Chapter19 foreigncurrencytransactions2008

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Chapter19 foreigncurrencytransactions2008

  1. 1. Gripping IFRS Foreign currency transactions Chapter 19 Foreign Currency TransactionsReference: IAS 21, IAS 39 and IFRS 7Contents: Page 1. Definitions 599 2. Foreign currency transactions 599 2.1 General 599 2.2 How exchange rates are quoted 599 Example 1: quoted exchange rates 600 2.3 Transactions 600 2.4 Dates 600 2.4.1 Determining the transaction date 600 2.4.2 Determining the settlement date 601 2.4.3 Determining the translation date 601 Example 2: transaction, settlement and translation dates 601 2.5 Recognition and measurement 602 2.5.1 Initial recognition and measurement 602 2.5.2 Subsequent measurement: monetary items 602 2.5.2.1 Overview 602 2.5.2.2 Translation at the end of the reporting period 602 2.5.2.3 Translation at settlement date 603 2.5.2.4 Exchange difference 603 Example 3: exchange differences 603 2.5.3 Subsequent measurement: non-monetary items 604 Example 4: measurement of plant bought from foreign 605 supplier Example 5: measurement of inventory owned by foreign 606 branch Example 6: measurement of plant owned by foreign branch 607 2.6 Exchange differences on monetary items 608 2.6.1 Import and export transactions 608 2.6.1.1 Transaction and settlement on same day 608 Example 7: import transaction: settled on same day 608 Example 8: export transaction: settled on same day 609 2.6.1.2 Settlement deferred (credit transactions) 609 2.6.1.2.1 Settlement of a credit transaction before year-end 609 Example 9: import: credit transaction settled before year-end 609 Example 10: export: credit transaction settled before year-end 610 2.6.1.2.2 Settlement of a credit transaction after year-end 610 Example 11: import: credit transaction settled after year-end 611 Example 12: export: credit transaction settled after year-end 611 Example 13: import: credit transaction: another example 612 2.6.2 Foreign loans 614 Example 14: foreign loans 614 597 Chapter 19
  2. 2. Gripping IFRS Foreign currency transactions Contents continued … Page 3. Presentation and functional currencies 615 3.1 General 615 3.2 Determining the functional currency 615 3.3 Accounting for a change in functional currency 616 3.4 Using a presentation currency other than the functional currency 616 3.4.1 Explanation of foreign currency translation reserve 616 Example 15: foreign currency translation reserve 617 4. Presentation and disclosure 618 5. Summary 619 598 Chapter 19
  3. 3. Gripping IFRS Foreign currency transactions1. DefinitionsThe following definitions are provided:• Exchange rate: is the ratio of exchange for two currencies.• Spot exchange rate: is the exchange rate for immediate delivery.• Closing Rate: is the spot exchange rate at the reporting date.• Exchange difference: is the difference resulting from translating a given number of units of one currency into another currency at different exchange rates.• Fair value: is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction.• Foreign currency: is a currency other than the functional currency of the entity.• Functional currency: is the currency of the primary economic environment in which the entity operates.• Foreign currency transaction: is a transaction that is denominated and/or requires settlement in a foreign currency.• Presentation currency: is the currency in which the financial statements are presented.• Monetary items: are units of currency held and assets and liabilities to be received or paid in a fixed or determinable number of units of currency.• Transaction date: the date on which the risks and rewards of ownership transfer (simplified definition: see the full definition from IAS 21).• Settlement date: the date upon which a foreign debtor or creditor pays or is paid.• Translation date: the date on which the balance in foreign currency is converted into local currency (transaction date, settlement date and reporting dates).2. Foreign currency transactions2.1 GeneralBusinesses frequently enter into transactions with foreign entities. These transactions(involving incomes, expenses, assets and liabilities) may be denominated in foreigncurrencies (e.g. an invoice that is in dollars, is referred to as ‘denominated in dollars’). Sincefinancial statements are prepared in one currency only, all foreign currency amounts must beconverted into the currency used for the financial statement (presentation currency). Tocomplicate matters, there is often a considerable time lag between the date that a foreigndebtor or creditor is created and the date upon which that debtor pays or creditor is paid. Thisinevitably results in exchange differences because exchange rates fluctuate on a daily basis.This chapter deals with IAS 21 – The Effects of Changes in Foreign Exchange Rates, whichsets out the method to be used in converting currencies for inclusion in financial statements.2.2 How exchange rates are quotedAn exchange rate is the price of one currency in another currency. For example, if we havetwo currencies, a local currency (LC) and a foreign currency (FC), we could quote the FC:LCexchange rate as, for example, FC1:LC4. This effectively means that to purchase 1 unit of FC,we would have to pay 4 units of LC. It is also possible to quote the same exchange rate asLC1: FC0.25. This effectively means that 1 unit of LC would purchase 0.25 units of the FC.Global market forces determine currency exchange rates. If you ask a bank or other currencydealer to buy or sell a particular currency, you will be quoted an exchange rate that is valid forthat particular day only (i.e. immediate delivery). This exchange rate is called a ‘spot rate’. 599 Chapter 19
  4. 4. Gripping IFRS Foreign currency transactionsExample 1: quoted exchange ratesYou are quoted a spot exchange rate on 1 March 20X1 of £1: $2.Required:A. If you had £1 000 to exchange (i.e. sell), how many $ would you receive (i.e. buy) from the currency dealer?B. If you had $1 000 to exchange (i.e. sell), how many £ would you receive (i.e. buy) from the currency dealer?C. Restate the exchange rate in the format £ …: $1.Solution to example 1: quoted exchange ratesA: £1 000 / 1 x 2 = $2 000B: $1 000 / 2 x 1 = £500C: £1 / 2 = £0.5 therefore, the exchange rate would be £0.5: $12.3 TransactionsThe types of foreign currency transactions that can be entered into are numerous. Commonexamples of transactions with foreign entities include:• borrowing or lending money;• purchasing or selling inventory; and• purchasing or selling depreciable assets.2.4 DatesDates involved with foreign currency transactions are very important because exchange ratesdiffer from day-to-day. The following dates are significant when recording the foreigncurrency transaction:• transaction date – this is when a loan is raised/made or an item is purchased or sold;• settlement date – this is when cash changes hands in settlement of the transaction (e.g. the creditor is paid or payment is received from the debtor); and• translation date – this is the financial year-end of the local entity.The transaction is recognised on transaction date, which is the date on which the definitionand recognition criteria are met. The order date occurs before the transaction date. Since weare normally not interested in the events before transaction date, the order date is normallyirrelevant.2.4.1 Determining the transaction dateThe first thing that must be determined in a foreign currency transaction is the transactiondate. The date on which the transaction must be recognised is established with reference tothe IFRS that applies to the type of transaction in question. A rule of thumb for a purchase orsale transaction is that the transaction date would be when the risks and rewards of ownershiptransfer from one entity to the other entity.For regular import or export transactions, establishing the date that risks and rewards aretransferred is complicated by the fact that goods sent to or ordered from other countriesusually spend a considerable time in transit.There are two common ways of shipping goods between countries. Goods can be shipped:• Free on Board (F.O.B); or• Cost, Insurance, Freight (C.I.F). 600 Chapter 19
  5. 5. Gripping IFRS Foreign currency transactionsIf a transaction is arranged on a Free on Board (F.O.B) basis, the situation is:• generally, as soon as the entity shipping the goods has delivered the goods to the port of departure and they have been loaded onto a ship, the risks of the remaining voyage transfers to the entity that will be receiving those goods; and therefore• the transaction date will generally be the date that the goods are loaded onto a ship in the originating country.If a transaction is arranged on a Cost Insurance Freight (C.I.F) basis, the situation is:• generally, the entity shipping the goods retains the risks of the voyage until the goods arrive in the receiving port and are cleared through customs; and therefore• the transaction date will generally be the date that the goods are offloaded at the destination harbour and are cleared through customs.The exact wording of the terms of the shipping documentation must, however, always beinvestigated first before determining the transaction date.2.4.2 Determining the settlement dateNext, the settlement date must be determined. The settlement date is the date on which:• a foreign creditor is fully or partially paid; or• full or partial payment is received from a foreign debtor.The settlement date is generally not difficult to establish.2.4.3 Determining the translation date (if applicable)It is possible for a foreign currency transaction to spread over more than one financial year.In other words, where such a transaction is spread over more than one financial year, at leastone year-end occurs between transaction date and settlement date. The year-end/s fallingbetween transaction and settlement date is known as the translation date.Example 2: determining transaction, settlement and translation datesOn 13 January 20X4, Home Limited faxed an order for 1 000 yellow bicycles to Far AwayLimited, a bicycle manufacturer in Iceland.On 16 January 20X4, Home Limited received a faxed confirmation from Far Away Limitedinforming them that the order had been accepted.On 25 January 20X4, Far Away Limited finished production of the required bicycles andpacked them for delivery.On 1 February 20X4, the bicycles were delivered to one of Iceland’s many harbours and wereloaded onto a ship.The ship set sail on 4 February 20X4.Due to stormy weather it only arrived at the port in Home Limited’s country on31 March 20X4.The bicycles were offloaded and released from customs on the same day.On 5 April 20X4, the bicycles finally arrived in Home Limited’s warehouse.Far Away Limited was paid on 30 April 20X4.Home Limited has a 28 February financial year-end. .Required:A. State the transaction, translation and settlement dates assuming the bicycles were shipped F.O.B.B. State the transaction, translation and settlement dates assuming the bicycles were shipped C.I.F. 601 Chapter 19
  6. 6. Gripping IFRS Foreign currency transactionsSolution to example 2: determining transaction, settlement and translation datesA.The transaction date is 1 February 20X4: in terms of an F.O.B. transaction, the risks of ownership ofthe bicycles would pass to Home Limited on the date the bicycles are loaded at the originating port.The translation date is 28 February 20X4 since this is Home Limited’s year-end on which date theforeign currency monetary item (foreign creditor) still exists, (the transaction date has occurred and thesettlement has not yet happened).The settlement date is 30 April 20X4 being the date on which Home Limited pays the foreign creditor.B.The transaction date is 31 March 20X4: in terms of a C.I.F. transaction, the risks of ownership of thebicycles would pass to Home Limited on the date that the bicycles are cleared from customs.There is no translation date because at both 28 February 20X4 and 28 February 20X5 no foreigncurrency monetary item (foreign creditor) existed. Thus there are no items to translate at either year-end. (explanation: at 28 February 20X4 the transaction date had not yet occurred and28 February 20X5 the foreign transaction had already been settled).The settlement date is 30 April 20X4 being the date when the foreign creditor was paid.2.5 Recognition and measurement2.5.1 Initial recognition and measurement (IAS 21.20 - .22)The foreign currency transaction is initially recognised on transaction date.The foreign currency transaction is measured by:• applying to the foreign currency amount• the exchange rate between foreign currency and functional currency• at the spot rate on transaction date.It is permissible to use an average exchange rate for the past week or month as long as itapproximates the spot exchange rate.2.5.2 Subsequent measurement: monetary items2.5.2.1 OverviewAs an exchange rate changes (and most fluctuate on a daily basis), the measurement ofamounts owing to or receivable from a foreign entity changes. For example, an exchange rateof FC1: LC4 in January can change to an exchange rate of FC1: LC7 in February andstrengthen back to FC1: LC6 in March. Due to this, a foreign debtor or creditor will owedifferent amounts depending on which date the balance is measured.Monetary items (amounts owing or receivable) are translated to the latest exchange rates:• on each subsequent reporting period; and• on settlement date.2.5.2.2 Translation at the end of the reporting periodIf the monetary item is not settled by end of the reporting period, then an exchange differenceis likely to be recognised. This is because the item was originally measured at the spot rate ontransaction date. If it is not yet settled at the date a report is being drafted, the balance owingor receivable will need to be re-measured at the spot rate on the date of the report. If there is 602 Chapter 19
  7. 7. Gripping IFRS Foreign currency transactionsa difference between the spot rate on transaction date and the spot rate on reporting date(sometimes referred to as the closing rate), then an exchange difference arises.2.5.2.3 Translation at settlement dateThe amount paid or received is based on the spot rate on settlement date. If the spot rate ontransaction / reporting date (whichever is applicable) is different to the spot rate on settlementdate, an exchange difference will arise.2.5.2.4 Exchange differencesThe translation of monetary items will almost always result in exchange differences: gains orlosses (unless there is no change in the exchange rate since transaction date).The exchange differences on monetary items are recognised in profit or loss in the period inwhich they arise. ♥♥ If the foreign exchange gain or loss relates to a foreign operation that is consolidated into the entity’s books, then this exchange gain or loss will not be recognised in profit or loss but rather in other comprehensive income. It would be reclassified as being part of profit or loss only on disposal of the foreign operation. Consolidations are not covered in this textbook and therefore this issue will not be covered further.Example 3: exchange differences – monetary itemOn 31 January an entity has a foreign debtor of FC2 000.The local currency is denominated as LC and the foreign currency is denominated as FC.The exchange rates of FC: LC are as follows: 31 January: FC1: LC4 28 February: FC1: LC7 31 March: FC1: LC6Required:A. Calculate the value of the foreign debtor in local currency units at the end of the months January, February and March.B. Calculate the exchange differences arising over those 3 months and in total.C. Show how the debtor and exchange differences would be journalised in the entity’s books on 31 January, 28 February and 31 March. Assume the debtor was created on 31 January through a sale of goods. Ignore the journal required for the cost of the sale.Solution to example 3: exchange differences – monetary itemA.On 31 January the foreign debtor would be worth FC2 000 x LC4 = LC8 000.On 28 February the foreign debtor would be worth FC2 000 x LC7 = LC14 000.On 31 March the foreign debtor would be worth FC2 000 x LC6 = LC12 000.B.Between 31 January and 28 February, an exchange difference (gain) of LC6 000 arises: [LC14 000-LC8 000].Between 28 February and 31 March, an exchange difference (loss) of LC2 000 arises: [LC12 000-LC14 000].In total, between 31 January and 31 March, a net exchange difference (net gain) of LC4 000 arises: [LC12 000-LC8 000]. 603 Chapter 19
  8. 8. Gripping IFRS Foreign currency transactionsC.Journals: Debit Credit31 JanuaryForeign debtor 8 000 Sales 8 000Sold goods to foreign customer28 FebruaryForeign debtor 6 000 Foreign exchange gain 6 000Translating foreign debtor31 MarchForeign exchange loss 2 000 Foreign debtor 2 000Translating foreign debtorNotice how the amount of sales income recognised is unaffected by changes in the exchange rates.2.5.3 Subsequent measurement: non-monetary itemsNon-monetary items include assets such as:• property, plant and equipment;• intangible assets; and• inventories.Foreign currency can affect non-monetary items in two basic ways:• Local currency denominated non-monetary items: They could have been purchased using foreign currency, in which case they are converted into the local currency at the spot rate on transaction date, and are thereafter denominated in the local currency (called the functional currency)• Foreign currency denominated non-monetary items: They could be owned by a foreign branch or foreign operation of the entity (the latter would require consolidation into the books of the entity), in which case they are denominated in foreign currency in the books of the branch (these will have to be converted into the local currency).Non-monetary items that:• are measured at historical cost in a foreign currency are translated using the exchange rate on transaction date;• are measured at a value other than historical cost (e.g. fair value or recoverable amount) in a foreign currency are translated using the exchange rate when the fair value was determined.The subsequent measurement of local currency denominated non-monetary items occurssimply in terms of the relevant IFRS. These items are not affected by subsequent changes inexchange rates. For example, if an item of plant is purchased where the purchase wasdenominated in a foreign currency, this is converted into the local currency on transactiondate and the plant is then measured in terms of IAS 16 Property, plant and equipment.The subsequent measurement of foreign currency denominated non-monetary items, whilstmeasured in terms of the relevant IFRS, may be affected by a change in an exchange rate.This occurs when the measurement of the item depends on the comparison of two or moreamounts. Typical examples are plant, where the measurement at year-end depends on acomparison of the carrying amount with the recoverable amount. Another example includesinventory, where the measurement at year-end depends on a comparison of the cost with thenet realisable value.The reason that an exchange rate can affect such items is because: 604 Chapter 19
  9. 9. Gripping IFRS Foreign currency transactions• the cost or carrying amount, as appropriate, is translated at the spot rate when the amount was determined (e.g. on transaction date); and• the net realisable value or recoverable amount, as appropriate, is translated at the spot rate on the date that this amount is calculated (e.g. on reporting date).Example 4: non-monetary item: measurement of plant bought from a foreign supplierOn 1 January 20X1, a South African company bought plant from an American company for$100 000. The South African company settled the debt on 31 March 20X1. Spot rates Date (Rand: Dollar) 1 January 20X1 R6.0: $1 31 March 20X1 R6.3: $1 31 December 20X1 R6.5: $1 31 December 20X2 R6.2: $1The plant is depreciated to a nil residual value over 5 years using the straight-line method.The recoverable amount was calculated on 31 December 20X2: R320 000.Required:Show all journal entries relating to plant for the years ended 31 December 20X1 and 20X2 inthe books of the South African entity.Solution to example 4: non-monetary item: journals1 January 20X1 Debit CreditPlant: cost $100 000 x R6 600 000 Foreign creditor 600 000Purchased plant from a foreign supplier (translated at spot rate)31 March 20X1Foreign exchange loss $100 000 x R6.30 – R600 000 30 000 Foreign creditor 30 000Translating foreign creditor on settlement date (at latest spot rate)Foreign creditor $100 000 x R6.30 630 000 Bank 630 000Payment of foreign creditor31 December 20X1Depreciation (R600 000 – 0) / 5 years 120 000 Plant: accumulated depreciation 120 000Depreciation of plant31 December 20X2Depreciation (R600 000 – 0) / 5 years 120 000 Plant: accumulated depreciation 120 000Depreciation of plantImpairment loss CA: 600 000 –120 000 –120 000 40 000 Plant: accumulated impairment loss – Recoverable amount: 320 000 40 000Translating foreign debtorNotice how the measurement of the non-monetary asset (plant) is not affected by the changes in theexchange rates. This is because it is a local currency denominated item. 605 Chapter 19
  10. 10. Gripping IFRS Foreign currency transactionsExample 5: non-monetary item: measurement of inventory owned by foreign branchA South African company (local currency: Rands: R) has a branch in Britain (local currency:Pound: £). On 1 January 20X1, the branch in Britain bought inventory from a British supplierfor £100 000 in cash. Spot rates Date (Rand: Pound) 1 January 20X1 R10.0: £1 31 December 20X1 R12.0: £1The inventory is still in stock and its net realisable value is estimated to be £90 000 at31 December 20X1.Required:Show all journal entries for the years ended 31 December 20X1:A. in the books of the British branch; andB. in the books of the South African entity.Solution to example 5A: inventory: journals in the books of a foreign branchJournals in the foreign branch: denominated in Pounds Debit Credit1 January 20X1Inventory Given: £100 000 100 000 Bank 100 000Purchased inventory from a local supplier (British)31 December 20X1Inventory write-down £100 000 – £90 000 10 000 Inventory 10 000Inventory written down to lower of cost or net realisable valueNotice how, in the branch’s books, the inventory is written down since the net realisable value inPounds is less than the carrying amount in Pounds.Solution to example 5B: inventory: journals in the books of the local entityJournals in the local entity: denominated in Rands Debit Credit1 January 20X1Inventory £100 000 x R10 1 000 000 Bank 1 000 000Purchased inventory from a foreign supplier (translated at spot rate)Notice how there is no write-down of inventory in the SA entity’s books because the net realisablevalue is measured using the spot rate on the date at which the recoverable amount is calculated (R12:£1) and the cost is measured using the spot rate on transaction date (R10: £1). The fact that the Britishbranch recognises a write-down whyereas the South African books does not, is purely as a result of thechange to the exchange rates! Pounds RandsCost: 31/12/20X1 Pounds: £100 000 100 000 1 000 000 Rands: £100 000 x R10Net realisable value: 31/12/20X1 Pounds: £90 000 90 000 1 080 000 Rands: £90 000 x R12Write-down 10 000 N/A 606 Chapter 19
  11. 11. Gripping IFRS Foreign currency transactionsExample 6: non-monetary item: measurement of plant owned by foreign branchA South African company (local currency: Rands: R) has a branch in Britain (local currency:Pound: £). On 1 January 20X1, the branch in Britain bought a plant for £100 000 in cash. Spot rates Date (Rand: Pound) 1 January 20X1 R12.0: £1 31 December 20X1 R10.7: £1 31 December 20X2 R10.0: £1The plant is depreciated to a nil residual value over 5 years using the straight-line method.The recoverable amount was calculated on 31 December 20X2: £70 000.Required:Show all journal entries for the years ended 31 December 20X1 and 31 December 20X2:A. in the books of the British branch; andB. in the books of the South African entity.Solution to example 6A: plant: journals in the books of the foreign branchJournals in the books of the foreign branch: denominated in Pounds Debit Credit1 January 20X1Plant: cost Given: £100 000 100 000 Bank 100 000Purchased plant31 December 20X1Depreciation (£100 000 – 0) / 5 years 20 000 Plant: accumulated depreciation 20 000Depreciation of plant31 December 20X2Depreciation (£100 000 – 0) / 5 years 20 000 Plant: accumulated depreciation 20 000Depreciation of plantNotice how, in the branch’s books, the asset is not considered to be impaired, since the recoverableamount in Pounds (£70 000) is greater than the carrying amount in Pounds (£100 000 – 20 000 –20 000). Notice that there are obviously no exchange differences in this example since the purchase inPounds is recorded in Pounds in the books of the British branch.Solution to example 6B: plant: journals in the books of the local entityJournals in the books of the local entity: denominated in Rands Debit Credit1 January 20X1Plant: cost £100 000 x R12 1 200 000 Bank 1 200 000Purchased plant from a foreign supplier (translated at spot rate)31 December 20X1Depreciation (1 200 000 – 0) / 5 years 240 000 Plant: accumulated depreciation 240 000Depreciation of plant31 December 20X2Depreciation (1 200 000 – 0) / 5 years 240 000 Plant: accumulated depreciation 240 000Depreciation of plantImpairment loss CA: 1 200 000 – 240 000 – 240 000 – 20 000 Plant: accumulated imp loss Recoverable amount: £70 000 x R10 20 000Impairment of plant (CA measured at spot rate on transaction date; RAmeasured at spot rate at year-end) 607 Chapter 19
  12. 12. Gripping IFRS Foreign currency transactionsNotice how the South African entity reflects an impairment on the plant despite the fact that, in Poundterms, the plant is not impaired! This is because of the change in the exchange rate.• the recoverable amount in the SA entity’s books is measured using the spot rate on the date at which the recoverable amount is calculated (R10: £1); whereas• the cost and related accumulated depreciation is measured using the spot rate on transaction date (R12: £1).Thus the change in exchange rate causes a South African impairment loss despite the fact that theBritish branch does not recognise an impairment loss! Pounds RandsCarrying amount: 31/12/20X2 Pounds: £100 000 x 3 / 5 yrs 60 000 720 000 Rands: £100 000 x 3 / 5 yrs x R12Recoverable amount: 31/12/20X2 Pounds: £70 000 70 000 700 000 Rands: £70 000 x R10Impairment N/A 20 0002.6 Exchange differences on monetary itemsIt should now be quite clear that fluctuating currency exchange rates will therefore have aneffect on all monetary items that are denominated in a foreign currency, including:• sales to a foreign customer (export) on credit;• purchases from a foreign supplier (import) on credit;• loans made to a foreign borrower; and• loans raised from a foreign lender.Although the basic principles apply to import, export and loan transactions, loan transactionshave an added complexity, being the interest accrual. Let us therefore first look at thejournals involving exports and imports and then let us look at loan transactions.2.6.1 Import and export transactions2.6.1.1 Transaction and settlement on the same day (cash transaction)If the date on which the transaction is journalised (transaction date) is the same date on whichcash changes hands in settlement of the transaction (settlement date), then there wouldobviously be no exchange differences to account for.Example 7: import transaction - settled on same day (cash transaction)A company in Botswana purchased inventory for £100 from a company in Britain on5 March 20X1, the transaction date.The purchase price was paid on this same day, when the spot rate was P3: £1.The local currency (functional currency) in Botswana is the Pula (P).The local currency (functional currency) in Britain is the Pound (£).Required:Show the journal entry/ies in the books of the company in Botswana.Solution to example 7: import transaction - settled on same day Debit Credit5 March 20X1Inventory 300 Bank 300Purchase of inventory: £100 x 3 = P300No exchange differences are possible since there is no balance payable that would need translation. 608 Chapter 19
  13. 13. Gripping IFRS Foreign currency transactionsExample 8: export transaction - settled on same day (cash transaction)A company in the United Kingdom sold inventory for P1 200 to a company in Botswana on17 May 20X5, the transaction date.The sale proceeds were received on the same day when the spot rate was P4: £1.The cost of the inventory to the UK company was £150.The local currency (functional currency) in Botswana is the Pula (P).The local currency (functional currency) in the United Kingdom is the Pound (£).Required:Show the journal entries in the books of the company in the United Kingdom.Solution to example 8: export transaction - settled on same day17 May 20X5 Debit CreditBank 300 Sales 300Sale of inventory for cash: P1200 / 4 = £300Cost of sales 150 Inventory 150Recording cost of the inventory sold: amount given2.6.1.2 Settlement deferred (credit transactions)Exchange differences arise when the settlement date occurs after transaction date. The initialtransaction (e.g. asset acquired, expense incurred or sale earned) is recorded at the spot rateon the transaction date and remains unaffected by movements in the exchange rates. Anymovement in the exchange rate after transaction date relating to the amount outstanding(payable or receivable) is recorded as a foreign exchange gain (income) or foreign exchangeloss (expense).2.6.1.2.1 Settlement of a credit transaction before year-endWhen the settlement of a credit transaction occurs before year-end:• record the initial transaction at spot rate on transaction date;• convert the outstanding balance (owing or receivable) to the spot rate on settlement date;• record the payment (made or received).Example 9: import - credit transaction settled before year-endA company in Botswana purchased inventory for £100 from a company in Britain on5 March 20X1, the transaction date. The purchase price was paid on 5 April 20X1. The year-end of the company in Botswana is 30 April 20X1. Spot rates Date (Pula: Pound) 5 March 20X1 P3: £1 5 April 20X1 P4: £1Required:Show the journal entry/ies in the books of the company in Botswana.Solution to example 9: import - credit transaction settled before year-end5 March 20X1 Debit CreditInventory 300 Foreign creditor 300Purchase of inventory on credit: £100 x 3 = P300 609 Chapter 19
  14. 14. Gripping IFRS Foreign currency transactions5 April 20X1 Debit CreditForeign exchange loss 100 Foreign creditor 100Translation of creditor to spot rate on settlement date: (£100 x 4) -300 = P100Foreign creditor 400 Bank 400Payment of creditor at spot rate on settlement date: £100 x 4 = P400Notice that since the £ became more expensive (£1 cost P3 on transaction date but cost P4 on date ofsettlement), the Botswana company made a loss of P100 by not paying for the inventory on date ofacquisition (transaction date). The cost of the inventory, however, remains unaffected since this is anon-monetary item!Example 10: export - credit transaction settled before year-endA company in the United Kingdom sold inventory for P1 200 to a company in Botswana on17 May 20X5, the transaction date. The inventory was paid for on 13 June 20X5.The inventory cost the UK company £150.The year-end of the company in the United Kingdom is 30 September.Relevant exchange rates are: Spot rates Date (Pound: Pula) 17 May 20X5 £1: P4 13 June 20X5 £1: P3Required:Show the journal entries in the books of the company in the United Kingdom.Solution to example 10: export - credit transaction settled before year-end17 May 20X5 Debit CreditForeign debtor 300 Sales 300Sale of inventory: P1 200 / 4 = £30031 March 20X5Cost of sales 150 Inventory 150Recording cost of sale of inventory: Cost = £150 (given)13 June 20X5Foreign debtor 100 Foreign exchange gain 100Translating debtor at settlement date: P1 200 / 3 – 300Bank 400 Foreign debtor 400Amount received from foreign debtor: P1 200 / 32.6.1.2.2 Settlement of a credit transaction after year-endWhen the settlement of a credit transaction occurs after year-end:• record the initial transaction at spot rate on transaction date;• translate the outstanding balances (owing or receivable) to the spot rate on translation date (year-end);• convert the outstanding balances (owing or receivable) to the spot rate on settlement date;• record the payment (made or received). 610 Chapter 19
  15. 15. Gripping IFRS Foreign currency transactionsExample 11: import - credit transaction settled after year-endA company in Botswana purchased inventory for £100 from a company in Britain on5 March 20X1, the transaction date. The purchase price was paid on 5 April 20X1. The yearend of the company in Botswana is 31 March. Spot rates Date (Pound: Pula) 5 March 20X1 £1: P3 31 March 20X1 £1: P3.70 5 April 20X1 £1: P4Required:Show the journal entry/ies in the books of the company in Botswana.Solution to example 11: import - credit transaction settled after year-end Debit Credit5 March 20X1Inventory £100 x 3 = P300 300 Foreign creditor 300Purchase of inventory on creditForeign exchange loss (£100 x 3.7) – 300 = P70 70 Foreign creditor 70Translation of creditor to spot rate at year-end5 April 20X1Foreign exchange loss (£100 x 4) – (300 + 70) = P30 30 Foreign creditor 30Conversion of creditor to spot rate on settlement dateForeign creditor £100 x 4 = P400 400 Bank 400Payment of creditor at spot rate on settlement dateNotice that since the £ became more expensive (£1 cost P3 on transaction date but cost P4 on date ofsettlement), the Botswana company made a loss of P100 by not paying for the inventory on the date ofacquisition (transaction date). This loss is recognised partially in the year ended 31 March 20X1(P70) and partially in the year ended 31 March 20X2 (P30).The cost of inventory remained unaffected because this is a non-monetary item!Example 12: export - credit transaction settled after year-endA company in the United Kingdom sold inventory for P1 200 to a company in Botswana on17 May 20X5, the transaction date. The sale proceeds were received on 13 June 20X5.The cost of the inventory to the UK company was £150.The UK company has a 31 May financial year-end.Relevant exchange rates are: Spot rates Date (Pound: Pula) 17 May 20X5 £1: P4 31 May 20X5 £1: P3.4 13 June 20X5 £1: P3 Required:Show the journal entries in the books of the company in the United Kingdom. 611 Chapter 19
  16. 16. Gripping IFRS Foreign currency transactionsSolution to example 12: export - credit transaction settled after year-end17 May 20X5 Debit CreditForeign debtor P1200 / 4 = £300 300 Sales 300Sale of inventoryCost of sales Cost = £150 (given) 150 Inventory 150Recording the cost of the inventory sold31 May 20X5Foreign debtor P1200 / £3.4 = £353 - 300 53 Foreign exchange gain 53Translating the foreign debtor at year-end13 June 20X5Foreign debtor P1200 / £3 = 400 – (300 + 53) = £47 47 Foreign exchange gain 47Translating foreign debtor at settlement dateBank P1200 / £3 400 Foreign debtor 400Proceeds received from foreign debtorNotice how the sales figure of 300 remains unaffected by changes in the exchange rate. This isbecause sales is a non-monetary item (you may want to read the definition of monetary items).Example 13: import – credit transaction – another exampleA company in the United Kingdom ordered inventory to the value of $900 from an Americancompany on 16 January 20X1. The transaction date is 5 February 20X1.The year-end is 31 March 20X1. The relevant exchange rates are as follows: Spot rates Date (Pound: dollar) 16 January 20X1 £1: $2.2 5 February 20X1 £1: $2.5 31 March 20X1 £1: $2.25 5 April 20X1 £1: $3.0Required:Show all journal entries and show the balances in the trial balance of the UK company as at31 March 20X1 assuming that the UK company paid the American company on:A. 5 February 20X1 (on transaction date; i.e. before year-end).B. 31 March 20X1 (at year-end).C. 5 April 20X1 (after year-end).Solution to example 13A: import – credit transaction – payment before year-endJournals:5 February 20X1 Debit CreditInventory $900 / £2.5 360 Bank 360Purchase of inventory: exchange rate £1: $2.5Trial balance as at 31 March 20X1 (extracts) Debit CreditInventory 360Creditor 0 612 Chapter 19
  17. 17. Gripping IFRS Foreign currency transactionsSolution to example 13B: import – credit transaction – payment at year-endJournals:5 February 20X1 Debit CreditInventory $900 / £2.5 360 Foreign creditor 360Purchase of inventory: exchange rate £1: $2.531 March 20X1Foreign exchange loss (expense) $900 / 2.25 – 360 40 Foreign creditor 40Translation of foreign creditor before paymentForeign creditor $900 / 2.25 = 400 400 Bank 400Payment of foreign creditor:Trial BalanceAs at 31 March 20X1 (extracts) Debit CreditInventory 360Foreign creditor 0Foreign exchange loss (expense) 40Solution to example 13C: import – credit transaction – payment after year-endJournals:5 February 20X1 Debit CreditInventory $900 / £2.5 360 Foreign creditor 360Purchase of inventory: exchange rate £1: $2.531 March 20X1Foreign exchange loss (expense) $900 / 2.25 – 360 40 Foreign creditor 40Translation of foreign creditor at year-end5 April 20X1Foreign creditor $900/ 3 – (360 + 40) 100 Foreign exchange gain (income) 100Translation of the foreign creditor before paymentForeign creditor $900/ 3 300 Bank 300Payment of foreign creditorTrial BalanceAs at 31 March 20X1 (extracts) Debit CreditInventory 360Foreign creditor 400Foreign exchange loss (expense) 40Notice that there is no exchange gain or loss when the amount is paid on transaction date (part A).Contrast this with:• part B where the foreign exchange loss recognised to payment date is 40; and• part C where a foreign exchange loss of 40 is recognised in 20X1 and a foreign exchange gain of 100 is recognised in 20X2 (i.e. a net foreign exchange gain of 100 – 40 = 60 on this transaction).In all 3 scenarios, the value of the inventory remains at £360 because this is a non-monetary item. 613 Chapter 19
  18. 18. Gripping IFRS Foreign currency transactions2.6.2 Foreign loansThe third type of possible transactions is the granting of loans to foreign entities or the receiptof a loan from a foreign lender.Interest receivable (on loans made) or interest payable (on loans received) must be calculatedbased on the outstanding foreign currency amount and then translated into the local currencyat the average rate over the period that the interest was earned.The easiest way to do this correctly is:• calculate the loan amortisation table in the foreign currency;• journalise the payment at the spot rate;• journalise the interest at the average rate; and• calculate the difference between the carrying amount of the loan and the value of the balance owing at spot rate at year end.This is best explained by way of an example:Example 14: foreign loansBrix ’n Stones Limited, a South African brick laying conglomerate, obtained a long term loanfrom Gill Bates, living in the Cayman Islands. The terms of the loan were as follows:• Gill transfers EUR100 000 into Brix ’n Stones Limited’s bank account on 1 January 20X4.• The interest rate on the loan was 7,931% p.a.• Brix ‘n Stones is required to make repayments on the loan of EUR25 000 annually, with the first payment falling due on 31 December 20X4.Brix ’n Stones Limited has the ZAR (South African Rand) as its functional currency. Thecurrency used in the Cayman Islands is the EUR (Euro). Brix ‘n Stones Limited has a 31December financial year-end.Relevant exchange rates are: Date Spot rates Average rates 1 January 20X4 EUR1: ZAR8 31 December 20X4 EUR1: ZAR8.5 31 December 20X5 EUR1: ZAR7.5 20X4 EUR1: ZAR8.20 20X5 EUR1: ZAR7.70Required:Show the journal entries required to record the above loan transaction in Brix ’n StonesLimited’s accounting records for the years ended 31 December 20X4 and 31 December 20X5.Solution to example 14: foreign loansJournals: Debit Credit1 January 20X4Bank 100 000 x 8 800 000 Long-term loan 800 000Proceeds received on the foreign loan raised from Cayman Islands31 December 20X4Finance cost 7 931 (W1) x 8.2 = 213 200 65 034 Long-term loan 65 034Interest expense on the foreign loan (converted at average rates) 614 Chapter 19
  19. 19. Gripping IFRS Foreign currency transactions31 December 20X4 continued … Debit CreditLong-term loan 25 000 x 8.5 212 500 Bank 212 500Payment of instalment on loan: (at spot rate on pmt date)Foreign exchange loss 82 931 (W1) x 8.5 – balance so far: 52 380 Long-term loan (800 000 + 65 034 – 212 500) 52 380Translating foreign loan at year end (at spot rate at year-end)31 December 20X5Finance cost 6 577 (W1) x 7.70 50 643 Long-term loan 50 643Interest expense raised on loan (converted at average rates)Long-term loan 25 000 x 7.5 187 500 Bank 187 500Payment of instalment on loan: (at spot rate on pmt date)Long-term loan 64 508 (W1) x 7.5 – balance so far: 84 247 Foreign exchange gain (82 931 x 8.5 + 50 643 – 187 500) 84 247Translating foreign loan at year end (at spot rate at year-end)Working 1: Effective interest rate table in foreign currency: EurosDate Interest Payments Balance 7,931% 100 00020X4 7 931 (25 000) 82 93120X5 6 577 (25 000) 64 50820X6 5 116 (25 000) 44 62420X7 3 539 (25 000) 23 16320X8 1 837 (25 000) 0 25 000 (125 000)3. Presentation and functional currencies3.1 GeneralIAS 21 allows an entity to present its financial statements in whichever currency it chooses to,this is then known as the presentation currency. However, IAS 21 requires that an entity’stransactions and balances be measured in that entity’s functional currency. Thus entities mustestablish their functional currencies. It is possible for an entity’s functional and presentationcurrency to be the same currency, but where it is not the same, a translation reserve willresult.3.2 Determining the functional currencyA functional currency is defined as the currency of the primary economic environment inwhich the entity operates. The primary economic environment in which an entity operates isusually taken to be the environment in which it primarily generates and expends cash.In establishing its functional currency, an entity should consider (extracts from IAS 21):• the currency that mainly influences the sales prices for goods and services (this will often be the currency in which prices for its goods and services are denominated and settled);• the currency of the country whose competitive forces and regulations mainly determine the sales prices of its goods and services; 615 Chapter 19
  20. 20. Gripping IFRS Foreign currency transactions• the currency that mainly influences labour, material and other costs of providing goods or services (this will often be the currency in which such costs are denominated and settled);• the currency in which funds from financing activities (i.e. issuing debt and equity instruments) are generated; and• the currency in which receipts from operating activities are usually retained.As these factors usually do not change often, once a functional currency is determined it is notchanged unless an entity’s circumstances have changed so significantly that the above factorswould result in a different functional currency being more appropriate.3.3 Accounting for a change in functional currencyAn entity may not change its functional currency unless there is a change in the underlyingtransactions and conditions that result in changes to the factors discussed in 3.2 above.Should there be a change in functional currency, it must be accounted for prospectively fromthe date of change of functional currency.Accounting for such a change is relatively simple. All items are translated into the functionalcurrency using the spot exchange rate available at the date of change. For non-monetaryitems, the new translated amount shall now be considered to be their historical cost.3.4 Using a presentation currency other than the functional currencyAs stated before, an entity may choose to present its financial statements in a currency of itschoice. That currency is then known as the presentation currency. Should an entity choose todisclose financial statements in a currency other than its functional currency, it will have totranslate all of its items from the functional to the presentation currency at year end.The following procedure is used to translate an entity’s trial balance into a presentationcurrency different to its functional currency:• all assets and liabilities (including comparative amounts) shall be translated into the presentation currency using the closing rate available at the reporting date;• all incomes and expenses shall be translated at the spot rate available at the dates of the various transactions (for practical purposes, it is often acceptable to use the average rate for the presentation period, provided the currency did not fluctuate too much); and• all resulting exchange differences are recognised in other comprehensive income (the account in which these exchange differences are accumulated is often referred to as the foreign currency translation reserve).3.4.1 Explanation of the foreign currency translation reserveExchange differences arise upon translation because:• assets and liabilities are translated at one rate, while movements in those assets and liabilities (represented by incomes and expenses) are translated at a different rate; and• opening balances of net assets are translated at a rate different to the previous closing rate. 616 Chapter 19
  21. 21. Gripping IFRS Foreign currency transactionsExample 15: foreign currency translation reserveSticky Fingers Limited, a sweet manufacturer in Never-never Land, has a functional currencyof Chocca’s (C). It has decided to present its financial statements in the currency of FarawayLand, (an island nearby), as most of its shareholders reside on this island. Faraway Land’scurrency is the Flipper (F). The following exchange rates are available: Dates Exchange Rates 20X5 1chocca: 6.5 flippers Average rate 31 December 20X5 1chocca: 7 flippers Spot rate Trial balance of Sticky Fingers Ltd at 31 December 20X5 Debit Credit Accounts payable 294 600 Accounts receivable 155 000 Bank 300 000 Land & buildings 944 300 Property, plant & equipment 600 000 Investments – at fair value 120 000 Ordinary share capital 403 300 General reserve 680 900 Long-term loan 810 500 Sales 1 509 500 Cost of sales 733 200 Operating expenses 407 000 Taxation 439 300 3 698 800 3 698 800Required:Translate the above trial balance into the presentation currency using the method required byIAS 21.Solution to example 15: foreign currency translation reserveAccount Working Debit CreditAccounts payable 294 600 x 7 2 062 200Accounts receivable 155 000 x 7 1 085 000Bank 300 000 x 7 2 100 000Land & buildings 944 300 x 7 6 610 100Property, plant & equipment 600 000 x 7 4 200 000Investments – at fair value 120 000 x 7 840 000Ordinary share capital 403 300 x 7 2 823 100General reserve 680 900 x 7 4 766 300Long-term loan 810 500 x 7 5 673 500Sales 1 509 500 x 6.5 9 811 750Cost of sales 733 200 x 6.5 4 765 800Operating expenses 407 000 x 6.5 2 645 500Taxation 439 300 x 6.5 2 855 450Foreign currency translation reserve Balancing figure 35 000 25 136 850 25 136 850If the foreign currency translation reserve relates to a foreign operation and if this foreignoperation is subsequently disposed of, the reserve would be reclassified from othercomprehensive income (where the exchange differences are accumulated as a separatecomponent of equity) to profit or loss, and disclosed as a reclassification adjustment.Since this textbook does not cover consolidations, foreign operations is not covered further inthis chapter. 617 Chapter 19
  22. 22. Gripping IFRS Foreign currency transactions4. Presentation and disclosureThe following disclosures are required by IAS 21:• the amount of the exchange differences recognised in profit and loss except for those arising on financial instruments measured at fair value through profit or loss;• the net exchange difference recognised in other comprehensive income and accumulated in a separate component of equity, reconciling the amount of such exchange differences at the beginning and end of the period.• if there is a change in the functional currency, state this fact and the reason for the change in functional currency.• where the presentation currency differs from the functional currency, - state the functional currency and the reason for using a different presentation currency; - it shall describe the financial statements as complying with the IFRSs only if they comply with all the requirements of each applicable IFRS including the method required for translating functional currency items to presentation currency amounts.• when an entity displays its financial statements or other financial information in a currency that is different from either its functional currency or its presentation currency and the IFRS requirements (referred to in the above bullet) are not all met, it shall: - clearly identify the information as supplementary information to distinguish it from the information that complies with IFRSs; - disclose the currency in which the supplementary information is displayed; - disclose the entity’s functional currency and the method of translation used to determine the supplementary information. 618 Chapter 19
  23. 23. Gripping IFRS Foreign currency transactions 5. Summary Foreign currency transactions Functional currency Exchange rates Dates• Of the primary • Two formats: • Transaction date economic environment • How much LC must • Reporting date• Currency in which all be paid for 1 unit • Settlement date transactions and of FC; or balances must be • How much FC can measured be bought for 1 unit of LC Recognition In profit and loss Measurement Initial Subsequent• spot rate on transaction date • Monetary: Spot rate on translation dates: settlement/ reporting dates • Non-monetary Historical cost: Spot rate on transaction date Other value: Spot rate on date that other value was determined 619 Chapter 19

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