CH. 16 BASIC FOREX

Question 1

Define Function Currency?

What are the primary factors to consider when determining functional currency?

if Primary factors are inconclusive, what are the Secondary Factors?

How do you determine if a foreign operation should adopt parents functional currency?

Answer 1

• Definition of Functional Currency*
• *An entity maintains its day-to-day financial records in its functional currency.**

“currency of the primary economic environment where the entity operates”

Primary factors to consider when determining its functional currency:

• The currency that mainly influences sales prices for goods and services
• The currency of the country whose competitive forces and regulations mainly determine the sales price of goods and services
• The currency mainly influences labour, materials and other costs of providing goods and services.

If the primary factors are inconclusive then the following - secondary factors should also be considered:

• currency in which funds from financing activities are generated
• currency in which receipts from operating activities are retained.

Foreign Subsidiary

There are times when a foreign subsidiary, rather than applying the above rules, should simply use the same functional currency as its parent.

In determining this, IAS 21 says that the following factors should be considered:

• Whether the foreign operation operates as an extension of the parent, rather than having significant autonomy
• The level of transactions with the parent
• Whether cash flows are readily available for remittance to its parent
• Whether the foreign operation has sufficient cash flows to service its debts
  without needing funds from its parent.

Question 2

How are foreign transactions initially recorded?

Answer 2

On Initial recognition

For transactions between the functional currency and the foreign currency, must each be translated on the date by using:

• Spot exchange rate. - rate on the day.

or

• An average rate for a period:- may be used as an approximation if rates do not fluctuate significantly.

Question 3

How are foreign currency items treated at the Year-End?

Answer 3

At the end of the reporting period, foreign currency assets and liabilities are treated as follows

• Monetary assets and liabilities:
  
  • RETRANSLATED AT THE CLOSING DATE using the Closing Rate. e.g
    
    • Foreign Cash held in hand or bank.
    • Trade Payables or Receivables
    • Bank Loans
• Non-Monetary Assets measured in terms of historical cost (eg non-current assets)
  
  • ​Not Restated
    
    • ​PPE held at H.c
    • Inventories
• Non-Monetary Assets measured at fair value:
  
  • Not Restated, But are restated on the date when the Fair Value is Measured
    
    • I.e F.V Measeurment often happens at the closing date/Year-End, so likely to be remeasured at the closing rate.

Question 4

What is an Exchange Difference?

and

Name the types of differences and how are they accounted for?

Answer 4

Exchange Differences

• When cash is received from an overseas credit customer, the settled amount should be translated into the functional currency using the spot exchange rate on the settlement date.
• If this amount differs from that used when the transaction occurred, there will be an exchange difference.

Exchange differences on settlement

• Exchange gains or losses on settlement of individual transactions are recognised in profit or loss in the period in which they arise.
• ​IAS 21 is not definitive in stating wherein profit or loss any such gains or losses are classified.
• *It would seem reasonable to regard them as items of operating expense or income. However, other profit or loss headings may also be appropriate.**

Exchange differences on the retranslation of monetary items at year-end

• Retranslation of monetary assets and liabilities must be recognised in profit or loss.
• IAS 21 does not specify the heading(s) under which such exchange gains or losses should be classified.
  It would seem reasonable to regard them as itemsof operating income or operating expense as appropriate.

Exchange differences on the retranslation of Non-monetary items FTVOCI

• If the fair value changes for a non-monetary asset recognised in (OCI), eg property, plant and equipment held under the revaluation model,
• The exchange difference component of the change in fair value is also recognised in OCI as a part of the revaluation, i.e it need not be separated out.
• So no exchange difference to show.

Question 5

Define Presentation Currency?

Answer 5

The presentation currency is defined by IAS 21 as

” the currency in which the entity presents its financial statements.”

• This can be different from the functional currency.

Question 6

How can there be a change in functional Currency?

and if there is a change in functional currency, How is it Treated?

Answer 6

The Functional Currency cannot be changed unless, there is a change to the underlying transactions, events and conditions of the primary and secondary factors.

If there has been a change in the Underlying Factors and the Functional Currency has now changed.

The effects are treated Prospectively:

• - All Items translated to the new functional currency using the spot rate on the date of the change.
• Translated amounts for non-monetary items are treated as their historical cost
• Exchange differences arising on FVTOCI items are not reclassified from equity to P/L to the disposal of the operation.

Question 7

What are the Criticisms of IAS 21 The Effects of Changes in Foreign Exchange Rates?

Answer 7

• *Criticisms of IAS 21**
• *Lack of theoretical underpinning**
• It is not clear why forex gains and losses on monetary items are recorded in P/L, yet forex gains and losses arising on consolidation of a foreign operation are reported in (OCI).
• It is argued that recording forex gains or losses on monetary items in profit or loss increases the volatility of reported profits. As such, it has been suggested that forex gains or losses should be recorded in OCI if there is a high chance of reversal.

Long-term items

• It is argued that retranslating long-term monetary items using the closing rate does not reflect economic substance. This is because a current exchange rate is being used to translate amounts that will be repaid in the future.
• ​Forex gains and losses on long-term items are highly likely to reverse prior to repayment/receipt, suggesting that such gains and losses are unrealised.
• *This provides further weight to the argument that foreign exchange** gains and losses on at least some monetary items should be recorded in OCI.

The average rate

• IAS 21 does not stipulate how to determine the average exchange rate in the reporting period. This increases the potential for entities to manipulate their net assets or total comprehensive income.
• The use of different average rates will limit comparability between reporting entities.

Monetary/non-monetary

• The distinction between monetary and non-monetary items can be ambiguous and would benefit from further clarification.

Foreign operations

• IAS 21 uses a restrictive definition of a ‘foreign operation’ – a subsidiary, associate, joint venture or branch whose activities are based in a country or currency other than that of the reporting entity.
• *It is argued that IAS 21 should instead use a definition of a foreign operation that is based on substance, rather​ than legal form.**