ACCT 6010 Advanced Financial Reporting
Foreign Currency Transactions
The University of 1
Learning Objectives
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Learning objectives
Text section(s)
After completing this topic students should be able to:
Describe and apply the concept of functional currency for a single entity and to groups;
Arthur et al. section 10.5
Account for foreign currency transactions;
Arthur et al.
section 10.2, & Henderson et al Ch 24 pp 875-886
Translate foreign currency assets and liabilities; and
Arthur et al.
section 10.2; & Henderson et al. Ch 24 pp 875-886
Understand the accounting effects of changes in
exchange rates.
The University of et al. Ch 24 pp 875-886
LS Class 9 1
References
– AASB 121
– AASB 101 para 35
Arthur et al. Chapter 10, pp. 558-576
– Henderson et al Issues in Financial Reporting, 16th Edition, pp.875-
– IAS Plus Summary of IAS 21
– Link is also on Canvas
– http://www.iasplus.com/standard/ias21.htm
– Videos on Canvas
The University of 3
Class Outline
1. Functional and presentation currencies
2. Foreign currency transactions
3. Disclosure
4. Foreign exchange risk
The University of 4
LS Class 9 2
1. Functional, Foreign and Presentation Currencies
Foreign currency
Any currency other than the “functional currency” [AASB 121.8] Functional currency:
The currency of the primary economic environment in which the entity operates
[AASB 121.8]
Presentation currency:
The currency in which the financial report is presented. [AASB 121.8]
The University of 5
Guidelines on Functional Currency
How do we determine functional currency?
The following factors are relevant in determining the functional currency:
– The currency
– that mainly determines selling prices and costs1;
– of the country whose competitive forces or regulations determine price; and
– The currency that influences labour, materials and other costs of providing
goods and services2.
[AASB 121.9]
1. Normally the currency of the sales price
2. Normally the currency in which the transaction is denominated.
The University of 6
LS Class 9 3
Guidelines on Determining the Functional Currency
Other indicators of functional currency:
– The currency in which borrowings and equity financing are denominated;
– The currency in which cash receipts from operating activities are retained.
[AASB 121.10]
The University of 7
Other Indicators for Groups
Additional indicators that are relevant for a group:
Indicators that function currency of a foreign operation (e.g. subsidiary) and the investor (e.g. parent) are the same:
a) theactivitiesoftheforeignoperationarecarriedoutasanextensionofthe
reporting entity.
e.g., foreign operation only sells goods imported from the reporting entity and remits the proceeds to it.
b) transactionswiththereportingentityareahighproportionoftheforeign operation’s activities;
c) cash flows generated by the activities of the foreign operation directly affect the cash flows of the reporting entity and are readily available for remittance to it;
d) cashflowsgeneratedbytheforeignoperationarenotsufficienttoservice existing and normally expected debt obligations without funds being made available by the reporting entity. [AASB 121.11]
We consider this paragraph in detail in class 12.
The University of 8
LS Class 9 4
If Indicators are Mixed
– If the functional currency is ambiguous because the indicators are mixed, professional judgement is required.
– In applying professional judgement, priority is given to the indicators in AASB121.9
[AASB121.12]
IFRS vs US GAAP point of difference
Under US GAAP there is no hierarchy of indicators to determine the functional currency of an entity, whereas a hierarchy exists under IFRS.
What are the advantages of IFRS approach?
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Presentation Currency
– IAS 21 allows more than one presentation currency. [AASB121.38] – Some countries limit this application of IFRS.
– Australia: For the purposes of reporting under the Corporations
Act only one presentation currency is permitted. E.g Woodside Petroleum’s presentation currency is USD
The University of 10
LS Class 9 5
Company A operates a clothing manufacturing business in Indonesia.
– Itpurchasesmaterials(cottonandwool)fromAustralia,whichit pays for in Australian dollars (AUD).
– It employees local workers who are paid in Indonesian rupiah (IDR).
– It sells its output locally and in international markets, as do other Indonesian clothing manufacturers.
– Output is priced in IDR.
– It has long-term debt in AUD.
– It maintains an Indonesian bank account.
The University of 11
Identifying the functional currency
1. Sales price for output;
2. Competitive forces & regulations;
3. Labour & materials;
4. Financing;
5. Currency in which receipts are retained
The University of 12
LS Class 9 6
B Corp. derives its income as the sole distributor in the Philippines for
an American construction equipment manufacturer (USCO Inc.).
– The price of output is determined by USCO’s recommended price (which is in USD).
– USCO invoices B Corp. in USD. USCO also provides a long term loan (in USD) at 6% per annum interest to finance B Corp.’s operations.
– Equity is in Philippine peso (PHP).
– Local costs (primarily transport) are relatively low.
– B Corp. keeps a small amount of cash in PHP, but otherwise keeps
receipts in USD (to hedge its USD cash outflows).
The University of 13
Identifying the functional currency
1. Sales price for output
2. Competitive forces & regulations
3. Labour & materials
4. Financing
5. Currency in which receipts are retained
v Complete Arthur et al. Q10.4
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LS Class 9 7
2. Foreign Currency Transactions
Steps in the process:
A. Initial recording of a foreign currency transaction
B. Balance date adjustments (where necessary).
C. Adjustments to monetary items and recording settlement
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A. Initial Recording
– Foreign currency transactions must be recorded in the functional currency.
[AASB 121.21]
– Record transaction (asset, liability, revenue and/or expense) in the functional currency at the spot rate at the date of the transaction.
– The spot rate is the exchange rate for immediate delivery [AASB 121.8]
The University of 16
LS Class 9 8
B. Subsequent to Transaction Date
– Translate monetary items at closing rate (spot rate at reporting date).
[AASB 121.23(a)]
– Translate non-monetary items
– If at historical cost, use historical rate (exchange rate at
date of original transaction)
– If at fair value, use exchange rate at the date when fair value was determined
[AASB 121.23(b)&(c)]
The University of 17
Which items are monetary?
Monetary items:
Financial assets and liabilities that represent a right to received or an obligation to deliver a fixed or determinable amount of currency [AASB 121.8]
E.g., loan, accounts payable, accounts receivable, cash
Non-monetary items:
All items other than monetary items [AASB 121.16]
E.g., prepayments, PPE, intangibles, goodwill, equity instruments,
deferred tax assets, deferred tax liabilities.
The University of 18
LS Class 9 9
C. Adjustments to Monetary Items & Settlement
General rule:
If exchange rate at settlement differs from exchange rate used to determine the carrying amount, the resulting difference is recognised in profit or loss. [AASB 121.28]
Exceptions are covered later
The University of 19
Which Spot Rate?
AASB 121 is silent on this
– There will generally be two prices quoted:
– Bid (or buying price) and the – Offer (or selling) rate
Ø Refer to “FX: Q&A” video on Canvas
– Conceptually, which of these rates is applicable will depend on whether it is to be applied to a foreign currency payable or a foreign currency receivable.
– If FX receivable, an inflow is in foreign currency units (FCU), use FX dealers buy price for that FCU
– Opposite if payable… outflow… dealer’s sell price
The University of 20
LS Class 9 10
Presentation of Exchange Rates
Indirect form (usual presentation) : AUD 1 = FCU /
E.g., AUD 1 = USD 0.80
Direct form:
FCU 1 = AUD x
E.g., USD 1 = AUD 1.25
Note: 1/0.8 = 1.25
Ø Refer to “FX: Gain & Loss” video on Canvas The University of 21
3. Disclosure
AASB 121, para. 52
Disclosures include:
– Exchange differences recognised in profit or loss
Ø Refer to “FX: Q & A” video on Canvas for discussion of potential relevance of this disclosure
AASB 101, para. 35
– Foreign currency gains and losses may be offset
v Now do Class 9 Exercise – AusEng Ltd
The University of 26
LS Class 9 11
Foreign Exchange Risk Disclosure
– AASB 7 requires disclosure of information in relation to financial instruments.
– This includes information in relation to “market risk”.
– One component of market risk is foreign exchange risk and entities normally need to provide a sensitivity analysis showing how profit or loss would have been effected by changes in exchange rates that would be “reasonably possible”.
– Example if AUD USD exchange rates changed by +/-10% ØRefer to Bluescope Steel Ltd Note 33(c)
– No clear rules on how to determine “reasonably possible” changes.
The University of 27
The University of 28
LS Class 9 12
The University of 29
4. Foreign Exchange Risk
– Foreigncurrencygainsandlossesonsettlementandontranslationof monetary assets and liabilities may increase volatility of earnings
– Foreigncurrencyriskmaybemanagedby: – Internal processes, e.g:
• minimising foreign currency transactions,
• leading or lagging payments to minimise exposure,
• create natural hedge (e.g. borrowing in same currency as exposure through assets).
– Use of derivative financial instruments to hedge exposure,
• e.g., enter into a forward exchange contract to mitigate exposure
from foreign currency liability
– The more common approach
The University of 30
LS Class 9 13
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LS Class 9 14
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