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Chapter 15
THE EFFECTS OF CHANGES IN FOREIGN EXCHANGE RATES (IAS 21 )
OBJECTIVES
The purpose of IAS 21 is to set out how to account for transactions in foreign currencies and foreign operations. The Standard also shows how to translate financial
statements into a presentation currency. The presentation currency is the currency in which the financial statements are presented. The Standard permits an entity to
present its financial statements in any currency (or currencies). The key issues are the exchange rate(s) that should be used and where the effects of changes in
exchange rates are reported in the financial statements.
(in accordance with IAS 21)
DEFINITIONS OF KEY TERMS
Exchange difference. The difference resulting from translating a given number of units of one currency into another currency at different exchange rates.
Foreign operation. A subsidiary, associate, joint venture, or branch whose activities are based or conducted in a country or currency other than those of the
reporting entity.
Functional currency. The currency of the primary economic environment in which the entity operates.
Closing rate. The spot exchange rate at the end of the reporting period.
Spot rate. The exchange rate for immediate delivery.
Presentation currency. The currency that is used to present the financial statements.
FUNCTIONAL CURRENCY
The functional currency should be determined by looking at several factors. This currency should be the one in which the entity normally generates and spends cash
and in which transactions are normally denominated. All transactions in currencies other than the functional currency are treated as transactions in foreign currencies.
Five factors can be taken into account in making this decision.
The currency
1. That mainly influences the price at which goods and services are sold
2. Of the country whose competitive forces and regulations mainly influence the entity’s pricing structure
3. That influences the costs of the entity
4. In which funds are generated
5. In which receipts from operating activities are retained
The first three items are generally considered to be the most influential in deciding the functional currency.
An entity will have to determine the functional currency of a foreign operation, such as a foreign subsidiary, and whether it is the same currency as that of the
reporting entity. Such factors as whether the foreign entity is an extension of the reporting entity’s business, what proportion of its transactions are with the reporting
entity, and the nature of the cash flows will help determine the functional currency of the foreign operation.
The entity’s functional currency reflects the transactions, events, and conditions under which the entity conducts its business. Once decided on, the functional
currency does not change unless there is a change in the underlying nature of the transactions and relevant conditions and events.
If the functional currency is the currency of a hyperinflationary economy, the financial statements should be restated using IAS 29, Financial Reporting in
Hyperinflationary Economies.
Where there is a change in the functional currency, it should be applied from the date of change. A change must be linked to a change in the nature of the
underlying transactions. For example, a change in the major market may lead to a change in the currency that influences sales prices. The change is accounted for
prospectively, not retrospectively.
RECORDING FOREIGN CURRENCY TRANSACTIONS USING THE FUNCTIONAL CURRENCY
Foreign currency transactions should be recorded initially at the spot rate of exchange at the date of the transaction. An approximate rate can be used. For example,
in general, an average rate for a particular period can be used, but if exchange rates are fluctuating wildly, an average rate cannot be used.
Subsequently, at the end of each reporting period, foreign currency monetary amounts should be reported using the closing rate. Nonmonetary items measured at
historical cost should be reported using the exchange rate at the date of the transaction. Nonmonetary items carried at fair value should be reported at the rate that
existed when the fair values were determined.
It is possible that the carrying value for an item will have been determined by a comparison of two amounts that have been measured at different dates. For example,