PAS 21: THE EFFECTS OF CHANGES IN FOREIGN EXCHANGE RATES

(Lecture Notes)

DEFINITION OF TERMS:
 Functional Currency - the currency of the primary economic environment in which the entity
operates. The primary economic environment in which an entity operates is normally the one in
which it primarily generates and expends cash.
 Presentation Currency – the currency in which financial statements are presented by the
reporting entity
 Exchange Rate – the ratio of exchange for two currencies
 Foreign Currency Transaction – the transaction that is denominated or requires settlement in a
foreign currency, including transactions arising when an entity:
 Buys or sells goods or services whose prices is denominated in a foreign currency
 Borrows or lends funds when the amounts of payable or receivable are dominated in a
foreign currency
 Acquires and disposes of assets, or incurs or settles liabilities, denominated in a foreign
currency
 Closing rate – the spot exchange rate at the balance sheet date
 Exchange difference – is the difference resulting from translating a given number of units of one
currency into another currency at different exchange rates
 Monetary items – units of currency held and assets and liabilities to be received and paid in a
fixed or determinable number of units of currency.
 Net investment in a foreign operation – the amount of the reporting entity’s interest in the net
assets of that operation.
 Foreign operation – an entity that is a subsidiary, associate, joint venture or branch of a
reporting entity, whose activities are based in a country other than that of a reporting entity.

PAS 21
The objective of which is to prescribe how to include foreign currency transactions and foreign
operations in the financial statements of an entity and how to translate financial statements from a
certain functional currency into the presentation currency. However, the principal issues are:
- Which exchange rates to use, and
- How to report the effects of changes in exchange rates in the financial statements

FOREIGN CURRENCY TRANSACTIONS

 Initial Recognition
A foreign currency transaction should be recorded initially at the exchange rate at the date of
the transaction. The use of averages is permitted if they are a reasonable estimate of actual.
 Reporting on Subsequent Balance Sheet Dates
- Foreign Currency monetary amounts should be reported using the closing rate.
- Non-monetary items carried at historical cost should be reported using the exchange rate at the
date of the transaction.
- Non-monetary items carried at fair value should be reported at the rate that existed when the
fair values were determined
 Recognition of Exchange Differences
- Exchange differences arising when monetary items are settled or when monetary items are
translated at rates different from those at which they were translated when initially recognized
are reported in profit or loss in the period.
- Exchange differences arising on monetary items that form part of the reporting entity’s net
investment, in a foreign operation are recognized, in the consolidated financial statements that
include the foreign operation, in a separate component of equity; upon disposal of the net
investment, they will be recognized in profit or loss.
- If a gain or loss on a non-monetary item is recognized directly in equity (for example, a property
revaluation under PAS 16), any foreign exchange component of that gain or loss is also
recognized directly in equity.
- An exchange loss on foreign currency debt used to finance the acquisition of an asset could no
longer be added to the carrying amount of the asset even if the loss resulted from a severe
devaluation of a currency against which there was no practical means of hedging.
 FOREIGN CURRENCY FINANCIAL STATEMENTS TRANSLATION
The results and financial position of an entity (refers to an entity whose functional currency is not the
currency of a hyperinflationary economy) are translated into a different presentation currency using the
following procedures:
 Assets and liabilities for each balance sheet presented are translated at the closing rate at the
date of that balance sheet. This would include any goodwill arising on the acquisition of a
foreign operation and any fair value adjustments to the carrying amounts of assets and liabilities
arising on the acquisition of that foreign operation are treated as part of the assets and liabilities
of the foreign operation.
 Income and expenses for each income statement are translated at exchange rates at the dates
of the transactions. For practical reasons, the use of average rate for the period may be used as
translation basis. However, if the exchange rates fluctuate significantly, the use of the average
rate for a period is inappropriate.
 All resulting exchange differences are recognized as a separate component of equity.

CHOICE OF FUNCTIONAL CURRENCY

Nature of operating and financial relationship between a parent and its foreign operation
↓ ↓
Foreign operation operates independently in Foreign operation is integrated with parent’s
economic and financial matters operation
↓ ↓
Functional currency should be the local currency Functional currency should be the parent’s
or a third currency currency
↓ ↓
Translation process (closing rate method) Remeasurement process (temporal method)

- Remeasurement is deemed necessary if

the books of the foreign operations are
kept in a currency that is not its functional
currency

COMPARISON OF THE TWO METHODS

*BALANCE SHEET ACCOUNTS*
Balance Sheet Current/Closing Rate Method Remeasurement (Temporal) Method
Monetary assets and liabilities Current/ closing rate Current/ closing rate
(e.g. receivables, payables,
cash and fixed deposits)
Non-monetary items at Current/ closing rate Historical Rate
historical cost (e.g. fixed For subsidiaries that have been
assets, investments at cost, acquired by the parent, the exchange
prepaid items, inventories rate on the date of acquisition serves
and intangible assets) as the historical rate for items that
were acquired before the date of
acquisition of the subsidiary by the
parent.
Non-monetary items at fair Current/ closing rate Rate at the date of the revaluation or
value (e.g. equity investment fair value determination
and re valued fixed assets)
Capital Stocks and pre- Historical (or actual) rate Historical (or actual) rate
acquisition retained earnings
Post-acquisition retained Not translated using a single Not translated using a single exchange
earnings exchange rate. This is a rate. This is a cumulative figure that is
cumulative figure that is carried forward from year to year
carried forward from year to
year
Translation gains or losses Other comprehensive income Taken to income statement as
(e.g. foreign currency gains/losses; remeasurement
translation reserve or the gain/loss arising from the revaluation
foreign currency translation of a non-monetary item is taken to
gain/loss OCI if the revaluation gains/losses are
taken to OCI.
*INCOME STATEMENT ACCOUNTS*
Income Statement Current/Closing Rate Method Remeasurement (Temporal) Method
Sales, purchases, expenses Historical rate or actual rate; Historical rate or actual rate;
and income items that result However, for practical However, for practical purpose, an
to outflow or inflow of purpose, an average rate may average rate may be used
monetary items be used on the assumption
that the items are evenly
spread out over the period
Cost of sales Historical rate or actual rate at Historical rate or actual rate at the
the date when inventory is date when inventory is sold or
sold or average rate if the cost average rate if the cost of sales is
of sales is evenly spread out evenly spread out
Depreciation, amortization Historical rate or actual rate at Historical rate of original acquisition
and any other allocation of the date when the expense is (either at the date of purchase for
non-monetary items incurred, or average rate if the historical cost items or the date of
expense is incurred evenly valuation for items carried at fair
throughout the year value)
Dividends and other Historical rate or actual rate Rate at the date of the revaluation or
appropriation of profits fair value determination

DISPOSAL OF A FOREIGN OPERATION

When a foreign operation is disposed, the cumulative amount of the exchange differences deferred in
the separate component of equity relating to that foreign operation shall be recognized in profit or loss
when the gain or loss on disposal is recognized.

CONVENIENCE TRANSLATIONS
Sometimes, 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 simply by translating all
amounts at end-of-period exchange rates. This is sometimes called a convenience translation. A result of
making a convenience translation is that the resulting financial information does not comply with all
PFRS. In this case, the following disclosures are required:
 Clearly identity the information as supplementary information to distinguish it from the
information that complies with PFRS
 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
When an entity presents its financial statements in a currency that is different from its functional
currency, it may describe those financial statements as complying with PFRS only if they comply with all
the requirements of each applicable Standard and Interpretation.

DISCLOSURE REQUIREMENTS
 The amount of exchange differences recognized in profit or loss
 Net exchange differences classified in a separate component of equity and a reconciliation of
the amount of such exchange differences at the beginning and end of the period
 When the presentation currency is different from the functional currency, disclose that fact
together with the functional currency and the reason for using a different presentation currency
 A change in the functional currency of either the reporting entity or a significant foreign
operation and the reason thereof.
 PAS 29: FINANCIAL REPORTING IN HYPERINFLATIONARY ECONOMIES
(Lecture Notes)

The objective of PAS 29 is to establish specific standards for enterprises reporting in the currency of a
hyperinflationary economy, so that the financial information provided is meaningful.

RESTATEMENT OF FINANCIAL STATEMENTS

(1) The basic principle in PAS 29 is that the financial statements of an entity that reports in the currency
of a hyperinflationary economy should be stated in terms of the measuring unit current at the balance
sheet date.
(2) Restatements are made by applying a general price index. Items such as monetary items that are
already stated at the measuring unit at the balance sheet date are not restated. Other terms are
restated based on the change in the general price index between the date those items were acquired or
incurred at the balance sheet date.
(3) A gain or loss on the net monetary position is included in net income. It should be disclosed
separately.

The standard does not establish an absolute rate at which hyperinflation is deemed to arise – but allows
judgment as to when restatement of financial statements become necessary. The characteristics of the
economic environment of a country which indicate the existence of hyperinflation include:
 The general population prefers to keep its wealth in non-monetary assets or in a relatively
stable foreign currency. Amounts of local currency held are immediately invested to
maintain purchasing power.
 The general population regards monetary amounts not in terms of the local currency but in
terms of a relatively stable foreign currency. Prices may be quoted in that currency.
 Sales and purchases on credit take place at prices that compensate for the expected loss of
purchasing power during the credit period, even if the period is short; and
 The cumulative inflation rate over three years approaches, or exceeds, 100%.

When an economy ceases to be hyperinflationary and an enterprise discontinues the preparation and
presentation of financial statements in accordance with PAS 29, it should treat the amounts expressed
in the measuring unit current at the end of the previous reporting period as the basis for the carrying
amounts in its subsequent financial statements

DISLOSURE REQUIREMENTS
- Gain or loss on monetary items
- The fact that financial statements and other prior period data have been restated for changes in
the general purchasing power of the reporting currency
- Whether the financial statements are based on a historical cost or current cost approach
- Identity and level of the price index at the balance sheet date and moves during the current and
previous reporting period.