Question

Summarize International Accounting Standard 21, the effects of changes in foreign exchange rates; and International Accounting Standard 39, Financial Instruments, recognition and measurement.

Answer 1

IAS 21:

IAS 21 The Effects of Changes in Foreign Exchange Rates outlines how to account for foreign currency transactions and operations in financial statements, and also how to translate financial statements into a presentation currency. An entity is required to determine a functional currency (for each of its operations if necessary) based on the primary economic environment in which it operates and generally records foreign currency transactions using the spot conversion rate to that functional currency on the date of the transaction.

Objective:

The objective of IAS 21 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 into a presentation currency. The principal issues are which exchange rate(s) to use and how to report the effects of changes in exchange rates in the financial statements.

Foreign currency transactions

A foreign currency transaction should be recorded initially at the rate of exchange at the date of the transaction (use of averages is permitted if they are a reasonable approximation of actual).

At each subsequent balance sheet date:

• 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

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 recognised or in previous financial statements are reported in profit or loss in the period, with one exception.The exception is that exchange differences arising on monetary items that form part of the reporting entity's net investment in a foreign operation are recognised, in the consolidated financial statements that include the foreign operation, in other comprehensive income; they will be recognised in profit or loss on disposal of the net investment

As regards a monetary item that forms part of an entity's investment in a foreign operation, the accounting treatment in consolidated financial statements should not be dependent on the currency of the monetary item. Also, the accounting should not depend on which entity within the group conducts a transaction with the foreign operation. If a gain or loss on a non-monetary item is recognised in other comprehensive income (for example, a property revaluation under IAS 16), any foreign exchange component of that gain or loss is also recognised in other comprehensive income.

Translation from the functional currency to the presentation currency

The results and financial position of an entity whose functional currency is not the currency of a hyperinflationary economy are translated into a different presentation currency using the following procedure

• assets and liabilities for each balance sheet presented (including comparatives) 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 (including comparatives) are translated at exchange rates at the dates of the transactions; and
• all resulting exchange differences are recognised in other comprehensive income.

Special rules apply for translating the results and financial position of an entity whose functional currency is the currency of a hyperinflationary economy into a different presentation currency.

Where the foreign entity reports in the currency of a hyperinflationary economy, the financial statements of the foreign entity should be restated as required by IAS 29 Financial Reporting in Hyperinflationary Economies, before translation into the reporting currency.

The requirements of IAS 21 regarding transactions and translation of financial statements should be strictly applied in the changeover of the national currencies of participating Member States of the European Union to the Euro – monetary assets and liabilities should continue to be translated the closing rate, cumulative exchange differences should remain in equity and exchange differences resulting from the translation of liabilities denominated in participating currencies should not be included in the carrying amount of related assets.

Disposal of a foreign operation

When a foreign operation is disposed of, the cumulative amount of the exchange differences recognised in other comprehensive income and accumulated in the separate component of equity relating to that foreign operation shall be recognised in profit or loss when the gain or loss on disposal is recognised.

Tax effects of exchange differences

These must be accounted for using IAS 12 Income Taxes.

Disclosure

• The amount of exchange differences recognised in profit or loss (excluding differences arising on financial instruments measured at fair value through profit or loss in accordance with IAS 39)
• Net exchange differences recognised in other comprehensive income and accumulated 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 therefor

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 IFRS only if they comply with all the requirements of each applicable Standard (including IAS 21) and each applicable Interpretation.

IAS 39:

IAS 39 Financial Instruments: Recognition and Measurement outlines the requirements for the recognition and measurement of financial assets, financial liabilities, and some contracts to buy or sell non-financial items. Financial instruments are initially recognised when an entity becomes a party to the contractual provisions of the instrument, and are classified into various categories depending upon the type of instrument, which then determines the subsequent measurement of the instrument (typically amortised cost or fair value). Special rules apply to embedded derivatives and hedging instruments.

The Following are excluded from the scope of IAS 39:

• interests in subsidiaries, associates, and joint ventures accounted for under IAS 27 Consolidated and Separate Financial Statements, IAS 28 Investments in Associates, or IAS 31 Interests in Joint Ventures (or, for periods beginning on or after 1 January 2013, IFRS 10 Consolidated Financial Statements, IAS 27 Separate Financial Statements or IAS 28 Investments in Associates and Joint Ventures); however IAS 39 applies in cases where under those standards such interests are to be accounted for under IAS 39. The standard also applies to most derivatives on an interest in a subsidiary, associate, or joint venture
• employers' rights and obligations under employee benefit plans to which IAS 19 Employee Benefits applies
• forward contracts between an acquirer and selling shareholder to buy or sell an acquiree that will result in a business combination at a future acquisition date
• rights and obligations under insurance contracts, except IAS 39 does apply to financial instruments that take the form of an insurance (or reinsurance) contract but that principally involve the transfer of financial risks and derivatives embedded in insurance contracts
• financial instruments that meet the definition of own equity under IAS 32 Financial Instruments: Presentation
• financial instruments, contracts and obligations under share-based payment transactions to which IFRS 2 Share-based Payment applies
• rights to reimbursement payments to which IAS 37 Provisions, Contingent Liabilities and Contingent Assets applies

Recognition and derecognition:

A financial instrument is recognised in the financial statements when the entity becomes a party to the financial instrument contract. An entity removes a financial liability from its statement of financial position when its obligation is extinguished. An entity removes a financial asset from its statement of financial position when its contractual rights to the asset’s cash flows expire; when it has transferred the asset and substantially all the risks and rewards of ownership; or when it has transferred the asset, and has retained some substantial risks and rewards of ownership, but the other party may sell the asset. The risks and rewards retained are recognised as an asset.

Measurement:

A financial asset or financial liability is measured initially at fair value. Subsequent measurement depends on the category of financial instrument. Some categories are measured at amortised cost, and some at fair value. In limited circumstances other measurement bases apply, for example, certain financial guarantee contracts.

The following are measured at amortised cost:

• held to maturity investments—non-derivative financial assets that the entity has the positive intention and ability to hold to maturity;
• loans and receivables—non-derivative financial assets with fixed or determinable payments that are not quoted in an active market; and
• financial liabilities that are not carried at fair value through profit or loss or otherwise required to be measured in accordance with another measurement basis.

The following are measured at fair value:

• financial assets and financial liabilities held for trading—this category includes derivatives not designated as hedging instruments and financial assets and financial liabilities that the entity has designated for measurement at fair value. All changes in fair value are reported in profit or loss.
• available for sale financial assets—all financial assets that do not fall within one of the other categories. These are measured at fair value. Unrealised changes in fair value are reported in other comprehensive income. Realised changes in fair value (from sale or impairment) are reported in profit or loss at the time of realisation.

IAS 39 sets out the conditions where special hedge accounting is permitted, and the procedures for doing hedge accounting.