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Chapter 19 Foreign Currency Transactions

Reference: IAS 21, IAS 39 and IFRS 7 Contents: 1. Definitions 2. Foreign currency transactions 2.1 General 2.2 How exchange rates are quoted Example 1: quoted exchange rates 2.3 Transactions 2.4 Dates 2.4.1 Determining the transaction date 2.4.2 Determining the settlement date 2.4.3 Determining the translation date Example 2: transaction, settlement and translation dates 2.5 Recognition and measurement 2.5.1 Initial recognition and measurement 2.5.2 Subsequent measurement: monetary items 2.5.2.1 Overview 2.5.2.2 Translation at the end of the reporting period 2.5.2.3 Translation at settlement date 2.5.2.4 Exchange difference Example 3: exchange differences 2.5.3 Subsequent measurement: non-monetary items Example 4: measurement of plant bought from foreign supplier Example 5: measurement of inventory owned by foreign branch Example 6: measurement of plant owned by foreign branch 2.6 Exchange differences on monetary items 2.6.1 Import and export transactions 2.6.1.1 Transaction and settlement on same day Example 7: import transaction: settled on same day Example 8: export transaction: settled on same day 2.6.1.2 Settlement deferred (credit transactions) 2.6.1.2.1 Settlement of a credit transaction before year-end Example 9: import: credit transaction settled before year-end Example 10: export: credit transaction settled before year-end 2.6.1.2.2 Settlement of a credit transaction after year-end Example 11: import: credit transaction settled after year-end Example 12: export: credit transaction settled after year-end Example 13: import: credit transaction: another example 2.6.2 Foreign loans Example 14: foreign loans Page 599 599 599 599 600 600 600 600 601 601 601 602 602 602 602 602 603 603 603 604 605 606 607 608 608 608 608 609 609 609 609 610 610 611 611 612 614 614

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Contents continued 3. Presentation and functional currencies 3.1 General 3.2 Determining the functional currency 3.3 Accounting for a change in functional currency 3.4 Using a presentation currency other than the functional currency 3.4.1 Explanation of foreign currency translation reserve Example 15: foreign currency translation reserve 4. Presentation and disclosure 5. Summary

Page 615 615 615 616 616 616 617 618 619

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1. Definitions The 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 arms 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). Foreign currency transactions General

2. 2.1

Businesses frequently enter into transactions with foreign entities. These transactions (involving incomes, expenses, assets and liabilities) may be denominated in foreign currencies (e.g. an invoice that is in dollars, is referred to as denominated in dollars). Since financial statements are prepared in one currency only, all foreign currency amounts must be converted into the currency used for the financial statement (presentation currency). To complicate matters, there is often a considerable time lag between the date that a foreign debtor or creditor is created and the date upon which that debtor pays or creditor is paid. This inevitably 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, which sets out the method to be used in converting currencies for inclusion in financial statements. 2.2 How exchange rates are quoted

An exchange rate is the price of one currency in another currency. For example, if we have two currencies, a local currency (LC) and a foreign currency (FC), we could quote the FC:LC exchange 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 as LC1: 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 currency dealer to buy or sell a particular currency, you will be quoted an exchange rate that is valid for that particular day only (i.e. immediate delivery). This exchange rate is called a spot rate.
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Example 1: quoted exchange rates You 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 rates
A: 1 000 / 1 x 2 = $2 000 B: $1 000 / 2 x 1 = 500 C: 1 / 2 = 0.5 therefore, the exchange rate would be 0.5: $1

2.3

Transactions

The types of foreign currency transactions that can be entered into are numerous. Common examples of transactions with foreign entities include: borrowing or lending money; purchasing or selling inventory; and purchasing or selling depreciable assets. 2.4 Dates

Dates involved with foreign currency transactions are very important because exchange rates differ from day-to-day. The following dates are significant when recording the foreign currency 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 definition and recognition criteria are met. The order date occurs before the transaction date. Since we are normally not interested in the events before transaction date, the order date is normally irrelevant. 2.4.1 Determining the transaction date The first thing that must be determined in a foreign currency transaction is the transaction date. The date on which the transaction must be recognised is established with reference to the IFRS that applies to the type of transaction in question. A rule of thumb for a purchase or sale transaction is that the transaction date would be when the risks and rewards of ownership transfer from one entity to the other entity. For regular import or export transactions, establishing the date that risks and rewards are transferred is complicated by the fact that goods sent to or ordered from other countries usually 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).

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If 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 be investigated first before determining the transaction date. 2.4.2 Determining the settlement date Next, 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 least one year-end occurs between transaction date and settlement date. The year-end/s falling between transaction and settlement date is known as the translation date. Example 2: determining transaction, settlement and translation dates On 13 January 20X4, Home Limited faxed an order for 1 000 yellow bicycles to Far Away Limited, a bicycle manufacturer in Iceland. On 16 January 20X4, Home Limited received a faxed confirmation from Far Away Limited informing them that the order had been accepted. On 25 January 20X4, Far Away Limited finished production of the required bicycles and packed them for delivery. On 1 February 20X4, the bicycles were delivered to one of Icelands many harbours and were loaded onto a ship. The ship set sail on 4 February 20X4. Due to stormy weather it only arrived at the port in Home Limiteds country on 31 March 20X4. The bicycles were offloaded and released from customs on the same day. On 5 April 20X4, the bicycles finally arrived in Home Limiteds 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.

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Solution to example 2: determining transaction, settlement and translation dates

A. The transaction date is 1 February 20X4: in terms of an F.O.B. transaction, the risks of ownership of the 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 Limiteds year-end on which date the foreign currency monetary item (foreign creditor) still exists, (the transaction date has occurred and the settlement 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 the bicycles 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 foreign currency monetary item (foreign creditor) existed. Thus there are no items to translate at either yearend. (explanation: at 28 February 20X4 the transaction date had not yet occurred and 28 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 measurement

2.5.1 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 it approximates the spot exchange rate. 2.5.2 Subsequent measurement: monetary items

2.5.2.1 Overview As an exchange rate changes (and most fluctuate on a daily basis), the measurement of amounts owing to or receivable from a foreign entity changes. For example, an exchange rate of FC1: LC4 in January can change to an exchange rate of FC1: LC7 in February and strengthen back to FC1: LC6 in March. Due to this, a foreign debtor or creditor will owe different 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 period If the monetary item is not settled by end of the reporting period, then an exchange difference is likely to be recognised. This is because the item was originally measured at the spot rate on transaction date. If it is not yet settled at the date a report is being drafted, the balance owing or receivable will need to be re-measured at the spot rate on the date of the report. If there is
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a 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 date The amount paid or received is based on the spot rate on settlement date. If the spot rate on transaction / reporting date (whichever is applicable) is different to the spot rate on settlement date, an exchange difference will arise. 2.5.2.4 Exchange differences The translation of monetary items will almost always result in exchange differences: gains or losses (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 in which they arise. If the foreign exchange gain or loss relates to a foreign operation that is consolidated into the entitys 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 item On 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: 28 February: 31 March: FC1: LC4 FC1: LC7 FC1: LC6

Required: 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 entitys 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 item
A. 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].

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C. Journals: Debit 31 January Foreign debtor Sales Sold goods to foreign customer 28 February Foreign debtor Foreign exchange gain Translating foreign debtor 31 March Foreign exchange loss Foreign debtor Translating foreign debtor 8 000 8 000 Credit

6 000 6 000

2 000 2 000

Notice how the amount of sales income recognised is unaffected by changes in the exchange rates.

2.5.3 Subsequent measurement: non-monetary items Non-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 occurs simply in terms of the relevant IFRS. These items are not affected by subsequent changes in exchange rates. For example, if an item of plant is purchased where the purchase was denominated in a foreign currency, this is converted into the local currency on transaction date 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, whilst measured 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 more amounts. Typical examples are plant, where the measurement at year-end depends on a comparison of the carrying amount with the recoverable amount. Another example includes inventory, where the measurement at year-end depends on a comparison of the cost with the net realisable value. The reason that an exchange rate can affect such items is because:
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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 supplier On 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.
Date 1 January 20X1 31 March 20X1 31 December 20X1 31 December 20X2 Spot rates (Rand: Dollar) R6.0: $1 R6.3: $1 R6.5: $1 R6.2: $1

The 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 in the books of the South African entity. Solution to example 4: non-monetary item: journals
1 January 20X1 Plant: cost $100 000 x R6 Foreign creditor Purchased plant from a foreign supplier (translated at spot rate) 31 March 20X1 Foreign exchange loss $100 000 x R6.30 R600 000 Foreign creditor Translating foreign creditor on settlement date (at latest spot rate) Foreign creditor Bank Payment of foreign creditor 31 December 20X1 Depreciation Plant: accumulated depreciation Depreciation of plant 31 December 20X2 Depreciation Plant: accumulated depreciation Depreciation of plant Impairment loss Plant: accumulated impairment loss Translating foreign debtor
$100 000 x R6.30

Debit 600 000

Credit 600 000

30 000 30 000

630 000 630 000

(R600 000 0) / 5 years

120 000 120 000

(R600 000 0) / 5 years

120 000 120 000

CA: 600 000 120 000 120 000 Recoverable amount: 320 000

40 000 40 000

Notice how the measurement of the non-monetary asset (plant) is not affected by the changes in the exchange rates. This is because it is a local currency denominated item.

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Example 5: non-monetary item: measurement of inventory owned by foreign branch A 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 supplier for 100 000 in cash. Spot rates Date (Rand: Pound) 1 January 20X1 R10.0: 1 31 December 20X1 R12.0: 1 The inventory is still in stock and its net realisable value is estimated to be 90 000 at 31 December 20X1. Required: Show all journal entries for the years ended 31 December 20X1: A. in the books of the British branch; and B. in the books of the South African entity. Solution to example 5A: inventory: journals in the books of a foreign branch
Journals in the foreign branch: denominated in Pounds Debit 1 January 20X1 Inventory Given: 100 000 Bank Purchased inventory from a local supplier (British) 31 December 20X1 Inventory write-down 100 000 90 000 Inventory Inventory written down to lower of cost or net realisable value 100 000 100 000 Credit

10 000 10 000

Notice how, in the branchs books, the inventory is written down since the net realisable value in Pounds is less than the carrying amount in Pounds.

Solution to example 5B: inventory: journals in the books of the local entity
Journals in the local entity: denominated in Rands Debit 1 January 20X1 Inventory 100 000 x R10 Bank Purchased inventory from a foreign supplier (translated at spot rate) 1 000 000 1 000 000 Credit

Notice how there is no write-down of inventory in the SA entitys books because the net realisable value 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 British branch recognises a write-down whyereas the South African books does not, is purely as a result of the change to the exchange rates! Pounds Rands Cost: 31/12/20X1 Pounds: 100 000 100 000 1 000 000 Rands: 100 000 x R10 Net realisable value: 31/12/20X1 Pounds: 90 000 90 000 1 080 000 Rands: 90 000 x R12 Write-down 10 000 N/A

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Example 6: non-monetary item: measurement of plant owned by foreign branch A 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.
Date 1 January 20X1 31 December 20X1 31 December 20X2 Spot rates (Rand: Pound) R12.0: 1 R10.7: 1 R10.0: 1

The 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; and B. in the books of the South African entity. Solution to example 6A: plant: journals in the books of the foreign branch
Journals in the books of the foreign branch: denominated in Pounds Debit 1 January 20X1 Plant: cost Bank Purchased plant 31 December 20X1 Depreciation Plant: accumulated depreciation Depreciation of plant 31 December 20X2 Depreciation Plant: accumulated depreciation Depreciation of plant
Given: 100 000

Credit

100 000 100 000

(100 000 0) / 5 years

20 000 20 000

(100 000 0) / 5 years

20 000 20 000

Notice how, in the branchs books, the asset is not considered to be impaired, since the recoverable amount 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 in Pounds is recorded in Pounds in the books of the British branch.

Solution to example 6B: plant: journals in the books of the local entity
Journals in the books of the local entity: denominated in Rands Debit 1 January 20X1 Plant: cost 100 000 x R12 Bank Purchased plant from a foreign supplier (translated at spot rate) 31 December 20X1 Depreciation (1 200 000 0) / 5 years Plant: accumulated depreciation Depreciation of plant 31 December 20X2 Depreciation (1 200 000 0) / 5 years Plant: accumulated depreciation Depreciation of plant Impairment loss CA: 1 200 000 240 000 240 000 Plant: accumulated imp loss Recoverable amount: 70 000 x R10 Impairment of plant (CA measured at spot rate on transaction date; RA measured at spot rate at year-end) 607 1 200 000 1 200 000 Credit

240 000 240 000

240 000 240 000 20 000 20 000

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Notice how the South African entity reflects an impairment on the plant despite the fact that, in Pound terms, the plant is not impaired! This is because of the change in the exchange rate. the recoverable amount in the SA entitys 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 the British branch does not recognise an impairment loss! Pounds Rands Carrying amount: 31/12/20X2 Pounds: 100 000 x 3 / 5 yrs 60 000 720 000 Recoverable amount: 31/12/20X2 Impairment
Rands: 100 000 x 3 / 5 yrs x R12 Pounds: 70 000 Rands: 70 000 x R10

70 000 N/A

700 000 20 000

2.6

Exchange differences on monetary items

It should now be quite clear that fluctuating currency exchange rates will therefore have an effect 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 transactions have an added complexity, being the interest accrual. Let us therefore first look at the journals involving exports and imports and then let us look at loan transactions. 2.6.1 Import and export transactions

2.6.1.1 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 which cash changes hands in settlement of the transaction (settlement date), then there would obviously 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 on 5 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 5 March 20X1 Inventory Bank Purchase of inventory: 100 x 3 = P300 300 300 Credit

No exchange differences are possible since there is no balance payable that would need translation.

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Example 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 on 17 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 day
17 May 20X5 Bank Sales Sale of inventory for cash: P1200 / 4 = 300 Cost of sales Inventory Recording cost of the inventory sold: amount given Debit 300 Credit 300 150 150

2.6.1.2 Settlement deferred (credit transactions) Exchange differences arise when the settlement date occurs after transaction date. The initial transaction (e.g. asset acquired, expense incurred or sale earned) is recorded at the spot rate on the transaction date and remains unaffected by movements in the exchange rates. Any movement 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 exchange loss (expense). 2.6.1.2.1 Settlement of a credit transaction before year-end When 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-end A company in Botswana purchased inventory for 100 from a company in Britain on 5 March 20X1, the transaction date. The purchase price was paid on 5 April 20X1. The yearend of the company in Botswana is 30 April 20X1.
Date 5 March 20X1 5 April 20X1 Spot rates (Pula: Pound) P3: 1 P4: 1

Required: Show the journal entry/ies in the books of the company in Botswana. Solution to example 9: import - credit transaction settled before year-end
5 March 20X1 Inventory Foreign creditor Purchase of inventory on credit: 100 x 3 = P300 609 Debit 300 Credit 300

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5 April 20X1 Foreign exchange loss Foreign creditor Translation of creditor to spot rate on settlement date: (100 x 4) 300 = P100 Foreign creditor Bank Payment of creditor at spot rate on settlement date: 100 x 4 = P400

Debit 100

Credit 100

400 400

Notice that since the became more expensive (1 cost P3 on transaction date but cost P4 on date of settlement), the Botswana company made a loss of P100 by not paying for the inventory on date of acquisition (transaction date). The cost of the inventory, however, remains unaffected since this is a non-monetary item!

Example 10: export - credit transaction settled before year-end A company in the United Kingdom sold inventory for P1 200 to a company in Botswana on 17 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:
Date 17 May 20X5 13 June 20X5 Spot rates (Pound: Pula) 1: P4 1: P3

Required: Show the journal entries in the books of the company in the United Kingdom. Solution to example 10: export - credit transaction settled before year-end
17 May 20X5 Foreign debtor Sales Sale of inventory: P1 200 / 4 = 300 31 March 20X5 Cost of sales Inventory Recording cost of sale of inventory: Cost = 150 (given) 13 June 20X5 Foreign debtor Foreign exchange gain Translating debtor at settlement date: P1 200 / 3 300 Bank Foreign debtor Amount received from foreign debtor: P1 200 / 3 Debit 300 Credit 300

150 150

100 100 400 400

2.6.1.2.2 Settlement of a credit transaction after year-end When 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).
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Example 11: import - credit transaction settled after year-end A company in Botswana purchased inventory for 100 from a company in Britain on 5 March 20X1, the transaction date. The purchase price was paid on 5 April 20X1. The year end 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: P4 Required: 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 5 March 20X1 Inventory 100 x 3 = P300 Foreign creditor Purchase of inventory on credit Foreign exchange loss (100 x 3.7) 300 = P70 Foreign creditor Translation of creditor to spot rate at year-end 5 April 20X1 Foreign exchange loss (100 x 4) (300 + 70) = P30 Foreign creditor Conversion of creditor to spot rate on settlement date Foreign creditor 100 x 4 = P400 Bank Payment of creditor at spot rate on settlement date 300 300 70 70 Credit

30 30 400 400

Notice that since the became more expensive (1 cost P3 on transaction date but cost P4 on date of settlement), the Botswana company made a loss of P100 by not paying for the inventory on the date of acquisition (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-end A company in the United Kingdom sold inventory for P1 200 to a company in Botswana on 17 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.

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Solution to example 12: export - credit transaction settled after year-end

17 May 20X5 Foreign debtor Sales Sale of inventory Debit 300 Credit 300 150 150

P1200 / 4 = 300

Cost of sales Cost = 150 (given) Inventory Recording the cost of the inventory sold 31 May 20X5 Foreign debtor P1200 / 3.4 = 353 - 300 Foreign exchange gain Translating the foreign debtor at year-end 13 June 20X5 Foreign debtor P1200 / 3 = 400 (300 + 53) = 47 Foreign exchange gain Translating foreign debtor at settlement date Bank P1200 / 3 Foreign debtor Proceeds received from foreign debtor

53 53

47 47 400 400

Notice how the sales figure of 300 remains unaffected by changes in the exchange rate. This is because sales is a non-monetary item (you may want to read the definition of monetary items).

Example 13: import credit transaction another example A company in the United Kingdom ordered inventory to the value of $900 from an American company 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:
Date 16 January 20X1 5 February 20X1 31 March 20X1 5 April 20X1 Spot rates (Pound: dollar) 1: $2.2 1: $2.5 1: $2.25 1: $3.0

Required: Show all journal entries and show the balances in the trial balance of the UK company as at 31 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-end
Journals: 5 February 20X1 Inventory $900 / 2.5 Bank Purchase of inventory: exchange rate 1: $2.5 Trial balance as at 31 March 20X1 (extracts) Inventory Creditor 612 Debit 360 Credit 0 Chapter 19 Debit 360 Credit 360

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Solution to example 13B: import credit transaction payment at year-end

Journals: 5 February 20X1 Inventory $900 / 2.5 Foreign creditor Purchase of inventory: exchange rate 1: $2.5 31 March 20X1 Foreign exchange loss (expense) $900 / 2.25 360 Foreign creditor Translation of foreign creditor before payment Foreign creditor $900 / 2.25 = 400 Bank Payment of foreign creditor:

Debit 360

Credit 360

40 40 400 400

Trial Balance As at 31 March 20X1 (extracts) Inventory Foreign creditor Foreign exchange loss (expense) Debit 360 40 Credit 0

Solution to example 13C: import credit transaction payment after year-end

Journals: 5 February 20X1 Inventory $900 / 2.5 Foreign creditor Purchase of inventory: exchange rate 1: $2.5 31 March 20X1 Foreign exchange loss (expense) $900 / 2.25 360 Foreign creditor Translation of foreign creditor at year-end 5 April 20X1 Foreign creditor $900/ 3 (360 + 40) Foreign exchange gain (income) Translation of the foreign creditor before payment Foreign creditor $900/ 3 Bank Payment of foreign creditor Trial Balance As at 31 March 20X1 (extracts) Inventory Foreign creditor Foreign exchange loss (expense) Debit 360 40 Credit 400

Debit 360

Credit 360

40 40

100 100 300 300

Notice 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

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2.6.2

Foreign loans

The third type of possible transactions is the granting of loans to foreign entities or the receipt of a loan from a foreign lender. Interest receivable (on loans made) or interest payable (on loans received) must be calculated based on the outstanding foreign currency amount and then translated into the local currency at 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 loans Brix n Stones Limited, a South African brick laying conglomerate, obtained a long term loan from Gill Bates, living in the Cayman Islands. The terms of the loan were as follows: Gill transfers EUR100 000 into Brix n Stones Limiteds 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. The currency used in the Cayman Islands is the EUR (Euro). Brix n Stones Limited has a 31 December financial year-end. Relevant exchange rates are:
Date 1 January 20X4 31 December 20X4 31 December 20X5 20X4 20X5 Spot rates EUR1: ZAR8 EUR1: ZAR8.5 EUR1: ZAR7.5 Average rates

EUR1: ZAR8.20 EUR1: ZAR7.70

Required: Show the journal entries required to record the above loan transaction in Brix n Stones Limiteds accounting records for the years ended 31 December 20X4 and 31 December 20X5. Solution to example 14: foreign loans
Journals: Debit 1 January 20X4 Bank 100 000 x 8 Long-term loan Proceeds received on the foreign loan raised from Cayman Islands 31 December 20X4 Finance cost 7 931 (W1) x 8.2 = 213 200 Long-term loan Interest expense on the foreign loan (converted at average rates) 800 000 800 000 Credit

65 034 65 034

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31 December 20X4 continued Long-term loan 25 000 x 8.5 Bank Payment of instalment on loan: (at spot rate on pmt date) Foreign exchange loss 82 931 (W1) x 8.5 balance so far: Long-term loan (800 000 + 65 034 212 500) Translating foreign loan at year end (at spot rate at year-end) 31 December 20X5 Finance cost 6 577 (W1) x 7.70 Long-term loan Interest expense raised on loan (converted at average rates) Long-term loan 25 000 x 7.5 Bank Payment of instalment on loan: (at spot rate on pmt date) Long-term loan 64 508 (W1) x 7.5 balance so far: Foreign exchange gain (82 931 x 8.5 + 50 643 187 500) Translating foreign loan at year end (at spot rate at year-end)

Debit 212 500

Credit 212 500

52 380 52 380

50 643 50 643 187 500 187 500 84 247 84 247

Working 1: Effective interest rate table in foreign currency: Euros Date Interest 7,931% 7 931 6 577 5 116 3 539 1 837 25 000 Payments Balance 100 000 82 931 64 508 44 624 23 163 0

20X4 20X5 20X6 20X7 20X8

(25 000) (25 000) (25 000) (25 000) (25 000) (125 000)

3. 3.1

Presentation and functional currencies General

IAS 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 entitys transactions and balances be measured in that entitys functional currency. Thus entities must establish their functional currencies. It is possible for an entitys functional and presentation currency to be the same currency, but where it is not the same, a translation reserve will result. 3.2 Determining the functional currency

A functional currency is defined as the currency of the primary economic environment in which the entity operates. The primary economic environment in which an entity operates is usually 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;
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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 not changed unless an entitys circumstances have changed so significantly that the above factors would result in a different functional currency being more appropriate. 3.3 Accounting for a change in functional currency

An entity may not change its functional currency unless there is a change in the underlying transactions 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 from the date of change of functional currency. Accounting for such a change is relatively simple. All items are translated into the functional currency using the spot exchange rate available at the date of change. For non-monetary items, the new translated amount shall now be considered to be their historical cost. 3.4 Using a presentation currency other than the functional currency

As stated before, an entity may choose to present its financial statements in a currency of its choice. That currency is then known as the presentation currency. Should an entity choose to disclose financial statements in a currency other than its functional currency, it will have to translate all of its items from the functional to the presentation currency at year end. The following procedure is used to translate an entitys trial balance into a presentation currency 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 reserve Exchange 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.

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Example 15: foreign currency translation reserve Sticky Fingers Limited, a sweet manufacturer in Never-never Land, has a functional currency of Choccas (C). It has decided to present its financial statements in the currency of Faraway Land, (an island nearby), as most of its shareholders reside on this island. Faraway Lands currency 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 Accounts payable Accounts receivable Bank Land & buildings Property, plant & equipment Investments at fair value Ordinary share capital General reserve Long-term loan Sales Cost of sales Operating expenses Taxation Debit 155 000 300 000 944 300 600 000 120 000 403 300 680 900 810 500 1 509 500 733 200 407 000 439 300 3 698 800 Credit 294 600

3 698 800

Required: Translate the above trial balance into the presentation currency using the method required by IAS 21. Solution to example 15: foreign currency translation reserve
Account Accounts payable Accounts receivable Bank Land & buildings Property, plant & equipment Investments at fair value Ordinary share capital General reserve Long-term loan Sales Cost of sales Operating expenses Taxation Foreign currency translation reserve Working 294 600 x 7 155 000 x 7 300 000 x 7 944 300 x 7 600 000 x 7 120 000 x 7 403 300 x 7 680 900 x 7 810 500 x 7 1 509 500 x 6.5 733 200 x 6.5 407 000 x 6.5 439 300 x 6.5 Balancing figure Debit 1 085 000 2 100 000 6 610 100 4 200 000 840 000 2 823 100 4 766 300 5 673 500 9 811 750 4 765 800 2 645 500 2 855 450 35 000 25 136 850 Credit 2 062 200

25 136 850

If the foreign currency translation reserve relates to a foreign operation and if this foreign operation is subsequently disposed of, the reserve would be reclassified from other comprehensive income (where the exchange differences are accumulated as a separate component 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 in this chapter.

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4. Presentation and disclosure The 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 entitys functional currency and the method of translation used to determine the supplementary information.

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5. Summary
Foreign currency transactions

Functional currency Of the primary economic environment Currency in which all transactions and balances must be measured

Exchange rates Two formats: How much LC must be paid for 1 unit of FC; or How much FC can be bought for 1 unit of LC

Dates Transaction date Reporting date Settlement date

Recognition In profit and loss Measurement

Initial spot rate on transaction date

Subsequent 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

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