In today’s global economy, it is common for entities to carry on foreign activities. This means that an entity might have transactions in foreign currencies. IAS 21 ‘The Effects Of Changes In Foreign Exchange Rates’ provides guidance in relation to transactions in foreign currencies, and other ‘foreign’ matters.

Assessment of Functional Currency and Transactions in Foreign Currencies

An entity needs to assess its functional currency, which is the currency of the primary economic environment in which the entity operates. IAS 21 provides guidance in selecting the most appropriate currency as the functional currency. Once that is determined, by default, any transactions entered in other currencies are essentially transactions in foreign currencies. How are exchange fluctuations accounted for? Do they affect profit? And if yes, how?

Foreign Operations

IAS 21 also provides guidance in relation to foreign operations, which include any subsidiary, associate, joint arrangement or branch that are not based in the country of the reporting entity. The question arising in this case is how the reporting entity presents best the results of, for instance, a group which contains subsidiaries and associates with multiple currencies. Are the group profits impacted by the exchange fluctuations deriving from consolidating the individual companies in the multinational group?

Changes in Functional and Presentation Currency, and Conversion from Functional to Presentation Currency

The functional currency is distinct from the presentation currency. The latter, in fact, is the currency in which the financial statements are presented to the shareholders, and is effectively a policy choice. It is worth mentioning that in Malta, the Companies Act requires the presentation of the financial statements in the currency of the share capital. Despite this restriction, technically it is still a policy choice, because an entity may always decide to change the currency of its share capital. Exchange rate movements need to also be considered when there is a change in functional currency, a change in presentation currency, or a conversion from the functional currency to the presentation currency.

Impact of Transactions in Foreign Currency on Profit

From all of the above aspects mentioned, it is only transactions in foreign currency that affect profit or loss. The other aspects highlighted either have no impact per se, or impact other comprehensive income (or equity, in the case of GAPSME preparers).

Monetary and Non-Monetary Items

It is important to understand the distinction between monetary and non-monetary items when reflecting the impact of transactions in foreign currency in the income statement.

Monetary items are defined under IAS 21 as units of a currency held, and assets and liabilities to be received or paid in a fixed or determinable number of units of currency. The following are some examples of monetary items for a Company with a Euro functional currency:

  • An example of a ‘unit of a currency held’ is a bank account denominated in USD.
  • An example of an ‘asset to be received […] in a fixed or determinable number of units of currency’ is a loan receivable denominated in GBP.
  • An example of a ‘liability to be paid […] in a fixed or determinable number of units of currency’ is a supplier’s invoice denominated in CHF.

Any items which are not monetary items are referred to as ‘non-monetary items’.

Realised and Unrealised Exchange

Monetary items trigger realised and unrealised gains or losses on exchange, which impact profit.

Suppose a Euro Company purchases a machine in USD on credit on 1 January 2020. The invoice states USD100,000. Contractually, the Company is required to settle USD100,000. The equivalent of USD100,000 will vary over time (based on the Euro-Dollar exchange rate).

Suppose the exchange rate on 1 January 2020 is 1.25:1, and the invoice is settled on 31 January 2020, when the exchange rate is 1.1. On the date of purchase, USD100,000 is equivalent to EUR80,000. On the date of settlement, USD100,000 is equivalent to EUR100,000. The journal entries resemble the following (all figures are in Euro, but the nominal accounts payable, is labelled as containing accounts payable in USD):

1 January 2020         DEBIT             Machinery                             80,000

CREDIT           Accounts Payable (USD)                              80,000

Being purchase of machinery in foreign currency (USD100,000) on credit.

 

31 January 2020       DEBIT             Accounts Payable (USD)      80,000

CREDIT           Cash                                                               100,000

DEBIT             ???                                          20,000

Being full settlement of accounts payable.

 As can be seen from the above journal entries, the cost of the asset is the equivalent amount of USD100,000 at the date of the contract (EUR80,000). The machinery is a type of non-monetary item. On the other hand, the accounts payable meets the definition of a monetary item. The accounts payable account reads EUR80,000, but the actual amount to be settled is the equivalent of the contractual amount of USD100,000 at the date of the settlement, which varies. In our case, in order to settle USD100,000, we needed to pay EUR100,000. As a result, we paid more than the accounts payable account reads. This implies that the company incurred a realised exchange loss of EUR20,000. This realised exchange loss impacts profit or loss.

An unrealised exchange gain or loss, on the other hand, is recognised in profit or loss when the monetary item is unsettled at year-end. Suppose the accounts payable described above is unsettled at year-end, this would trigger an unrealised exchange gain or loss, which would be based on the year-end exchange rate.

Further Mention

A further mention is required for non-monetary items in foreign currency that are revalued. In this case, non-monetary items are translated using the exchange rates at the date when the fair value was measured.

This contrasts from non-monetary items held under a cost model (such as, possibly, the machine in the example above). In this case, these are translated at the date of the transaction.

Should you prefer instead to address a specific technical query to our financial reporting team, please drop an email: ifrshelpdesk@zampadebattista.com