R) from the entity Bank sells the foreign currency ($) to the entity
  DIRECT QUOTATION INDIRECT QUOTATION INDIRECT QUOTATION DIRECT QUOTATION
• Always look at this from the bank's perspective

SUMMARY

• S1 = R14.28 USE MULTIPLICATION
• R1 = $0,07 USE DIVISION
• DIRECT QUOTATION INDIRECT QUOTATION
• Creditor
  • Sell rate
• Buy rate
• Debtor
  • Buy rate
• Sell rate
• NB!!! Choose the correct rate within a question.
• Gripping GAAP example 1

Accounting for Transactions in a Foreign Currency – Important Definitions

• Important dates
  • Transaction date
    • DATE the definition and recognition criteria is met
  • Date on which CONTROL is transferred per IFRS 15
  • Reporting date
    • YEAR END
    • Only be applicable if reporting date is between transaction date and settlement date.
  • Settlement date
    • DATE WHEN CASH CHANGES HANDS
    • Entity pays the creditor
    • Receive payment from the debtor
• Initial recognition and measurement
  • Spot rate on transaction date
• Subsequent measurement
  • Monetary item will be remeasured to the closing rate at year's end
  • Non-monetary item is not impacted
• Subsequent measurement
  • Monetary item will be remeasured at spot rate on settlement date and then derecognized
  • Non-monetary item is not impacted
• Exam technique - Always draw a timeline

Transaction Date ≠ Defined In IAS 21

• Date when control is transferred per IFRS 15
• The following are indicators of when control is obtained (IFRS15:38):
  • The entity has a present right to payment.
  • The customer has accepted the asset.
  • The customer has significant risks and rewards of ownership of the asset.
  • The customer has physical possession (physical possession does not, on its own, determine which party has control).
  • The customer has legal title to the asset (customer is able to sell an asset, exchange, or use it to secure or settle debt).
• Complication = Shipping terms
• International Chamber of Commerce Terms of Trade has defined the terms
  • Free on Board FOB
  • Carriage, Insurance, Freight CIF
  • Delivered at Terminal DAT
  • Delivered Duty Paid DDP

Shipping Terms: Transaction Date NOT IN IAS 21

• Free on Board FOB
• Carriage, Insurance, Freight CIF
• Risk and Rewards transfer when goods are loaded at the point of shipment.
• The cost of insurance (therefore the risks) is carried by a specific party, as specified in the purchase contract.
• If the seller carries the risks (usually):
  • Transaction date is the date on which goods arrive at the port of the buyer’s country = Income is recognized at the point of delivery
• If the buyer carries the risks:
  • Transaction date is the date on which goods are loaded onto the ship of the seller’s country. = Income is recognized at point of dispatch/shipment
• If the seller takes out the insurance and the buyer is the recipient of the insurance, then the transaction date is the date when the goods leave the port of the seller’s country.

Shipping Terms: Transaction Date NOT IN IAS 21

• Delivered at Terminal DAT
• Delivered Duty Paid DDP
• Risk and rewards transfer when goods are offloaded at the named destination terminal
• Risk and rewards transfer when goods have arrived at the named destination port or other place and the import clearances have been obtained.
• Gripping GAAP example 2

MONETARY ITEM VS NON-MONETARY ITEM

Monetary item Non-monetary item
Examples
Receivables (sales to foreign debtor) Payable (purchase from foreign creditor) Loan to foreign borrower Loan from a foreign lender Sales Inventory
Initial recognition date
Transaction date Transaction date
Initial measurement
Foreign currency amount x spot exchange rate on transaction date (divide if indirect quotation is given) Foreign currency amount x spot exchange rate on transaction date (divide if indirect quotation is given)
Subsequent measurement
Reporting date before settlement date (foreign exchange gains/losses are unrealized) And Settlement date (foreign exchange gains/losses realized) If there is a difference in the exchange rate on these days. Where is the foreign exchange rate movement recognized?
Profit or loss N/A and therefore no foreign exchange differences are recognized.

Import/ Export Transactions

Import Transaction (CREDITOR) Export transaction (DEBTOR)
Step 1: Record the transaction at the spot rate on transaction date (initial recognition and measurement)
Dr. Inventory / PPE / IA (SOFP) Cr. Creditor (SOFP) Dr. Debtor (SOFP) Cr. Sales (P/L)
Step 2: Recognize foreign exchange difference (gain/loss) on MONETARY item on a Reporting date (if between transaction date and settlement date) b Settlement date
Dr./Cr. Foreign exchange difference (P/L) Dr./Cr. Creditor (SOFP) Rate INCREASES – more expensive to pay the creditor = LOSS (Dr. Foreign exchange difference loss (P/L)) Rate DECREASES – cheaper to pay the creditor = GAIN (Cr. Foreign exchange difference gain (P/L)) No restatement of INVENTORY as it is a NON-MONTARY ITEM Dr./Cr. Foreign exchange difference (P/L) Dr./Cr. Debtor (SOFP) Rate INCREASES – receive more from the debtor = GAIN (Cr. Foreign exchange difference gain (P/L)) Rate DECREASES – receive less from the debtor = LOSS (Dr. Foreign exchange difference loss (P/L)) No restatement of SALES as it is a NON-MONTARY ITEM
Step 3: On settlement date, record the payment / receipt of cash
Dr. Creditor (SOFP) Cr. Bank (SOFP) Dr. Bank (SOFP) Cr. Debtor (SOFP)
Gripping GAAP example 3-10

Foreign Denominated Loans

• Loan is denominated in a foreign currency
• Always calculate the interest, principle, and outstanding balance in the foreign currency and then translate.
• The balancing figure will be the foreign exchange difference to be recorded in profit or loss.
• Elements of a financial instrument
  • Conversion Initial receipt of the loan Translate at spot rate on transaction date
  • Loan repayment Translate at spot rate on transaction date / settlement date
  • Interest accrual Translate at average rate over the accrual period
  • Loan balance at the reporting date Translate at closing rate (Spot rate at reporting date) as it is a monetary item.
• The above will not balance as there are different exchange rates used.
• To bring this journal into balance – record a foreign exchange movement in profit or loss.
• Gripping GAAP example 11 and 12

Foreign Denominated Loans

LOAN FROM PAYABLE LOAN TO RECEIVABLE
Step 1: Record the granting or receiving of the loan at spot rate on transaction date
Dr. Bank (SOFP) ‘’INFLOW” Cr. Loan from (payable) (SOFP) Dr. Loan to (receivable) (SOFP) Cr. Bank (SOFP) ‘’OUTFLOW”
Step 2: Record the interest income/ expense in profit or loss at the average rate. Interest is calculated on the effective interest rate method
Dr. Interest expense (P/L) Cr. Loan from (payable) (SOFP) Dr. Loan to (receivable) (SOFP) Cr. Interest income (P/L)
Step 3: Record the principal payment being paid or received at the spot rate on settlement date
Dr. Loan from (payable) (SOFP) Cr. Bank (SOFP) ‘’OUTFLOW” Dr. Bank (SOFP) ‘’INFLOW” Cr. Loan to (receivable) (SOFP)
Step 4: Record the foreign exchange difference in profit or loss to bring the monetary item to be stated at the reporting date / settlement date spot rate (Balancing number)
Dr./Cr. Foreign exchange difference (P/L) Dr./Cr. Loan from (payable) (SOFP) Rate INCREASES – more expensive to pay the loan = LOSS (Dr. Foreign exchange difference loss (P/L)) Rate DECREASES – cheaper to pay the loan = GAIN (Cr. Foreign exchange difference loss (P/L)) Dr./Cr. Foreign exchange difference (P/L) Dr./Cr. Loan to (receivable) (SOFP) Rate INCREASES – receive more from the borrower = GAIN (Cr. Foreign exchange difference loss (P/L)) Rate DECREASES – receive less from the borrower = LOSS (Dr. Foreign exchange difference loss (P/L))

Subsequent Measurement: Non-Monetary Item (IAS 21.23 (b) and (c))

• COST MODEL
  • No restatement as it continues to be measured at the historical cost on transaction date. (IAS 23(b))
• REVALUATION MODEL / FAIR VALUE MODEL
  • Measured at fair value in foreign currency translated at the spot rate on the date when the fair value was remeasured. (IAS 23(c))
• Gripping GAAP example 13

IAS 21 Amendment - The Lack of Exchangeability of Currencies

• Specify when a currency is exchangeable into another currency and when it is not — a currency is exchangeable when an entity is able to exchange that currency for the other currency through markets or exchange mechanisms that create enforceable rights and obligations without undue delay at the measurement date and for a specified purpose; a currency is not exchangeable into the other currency if an entity can only obtain an insignificant amount of the other currency.
• Specify how an entity determines the exchange rate to apply when a currency is not exchangeable — when a currency is not exchangeable at the measurement date, an entity estimates the spot exchange rate as the rate that would have applied to an orderly transaction between market participants at the measurement date and that would faithfully reflect the economic conditions prevailing.
• Require the disclosure of additional information when a currency is not exchangeable — when a currency is not exchangeable an entity discloses information that would enable users of its financial statements to evaluate how a currency’s lack of exchangeability affects, or is expected to affect, its financial performance, financial position, and cash flows.
• We won’t test the exchangeability of currencies in ACCC372, but it’s just background for you going into PGDA.