5.1.1 Identifying the date of transaction

The date of a transaction is the date on which it first qualifies for recognition in accordance with IFRS. Although this sounds relatively straightforward, the following example illustrates the difficulty that can sometimes arise in determining the transaction date:

In the example above, one of the difficulties in identifying the date of transaction is the fact that IAS 2 contains little guidance on determining when purchased inventory should be recognised as an asset. Some standards, particularly those published more recently such as IFRS 15 – Revenue from Contracts with Customers – contain more detailed guidance in this respect. Nevertheless, determining the date of transaction may still require the application of judgement and the date that a transaction is recorded in an entity's books and records will not necessarily be the same as the date at which it qualifies for recognition under IFRS. Other situations where this issue is likely to arise is where an entity is recording a transaction that relates to a period, rather than one being recognised at a single point in time, as illustrated below:

5.1.2 Deposits and other consideration received or paid in advance

An entity might receive (or pay) a deposit in a foreign currency in advance of delivering (or receiving) goods or services in circumstances where the resulting liability (or asset) is considered a non-monetary item – see 5.4.1 below. IFRIC 22 explains that, in general, the appropriate application of IAS 21 in these circumstances is to use the exchange rate at the date the advance payment is recognised, normally the payment date, rather than a subsequent date (or dates) when the goods or services are actually delivered. [IFRIC 22.8]. If there are multiple payments or receipts in advance, an entity should determine a date of transaction for each payment or receipt of advance consideration. [IFRIC 22.9].

IFRIC 22 applies to a foreign currency transaction (or part of it) when an entity recognises a non-monetary asset or non-monetary liability arising from the payment or receipt of advance consideration before the related asset, expense or income (or part of it) is recognised. [IFRIC 22.4]. It does not apply when an entity measures the asset, income or expense arising from the advance payment at fair value or at the fair value of the consideration paid or received at a date other than the date of initial recognition of the non-monetary asset or non-monetary liability, for example the measurement of goodwill when applying IFRS 3 – Business Combinations. [IFRIC 22.5].

The interpretation need not be applied to income taxes or insurance contracts (including reinsurance contracts) issued or reinsurance contracts held. [IFRIC 22.6]. In fact, once IFRS 17 – Insurance Contracts – is applied, a group of insurance contracts is treated as a monetary item (see Chapter 56 at 7.3) and therefore the interpretation is unlikely to be relevant. [IFRIC 22.BC8, IFRS 17.30].

5.1.3 Using average rates

Rather than using the actual rate ruling at the date of the transaction ‘an average rate for a week or month may be used for all foreign currency transactions occurring during that period’, if the exchange rate does not fluctuate significantly (see 5.1 above). [IAS 21.22]. For entities which engage in a large number of foreign currency transactions it will be more convenient for them to use an average rate rather than using the exact rate for each transaction. If an average rate is to be used, what guidance can be given in choosing and using such a rate?

1. Length of period

   As an average rate should only be used as an approximation of actual rates then care has to be taken that significant fluctuations in the day-to-day exchange rates do not arise in the period selected. For this reason the period chosen should not be too long. We believe that the period should be no longer than one month and where there is volatility of exchange rates it will be better to set rates on a more frequent basis, say, a weekly basis, especially where the value of transactions is significant.

2. Estimate of average rate relevant to date of transaction

   The estimation of the appropriate average rate will depend on whether the rate is to be applied to transactions which have already occurred or to transactions which will occur after setting the rate. Obviously, if the transactions have already occurred then the average rate used should relate to the period during which those transactions occurred; e.g. purchase transactions for the previous week should be translated using the average rate for that week, not an average rate for the week the invoices are being recorded.

   If the rate is being set for the following period the rate selected should be a reasonable estimate of the expected exchange rate during that period. This could be done by using the closing rate at the end of the previous period or by using the actual average rate for the previous period. We would suggest that the former be used. Whatever means is used to estimate the average rate, the actual rates during the period should be monitored and if there is a significant move in the exchange rate away from the average rate then the rate being applied should be revised.

3. Application of average rate to type of item

   We believe that average rates should be used only as a matter of convenience where there are a large number of transactions. Even where an average rate is used, we recommend that the actual rate should be used for large one-off transactions such as the purchase of a fixed asset or an overseas investment or taking out a foreign loan. Where the number of foreign currency transactions is small it will probably not be worthwhile setting and monitoring average rates and therefore actual rates should be used.

5.1.4 Practical difficulties in determining exchange rates

In most cases determining an exchange rate will be a relatively straightforward exercise, but this will not always be the case, particularly where there are restrictions on entities wishing to exchange one currency for another, typically a local currency for a foreign currency. For example:

• legal restrictions might permit sales of local currency only at an official rate rather than a rate that reflects more fully market participants’ views of the currency's relative value or its underlying economics. Those official rates may or may not be pegged to another country's currency, for example the US dollar;
• exchange rates set by governments might vary according to the nature of the underlying transaction; and
• the volume of currency that can be exchanged through official mechanisms may be limited by formal or informal restrictions imposed by government, often designed to help manage the government's sometimes scarce foreign exchange reserves.

These situations are often encountered in countries that have more of a closed economy and which may be experiencing a degree of economic strain. High inflation or even hyperinflation and devaluations can be symptomatic of these situations as can the development of a ‘black market’ in foreign currencies, the use of which could to some extent be unlawful. Determining an appropriate exchange rate to use in these circumstances can be difficult as discussed at 5.1.4.A to 5.1.4.C below.

In more extreme cases of economic strain or hyperinflation a country may eventually replace its local currency completely or even adopt a third country's currency as its own. Examples of the latter include Ecuador and Zimbabwe which have both in recent times effectively adopted the US dollar as their official currency. In addition to the underlying economic problems these actions are designed to address they may also go some way towards addressing some of the associated financial reporting issues.

It is also important to recognise that economic characteristics such as those mentioned above are not always associated with difficult economic conditions, e.g. many successful economies have a currency that to some extent is, or has been, pegged to another currency or is otherwise linked to a different currency,

5.3.1 Monetary items

The general rule in IAS 21 is that exchange differences on the settlement or retranslation of monetary items should be recognised in profit or loss in the period in which they arise. [IAS 21.28].

When monetary items arise from a foreign currency transaction and there is a change in the exchange rate between the transaction date and the date of settlement, an exchange difference results. When the transaction is settled within the same accounting period as that in which it occurred, all the exchange difference is recognised in that period. However, when the transaction is settled in a subsequent accounting period, the exchange difference recognised in each period up to the date of settlement is determined by the change in exchange rates during each period. [IAS 21.29].

These requirements can be illustrated in the following examples:

There are situations where the general rule above will not be applied. The first exception relates to exchange differences arising on a monetary item that, in substance, forms part of an entity's net investment in a foreign operation (see 6.3.1 below). In this situation the exchange differences should be recognised initially in other comprehensive income until the disposal of the investment (see 6.6 below). However, this treatment only applies in the financial statements that include the foreign operation and the reporting entity (e.g. consolidated financial statements when the foreign operation is a consolidated subsidiary or equity method investment). It does not apply to the reporting entity's separate financial statements or the financial statements of the foreign operation. Rather, the exchange differences will be recognised in profit or loss in the period in which they arise in the financial statements of the entity that has the foreign currency exposure. [IAS 21.32]. This is discussed further at 6.3.1 below.

The next exception relates to hedge accounting for foreign currency items, to which IFRS 9 applies. The application of hedge accounting requires an entity to account for some exchange differences differently from the treatment required by IAS 21. For example, IFRS 9 requires that exchange differences on monetary items that qualify as hedging instruments in a cash flow hedge or a hedge of a net investment in a foreign operation are recognised initially in other comprehensive income to the extent the hedge is effective. Hedge accounting is discussed in more detail in Chapter 53.

Another situation where exchange differences on monetary items are not recognised in profit or loss in the period they arise would be where an entity capitalises borrowing costs under IAS 23 – Borrowing Costs – since that standard requires exchange differences arising from foreign currency borrowings to be capitalised to the extent that they are regarded as an adjustment to interest costs (see Chapter 21 at 5.4). [IAS 23.6].

One example of a monetary item given by IAS 21 is ‘provisions that are to be settled in cash’. In most cases it will be appropriate for the exchange differences arising on provisions to be recognised in profit or loss in the period they arise. However, it may be that an entity has recognised a decommissioning provision under IAS 37 – Provisions, Contingent Liabilities and Contingent Assets. One practical difficulty with such a provision is that due to the long timescale of when the actual cash outflows will arise, an entity may not be able to say with any certainty the currency in which the transaction will actually be settled. Nevertheless if it is determined that it is expected to be settled in a foreign currency it will be a monetary item. The main issue then is what should happen to any exchange differences. IFRIC 1 – Changes in Existing Decommissioning, Restoration and Similar Liabilities – applies to any decommissioning or similar liability that has been both included as part of the cost of an asset and measured as a liability in accordance with IAS 37 (see Chapter 26 at 6.3.1). IFRIC 1 requires, inter alia, that any adjustment to such a provision resulting from changes in the estimated outflow of resources embodying economic benefits (e.g. cash flows) required to settle the obligation should not be recognised in profit or loss as it occurs, but should be added to or deducted from the cost of the asset to which it relates. The requirement of IAS 21 to recognise the exchange differences arising on the provision in profit or loss in the period in which they arise conflicts with this requirement in IFRIC 1. Accordingly, we believe that either approach could be applied as an accounting policy choice. However, in our experience, such exchange differences are most commonly dealt with in accordance with IFRIC 1, particularly by entities with material long-term provisions.

5.3.2 Non-monetary items

When non-monetary items are measured at fair value in a foreign currency they should be translated using the exchange rate as at the date when the fair value was determined. Therefore, any re-measurement gain or loss will include an element relating to the change in exchange rates. In this situation, the exchange differences are recognised as part of the gain or loss arising on the fair value re-measurement.

When a gain or loss on a non-monetary item is recognised in other comprehensive income, any exchange component of that gain or loss should also be recognised in other comprehensive income. [IAS 21.30]. For example, IAS 16 requires some gains and losses arising on a revaluation of property, plant and equipment to be recognised in other comprehensive income (see Chapter 18 at 6.2). When such an asset is measured in a foreign currency, the revalued amount should be translated using the rate at the date the value is determined, resulting in an exchange difference that is also recognised in other comprehensive income. [IAS 21.31].

Conversely, when a gain or loss on a non-monetary item is recognised in profit or loss, e.g. financial instruments that are measured at fair value through profit or loss in accordance with IFRS 9 (see Chapter 50 at 2.4) or an investment property accounted for using the fair value model (see Chapter 19 at 6), any exchange component of that gain or loss should be recognised in profit or loss. [IAS 21.30].

An example of an accounting policy dealing with the reporting of foreign currency transactions in the functional currency of an entity is illustrated below.

5.4.1 Deposits or progress payments

Entities may be required to pay deposits or progress payments when acquiring certain assets, such as property, plant and equipment or inventories, from foreign suppliers. The question then arises as to whether such payments should be retranslated as monetary items or not.

5.4.2 Investments in preference shares

Entities may invest in preference shares of other entities. Whether such shares are monetary items or not will depend on the rights attaching to the shares. IFRS 9 states that investments in equity instruments are non-monetary items (see 5.4 above). [IFRS 9.B5.7.3]. Thus, if the terms of the preference shares are such that they are classified by the issuer as equity, rather than as a financial liability, then they are non-monetary items. However, if the terms of the preference shares are such that they are classified by the issuer as a financial liability (e.g. a preference share that provides for mandatory redemption by the issuer for a fixed or determinable amount at a fixed or determinable future date) and by the holder as a financial asset measured at amortised cost or at fair value through other comprehensive income (see Chapter 50 at 4.1), they should be treated as monetary items.

5.4.3 Foreign currency share capital

An entity may issue share capital denominated in a currency that is not its functional currency or, due to changes in circumstances that result in a re-determination of its functional currency, may find that its share capital is no longer denominated in its functional currency. Neither IAS 21, IAS 32 nor IFRS 9 address the treatment of translation of share capital denominated in a currency other than the functional currency. In theory two treatments are possible: the foreign currency share capital (and any related share premium or additional paid-in capital) could be maintained at a fixed amount by being translated at a historical rate of exchange, or it could be retranslated annually at the closing rate as if it were a monetary amount. In the latter case a second question would arise: whether to recognise the difference arising on translation in profit or loss or in other comprehensive income or to deal with it within equity.

Where the shares denominated in a foreign currency are ordinary shares, or are otherwise irredeemable and classified as equity instruments, in our experience the most commonly applied view is that the shares should be translated at historical rates and not remeasured. This view reflects the fact that the effect of rate changes is not expected to have an impact on the entity's cash flows associated with those shares. Such capital items are included within the examples of non-monetary items listed in US GAAP (FASB ASC 830 – Foreign Currency Matters) as accounts to be remeasured using historical exchange rates when the temporal method is being applied. IAS 21 requires non-monetary items that are measured at historical cost in a foreign currency to be translated using the historical rate (see 5.2 above).

Where such share capital is retranslated at the closing rate, we do not believe that it is appropriate for the exchange differences to be recognised in profit or loss, since they do not affect the cash flows of the entity. Further, because the retranslation of such items has no effect on assets or liabilities it is not an item of income or expense to be recognised in other comprehensive income. Instead, the exchange differences should be taken to equity. Consequently, whether such share capital is maintained at a historical rate, or is dealt with in this way, the treatment has no impact on the overall equity of the entity.

Where the shares are not classified as equity instruments, but as financial liabilities, under IAS 32, e.g. preference shares that provide for mandatory redemption by the issuer for a fixed or determinable amount at a fixed or determinable future date, then, as with investments in such shares (see 5.4.2 above), they should be treated as monetary items and translated at the closing rate. Any exchange differences will be recognised in profit or loss, unless the shares form part of a hedging relationship and IFRS 9 would require the exchange differences to be accounted for differently (see Chapter 53).

5.4.4 Deferred tax

One of the examples of a monetary item included within the exposure draft that preceded IAS 21 was deferred tax.⁷ However, this was dropped from the list of examples in the final standard. No explanation is given in IAS 21 as to why this is the case. Until 2007, IAS 12 – Income Taxes – suggested that any deferred foreign tax assets or liabilities are monetary items since it stated that ‘where exchange differences on deferred foreign tax liabilities or assets are recognised in the income statement, such differences may be classified as deferred tax expense (income) if that presentation is considered to be the most useful to financial statement users’.⁸ The reference to ‘income statement’ has now been changed to ‘statement of comprehensive income’, although the suggestion remains the same.

5.4.5 Post-employment benefit plans – foreign currency assets

For most entities, benefits payable under a defined benefit post-employment plan will be payable in the functional currency of the entity. However, such a plan may have monetary assets that are denominated in a foreign currency and/or non-monetary assets, the fair value of which are determined in a foreign currency. (Where benefits are payable in a currency that is different to the entity's functional currency, the considerations at 5.4.6 below will be relevant.)

Consider, for example, a UK company with the pound sterling as its functional currency which has a funded pension scheme in which benefit payments are based on the employees’ sterling denominated salaries and are paid in sterling. The majority of plan assets comprise a mix of sterling denominated bonds, UK equities and UK properties. However, those assets also include a number of US dollar denominated bonds and equities issued by US companies that are listed on a US stock exchange. IAS 19 – Employee Benefits – requires all these assets to be measured at their fair value at the end of the reporting period, but how should the entity deal with any exchange differences or changes in fair value attributable to changes in exchange rates arising on the US assets?

IAS 21 gives as an example of a monetary item ‘pensions and other employee benefits to be paid in cash’. Further, the accounting for defined benefit schemes under IAS 19 requires an entity to reflect net interest on the net defined benefit asset or liability in profit or loss and any difference between this amount and the actual return on plan assets in other comprehensive income (see Chapter 35 at 10.3 and 10.4.2). [IAS 19.120, 127(b)]. Consequently, it would seem appropriate to view the net pension asset or liability as a single unit of account measured in sterling. Therefore the gains and losses on all the US plan assets attributable to changes in foreign exchange rates would be dealt with as remeasurements in accordance with IAS 19 and recognised in other comprehensive income.

5.4.6 Post-employment benefit plans – foreign currency plans

For some entities the pension benefits payable under a post-employment benefit plan will not be payable in the functional currency of the entity. For example, a UK entity in the oil and gas industry may determine that its functional currency is the US dollar, but its employee costs including the pension benefits are payable in sterling. How should such an entity account for its post-employment benefit plan?

One of the examples of a monetary item given by IAS 21 is ‘pensions and other employee benefits to be paid in cash’. However, the standard does not expand on this, and does not appear to make any distinction between pensions provided by defined contribution plans or defined benefit plans. Nor does it distinguish between funded or unfunded defined benefit plans.

Clearly for pensions that are payable under a defined contribution plan (or one that is accounted for as such) this is straightforward. Any liability for outstanding contributions at the end of the reporting period is a monetary item that should be translated at the closing rate, with any resulting exchange differences recognised in profit or loss. For an unfunded defined benefit plan in which the benefit payments are denominated in a foreign currency, applying IAS 21 would also seem to be straightforward. The defined benefit obligation is regarded as a monetary liability and exchange differences on the entire balance are recognised in profit or loss.

A funded defined benefit plan is a more a complex arrangement to assess under IAS 21, particularly if the plan assets include items that considered in their own right would be non-monetary and/or foreign currency monetary items. However, in the light of the guidance in IAS 21 noted above, our preferred view is to consider such arrangements as a single monetary item denominated in the currency in which the benefit payments are made. Therefore the requirements of IAS 19 will be applied in the currency in which the benefit payments are denominated and foreign currency gains or losses on the net asset or liability would be recognised in profit or loss.

Another approach would be to argue that a funded scheme is more akin to a non-monetary item and the exchange differences relating to the defined benefit obligation are similar to actuarial gains and losses. The calculation of the obligation under IAS 19 will be based on actuarial assumptions that reflect the currency of the obligation to the employee (for example, the discount rate used ‘shall be consistent with the currency and estimated term’ of the obligation [IAS 19.83]). Any variations from those assumptions on both the obligation and the assets are dealt with in the same way under IAS 19. Actuarial assumptions are ‘an entity's best estimates of the variables that will determine the ultimate cost of providing post-employment benefits’ and include financial assumptions. [IAS 19.76]. Although IAS 19 does not refer to exchange rates, it is clearly a variable that will determine the ultimate cost to the entity of providing the post-employment benefits. On that basis, the exchange differences relating to the defined benefit obligation would be accounted for in a similar manner to actuarial gains and losses. Although not our preferred accounting treatment, we consider this to be an acceptable approach.

Some might argue that the plan should be regarded as a ‘foreign operation’ under IAS 21 (see 2.3 above). However, in this situation it is very difficult to say that its ‘functional currency’ can be regarded as being different from that of the reporting entity given the relationship between the plan and the reporting entity (see 4 above). Thus, it would appear that the entity cannot treat the plan as a foreign operation with a different functional currency from its own.

6.1.1 Functional currency is not that of a hyperinflationary economy

The results and financial position of an entity whose functional currency is not the currency of a hyperinflationary economy should be translated into a different presentation currency using the following procedures: [IAS 21.39]

1. assets and liabilities for each statement of financial position presented (i.e. including comparatives) are translated at the closing rate at the reporting date;
2. income and expenses for each statement of comprehensive income or separate income statement presented (i.e. including comparatives) are translated at exchange rates at the dates of the transactions; and
3. all resulting exchange differences are recognised in other comprehensive income.

For practical reasons, the reporting entity may use a rate that approximates the actual exchange rate, e.g. an average rate for the period, to translate income and expense items. However, if exchange rates fluctuate significantly, the use of the average rate for a period is inappropriate. [IAS 21.40].

As discussed at 5.1.2 above, IFRIC 22 explains how to determine the ‘date of transaction’ for the purposes of an entity recording a foreign currency transaction in its functional currency, particularly when payments are made or received in advance of the associated transaction occurring. However, in our view, this guidance does not apply to the translation of an entity's results into a presentation currency; instead the date of transaction for this purpose is the date on which income or expense is recorded in profit or loss or other comprehensive income of the foreign operation.

A foreign operation may have reclassification adjustments to profit or loss of gains or losses previously recognised in other comprehensive income, for example as a result of the application of cash flow hedge accounting. However, IAS 21 does not explicitly address how these adjustments should be translated into the presentation currency. In our experience the most commonly applied approach is to regard them as income or expenses of the foreign operation to be translated at the exchange rate at the date of reclassification in accordance with paragraph 39(b). For cash flow hedges, this better reflects the hedge accounting reported in the foreign operation's own financial statements. Nevertheless, some would argue that reclassification adjustments do not represent income or expenses. Consequently, paragraph 39(b) would not apply and the reclassification is translated using the historical exchange rates at the dates the original gains or losses arose. In our view, each of these approaches represents an acceptable accounting policy choice.

The translational process above makes only limited reference to the translation of equity items, although the selection of accounting policy for translating reclassification adjustments is likely to influence whether an entity translates the associated equity balance in order to prevent a residual amount being left within the reserve. The treatment of such items is discussed at 6.2 below.

IAS 21 indicates that the exchange differences referred to in item (c) above result from: [IAS 21.41]

• translating income and expenses at the exchange rates at the dates of the transactions and assets and liabilities at the closing rate. Such exchange differences arise both on income and expense items recognised in profit or loss and on those recognised in other comprehensive income; and
• translating the opening net assets at a closing rate that differs from the previous closing rate.

This is not in fact completely accurate since if the entity has had any transactions with equity holders that have resulted in a change in the net assets during the period there are likely to be further exchange differences that need to be recognised to the extent that the closing rate differs from the rate used to translate the transaction. This will particularly be the case where a parent has subscribed for further equity shares in a subsidiary.

The reason why these exchange differences are not recognised in profit or loss is because the changes in exchange rates have little or no direct effect on the present and future cash flows from operations. [IAS 21.41].

The application of these procedures is illustrated in the following example.

When the exchange differences relate to a foreign operation that is consolidated but not wholly-owned, accumulated exchange differences arising from translation and attributable to non-controlling interests are allocated to, and recognised as part of, non-controlling interests in the consolidated statement of financial position. [IAS 21.41].

An example of an accounting policy dealing with the translation of entities whose functional currency is not that of a hyperinflationary economy is illustrated in the following extract.

The IASB had considered an alternative translation method, which would have been to translate all amounts (including comparatives) at the most recent closing rate. This was considered to have several advantages: it is simple to apply; it does not generate any new gains and losses; and it does not change ratios such as return on assets. Supporters of this method believed that the process of merely expressing amounts in a different currency should preserve the same relationships among amounts as measured in the functional currency. [IAS 21.BC17]. These views were probably based more on the IASB's proposals for allowing an entity to present its financial statements in a currency other than its functional currency, rather than the translation of foreign operations for inclusion in consolidated financial statements. Such an approach does have theoretical appeal. However, the major drawback is that it would require the comparatives to be restated from those previously reported.

The IASB rejected this alternative and decided to require the method that the previous version of IAS 21 required for translating the financial statements of a foreign operation. [IAS 21.BC20]. It is asserted that this method results in the same amounts in the presentation currency regardless of whether the financial statements of a foreign operation are first translated into the functional currency of another group entity and then into the presentation currency or translated directly into the presentation currency. [IAS 21.BC18]. We agree that it will result in the same amounts for the statement of financial position, regardless of whether the translation process is a single or two-stage process. However, it does not necessarily hold true for income and expense items particularly if an indirectly held foreign operation is disposed of – this is discussed further at 6.1.5 and 6.6.3 below. Differences will also arise between the two methods if an average rate is used, although these are likely to be insignificant.

The IASB states that the method chosen avoids the need to decide the currency in which to express the financial statements of a multinational group before they are translated into the presentation currency. In addition, it produces the same amounts in the presentation currency for a stand-alone entity as for an identical subsidiary of a parent whose functional currency is the presentation currency. [IAS 21.BC19]. For example, if a Swiss entity with the Swiss franc as its functional currency wishes to present its financial statements in euros, the translated amounts in euros should be the same as those for an identical entity with the Swiss franc as its functional currency that are included within the consolidated financial statements of its parent that presents its financial statements in euros.

6.1.2 Functional currency is that of a hyperinflationary economy

The results and financial position of an entity whose functional currency is the currency of a hyperinflationary economy should be translated into a different presentation currency using the following procedures: [IAS 21.42]

1. all amounts (i.e. assets, liabilities, equity items, income and expenses, including comparatives) are translated at the closing rate at the date of the most recent statement of financial position; except that
2. when amounts are translated into the currency of a non-hyperinflationary economy, comparative amounts are those that were presented as current year amounts in the relevant prior year financial statements (i.e. not adjusted for subsequent changes in the price level or subsequent changes in exchange rates). Similarly, in the period during which the functional currency of a foreign operation such as a subsidiary becomes hyperinflationary and applies IAS 29 for the first time, the parent's consolidated financial statement for the comparative period should not in our view be restated for the effects of hyperinflation.

When an entity's functional currency is the currency of a hyperinflationary economy, the entity should restate its financial statements in accordance with IAS 29 before applying the translation method set out above, except for comparative amounts that are translated into a currency of a non-hyperinflationary economy (see (b) above). [IAS 21.43].

When the economy ceases to be hyperinflationary and the entity no longer restates its financial statements in accordance with IAS 29, it should use as the historical costs for translation into the presentation currency the amounts restated to the price level at the date the entity ceased restating its financial statements. [IAS 21.43].

It is unclear what should happen to such an exchange difference (and also the movement in share capital caused by the change in exchange rates) since paragraph 42 of IAS 21 makes no reference to any possible exchange differences arising from this process. Similar issues arise when the functional currency of a foreign operation first becomes hyperinflationary. It would seem inappropriate to recognise such amounts in profit or loss, but there is uncertainty over whether they should be recognised in other comprehensive income and/or directly equity and a more extensive discussion of how we consider entities should approach this issue is included in Chapter 16 at 11.

An example of an accounting policy dealing with the translation of entities whose functional currency is that of a hyperinflationary economy is illustrated in the following extract.

6.1.3 Dual rates, suspension of rates and lack of exchangeability

The problems of dual rates, suspensions of rates and lack of exchangeability in relation to the translation of foreign currency transactions and balances into an entity's functional currency and the related requirements of IAS 21 dealing with such issues have already been discussed in 5.1.4 above. However, the standard makes no reference to them in the context of translating the results and financial position of an entity into a different presentation currency, particularly where the results and financial position of a foreign operation are being translated for inclusion in the financial statements of the reporting entity by consolidation or the equity method.

Where the problem is one of a temporary suspension of rates, the predominant practice noted by the Interpretations Committee is for the requirement in IAS 21 relating to transactions and balances to be followed; i.e. by using ‘the first subsequent rate at which exchanges could be made’. In this context the rate will be the one at which future cash flows could be settled when viewing the net investment as a whole.¹⁰ This approach is broadly consistent with US GAAP which states that the rate to be used to translate foreign financial statements should be, in the absence of unusual circumstances, the rate applicable to dividend remittance.

The standard does not address the situation where there is a longer-term lack of exchangeability. In these circumstances the discussion at 5.1.4.C above, including the Interpretations Committee's consideration of this issue in the context of the Venezuelan currency, will be relevant. Determining the appropriate exchange rate(s) to use will require the application of judgement. The rate(s) selected will depend on the entity's individual facts and circumstances, particularly its legal ability to convert currency or to settle transactions using a specific rate and its intent to use a particular mechanism, including whether the rate available through that mechanism is published or readily determinable. The disclosure requirements highlighted by the committee and covered at 10.4 below will also be relevant in these circumstances.

6.1.4 Calculation of average rate

When translating the results of an entity whose functional currency is not that of a hyperinflationary economy, for practical reasons, the reporting entity may use a rate that approximates the actual exchange rate, e.g. an average rate for the period, to translate income and expense items. [IAS 21.40].

The standard does not give any guidance on the factors that should be taken into account in determining what may be an appropriate average rate for the period – it merely says that ‘if exchange rates fluctuate significantly, the use of the average rate for the period is inappropriate’. [IAS 21.40]. What methods are, therefore, available to entities to use in calculating an appropriate average rate? Possible methods might be:

1. mid-year rate;
2. average of opening and closing rates;
3. average of month end/quarter end rates;
4. average of monthly average rates;
5. monthly/quarterly results at month end/quarter end rates; or
6. monthly/quarterly results at monthly/quarterly averages.

It can be seen that by far the simplest methods to use are the methods (a) to (d).

In our view methods (a) and (b) should not normally be used as it is unlikely in times of volatile exchange rates that they will give appropriate weighting to the exchange rates which have been in existence throughout the period in question. They are only likely to give an acceptable answer if the exchange rate has been static or steadily increasing or decreasing throughout the period.

Method (c) based on quarter end rates has similar drawbacks and therefore should not normally be used.

Method (c) based on month end rates and method (d) are better than the previous methods as they do take into account more exchange rates which have applied throughout the year, with method (d) being more precise, as this will have taken account of daily exchange rates. Average monthly rates for most major currencies are likely to be given in publications issued by the government, banks and other sources and therefore it is unnecessary for entities to calculate their own. The work involved in calculating an average for the year, therefore, is not very onerous. Method (d) will normally give reasonable and acceptable results when there are no seasonal variations in items of income and expenditure.

Where there are seasonal variations in items of income and expenditure, using a single average rate for the entire reporting period is unlikely to result in a reasonable approximation of applying actual rates. In these situations appropriate exchange rates should be applied to the appropriate items. This can be done by using either of methods (e) or (f) preferably using figures and rates for each month. Where such a method is being used care should be taken to ensure that the periodic accounts are accurate and that cut-off procedures have been adequate, otherwise significant items may be translated at the wrong average rate.

Where there are significant one-off items of income and expenses then it is likely that actual rates at the date of the transaction will need to be used to translate such items.

6.1.5 Accounting for foreign operations where sub-groups exist

A reporting entity comprising a group with intermediate holding companies may adopt either the direct or the step-by-step method of consolidation. The direct method involves the financial statements of foreign operations being translated directly into the presentation currency of the ultimate parent. The step-by-step method involves the financial statements of the foreign operation first being translated into the functional currency of any intermediate parent(s) and then into the presentation currency of the ultimate parent. [IFRIC 16.17].

It is asserted that both methods will result in the same amounts being reported in the presentation currency. [IAS 21.BC18]. However, as set out at 6.6.3 below, particularly in Example 15.19, and as acknowledged by the Interpretations Committee,¹¹ this assertion is demonstrably untrue in certain situations.

Whilst the various requirements of the standard appear to indicate that the direct method should be used and the Interpretations Committee has indicated it is the conceptually correct method,¹² IAS 21 does not require an entity to use the direct method or to make adjustments to produce the same result. Rather, an entity has an accounting policy choice as to which of the two methods it should use and the method selected should be used consistently for all net investments. [IFRIC 16.17].

6.2.1 Share capital

Where an entity presents its financial statements in a currency other than its functional currency, it would seem more appropriate that its share capital (whether they are ordinary shares, or are otherwise irredeemable and classified as equity instruments) should be translated at historical rates of exchange. Such capital items are included within the examples of non-monetary items listed in US GAAP as accounts to be remeasured using historical exchange rates when the temporal method is being applied (see 5.4.3 above). IAS 21 requires non-monetary items that are measured at historical cost in a foreign currency to be translated using the historical rate (see 5.2 above). Translation at an historical rate would imply using the rate ruling at the date of the issue of the shares. However, where a subsidiary is presenting its financial statements in the currency of its parent, it may be that the more appropriate historical rate for share capital that was in issue at the date it became a subsidiary would be that ruling at the date it became a subsidiary of the parent, rather than at earlier dates of issue.

Where such share capital is retranslated at the closing rate, we do not believe that it is appropriate for the exchange differences to be recognised in other comprehensive income nor for them to be taken to the separate component of equity required by IAS 21 (since to do so could result in them being reclassified from equity to profit or loss upon disposal of part of the entity's operations in the future), but should either be taken to retained earnings or some other reserve. Consequently, whether such share capital is maintained at a historical rate, or is dealt with in this way, the treatment has no impact on the overall equity of the entity.

6.2.2 Other equity balances resulting from transactions with equity holders

In addition to share capital, an entity may have other equity balances resulting from the issue of shares, such as a share premium account (additional paid-in capital). Like share capital, the translation of such balances could be done at either historical rates or at the closing rate. However, we believe that whichever method is adopted it should be consistent with the treatment used for share capital. Again, where exchange differences arise through using the closing rate, we believe that it is not appropriate for them to be recognised in other comprehensive income or taken to the separate component of equity required by IAS 21.

A similar approach should be adopted where an entity has acquired its own equity shares and has deducted those ‘treasury shares’ from equity as required by IAS 32 (see Chapter 47 at 9).

6.2.3 Other equity balances resulting from income and expenses being recognised in other comprehensive income

Under IAS 21, income and expenses recognised in other comprehensive income are translated at the exchange rates ruling at the dates of the transaction. [IAS 21.39(b), 41]. Examples of such items include certain gains and losses on:

• revalued property, plant and equipment under IAS 16 (see Chapter 18 at 6.2) and revalued intangible assets under IAS 38 – Intangible Assets (see Chapter 17 at 8.2);
• debt instruments measured at fair value through other comprehensive income, investments in equity instruments designated at fair value through other comprehensive income and financial liabilities designated at fair value through profit or loss under IFRS 9 (see Chapter 50 at 2.3, 2.5 and 2.4 respectively);
• gains and losses on cash flow hedges under IFRS 9 (see Chapter 53); and
• any amounts of current and deferred tax recognised in other comprehensive income under IAS 12 (see Chapter 33 at 10).

This would suggest that where these gains and losses are accumulated within a separate reserve or component of equity, then any period-end balance should represent the cumulative translated amounts of such gains and losses. However, as IAS 21 is silent on the matter it would seem that it would be acceptable to translate these equity balances at the closing rate.

The treatment of equity balances that are subsequently reclassified to profit or loss, for example cash flow hedge reserves of a foreign operation, typically depends on the exchange rate used to translate the reclassification adjustments (a topic which is discussed at 6.1.1 above). Where reclassification adjustments are translated using the exchange rate at the date of reclassification, translating the equity balance at closing rate should mean no residual balance is left in the reserve once the hedge accounting is completely accounted for. Conversely, where reclassification adjustments are translated using exchange rates at the dates the original gains or losses arose, an entity would avoid a residual balance remaining in the reserve by not retranslating the equity balance. However, whether such balances are maintained at the original translated rates, or are translated at closing rates, the treatment has no impact on the overall equity of the entity.

6.3.1 Monetary items included as part of the net investment in a foreign operation – general

As an exception to the general rule at 6.3 above, where an exchange difference arises on an intragroup balance that, in substance, forms part of an entity's net investment in a foreign operation, then the exchange difference is not to be recognised in profit or loss in the consolidated financial statements, but is recognised in other comprehensive income and accumulated in a separate component of equity until the disposal of the foreign operation (see 6.6 below). [IAS 21.32, 45].

The ‘net investment in a foreign operation’ is defined as being ‘the amount of the reporting entity's interest in the net assets of that operation’. [IAS 21.8]. This will include a monetary item that is receivable from or payable to a foreign operation for which settlement is neither planned nor likely to occur in the foreseeable future (often referred to as a ‘permanent as equity’ loan) because it is, in substance, a part of the entity's net investment in that foreign operation. Such monetary items may include long-term receivables or loans. They do not include trade receivables or trade payables. [IAS 21.15].

In our view, trade receivables and payables can be included as part of the net investment in the foreign operation, but only if cash settlement is not made or planned to be made in the foreseeable future. However, if a subsidiary makes payment for purchases from its parent, but is continually indebted to the parent as a result of new purchases, then in these circumstances, since individual transactions are settled, no part of the inter-company balance should be regarded as part of the net investment in the subsidiary. Accordingly, exchange differences on such balances should be recognised in profit or loss.

These requirements are illustrated in the following example.

The question of whether or not a monetary item is as permanent as equity can, in certain circumstances, require the application of significant judgement.

6.3.2 Monetary items included as part of the net investment in a foreign operation – currency of the monetary item

When a monetary item is considered to form part of a reporting entity's net investment in a foreign operation and is denominated in the functional currency of the reporting entity, an exchange difference will be recognised in profit or loss for the period when it arises in the foreign operation's individual financial statements. If the item is denominated in the functional currency of the foreign operation, an exchange difference will be recognised in profit or loss for the period when it arises in the reporting entity's separate financial statements. Such exchange differences are only recognised in other comprehensive income and accumulated in a separate component of equity in the financial statements that include the foreign operation and the reporting entity (i.e. financial statements in which the foreign operation is consolidated or accounted for using the equity method). [IAS 21.32, 33].

In most situations, intragroup balances for which settlement is neither planned nor likely to occur in the foreseeable future will be denominated in the functional currency of either the reporting entity or the foreign operation. However, this will not always be the case. If a monetary item is denominated in a currency other than the functional currency of either the reporting entity or the foreign operation, the exchange difference arising in the reporting entity's separate financial statements and in the foreign operation's individual financial statements are also recognised in other comprehensive income and accumulated in the separate component of equity in the financial statements that include the foreign operation and the reporting entity (i.e. financial statements in which the foreign operation is consolidated or accounted for using the equity method). [IAS 21.33].

6.3.3 Monetary items included as part of the net investment in a foreign operation – treatment in the individual financial statements

The exception for exchange differences on monetary items forming part of the net investment in a foreign operation applies only in the financial statements that include the foreign operation (for example consolidated financial statements when the foreign operation is a subsidiary). In the individual financial statements of the entity (or entities) with the currency exposure the exchange differences have to be reflected in that entity's profit or loss for the period.

6.3.4 Monetary items transacted by other members of the group

As illustrated in the examples above, the requirements of IAS 21 whereby exchange differences on a monetary item that forms part of the net investment in a foreign operation are recognised in other comprehensive income clearly apply where the monetary item is transacted between the parent preparing the consolidated financial statements and the subsidiary that is the foreign operation. However, loans from any entity (and in any currency) qualify for net investment treatment, so long as the conditions of paragraph 15 are met. [IAS 21.15A].

6.3.5 Monetary items becoming part of the net investment in a foreign operation

An entity's plans and expectations in respect of an intragroup monetary item may change over time and the status of such items should be assessed each period. For example, a parent may decide that its subsidiary requires refinancing and instead of investing more equity capital in the subsidiary decides that an existing inter-company account, which has previously been regarded as a normal monetary item, should become a long-term deferred trading balance and no repayment of such amount will be requested within the foreseeable future. In our view, such a ‘capital injection’ should be regarded as having occurred at the time it is decided to redesignate the inter-company account. Consequently, the exchange differences arising on the account up to that date should be recognised in profit or loss and the exchange differences arising thereafter would be recognised in other comprehensive income on consolidation. This is discussed further in the following example.

6.3.6 Monetary items ceasing to be part of the net investment in a foreign operation

The previous section dealt with the situation where a pre-existing monetary item was subsequently considered to form part of the net investment in a foreign operation. However, what happens where a monetary item ceases to be considered part of the net investment in a foreign operation, either because the circumstances have changed such that it is now planned or is likely to be settled in the foreseeable future or indeed that the monetary item is in fact settled?

Where the circumstances have changed such that the monetary item is now planned or is likely to be settled in the foreseeable future, then similar issues to those discussed at 6.3.1 above apply; i.e. are the exchange differences on the intragroup balance to be recognised in profit or loss only from the date of change or from the beginning of the financial year? For the same reasons set out in Example 15.14 above, in our view, the monetary item ceases to form part of the net investment in the foreign operation at the moment in time when the entity decides that settlement is planned or is likely to occur in the foreseeable future. Accordingly, exchange differences arising on the monetary item up to that date are recognised in other comprehensive income and accumulated in a separate component of equity. The exchange differences that arise after that date are recognised in profit or loss.

Consideration also needs to be given as to the treatment of the cumulative exchange differences on the monetary item that have been recognised in other comprehensive income, including those that had been recognised in other comprehensive income in prior years. The treatment of these exchange differences is to recognise them in other comprehensive income and accumulate them in a separate component of equity until the disposal of the foreign operation. [IAS 21.45]. The principle question is whether the change in circumstances or actual settlement in cash of the intragroup balance represents a disposal or partial disposal of the foreign operation and this is considered in more detail at 6.6 below.

6.3.7 Dividends

If a subsidiary pays a dividend to the parent during the year the parent should record the dividend at the rate ruling when the dividend was declared. An exchange difference will arise in the parent's own financial statements if the exchange rate moves between the declaration date and the date the dividend is actually received. This exchange difference is required to be recognised in profit or loss and will remain there on consolidation.

The same will apply if the subsidiary declares a dividend to its parent on the last day of its financial year and this is recorded at the year-end in both entities’ financial statements. There is no problem in that year as both the intragroup balances and the dividends will eliminate on consolidation with no exchange differences arising. However, as the dividend will not be received until the following year an exchange difference will arise in the parent's financial statements in that year if exchange rates have moved in the meantime. Again, this exchange difference should remain in consolidated profit or loss as it is no different from any other exchange difference arising on intragroup balances resulting from other types of intragroup transactions. It should not be recognised in other comprehensive income.

It may seem odd that the consolidated results can be affected by exchange differences on inter-company dividends. However, once the dividend has been declared, the parent now effectively has a functional currency exposure to assets that were previously regarded as part of the net investment. In order to minimise the effect of exchange rate movements entities should, therefore, arrange for inter-company dividends to be paid on the same day the dividend is declared, or as soon after the dividend is declared as possible.

6.3.8 Unrealised profits on intragroup transactions

The other problem area is the elimination of unrealised profits resulting from intragroup transactions when one of the parties to the transaction is a foreign subsidiary.

If in the above example the goods had been sold by the Italian parent to the Swiss subsidiary then the approach in US GAAP would say the amount to be eliminated is the amount of profit shown in the Italian entity's financial statements. Again, this will not necessarily result in the goods being carried in the consolidated financial statements at their original cost to the group.

6.6.1 Disposals and transactions treated as disposals

6.6.2 Partial disposals

6.6.3 Comparison of the effect of step-by-step and direct methods of consolidation on accounting for disposals

We illustrated the basic requirement to reclassify cumulative exchange differences from equity to profit or loss on the disposal of a foreign operation in Example 15.17 at 6.6.1.A above where a parent sold a direct interest in a subsidiary. This requirement also applies on the sale of an indirect subsidiary. However, where the intermediate holding company and the subsidiary each have different functional currencies, the method of consolidation can have an impact on the amount of exchange differences reclassified from equity to profit or loss on the disposal of the subsidiary.

If the step-by-step method is used, this amount will have been measured based on the functional currencies of the intermediate holding company and the subsidiary. The translation of that amount into the presentation currency of the ultimate parent will not be the same as if the ultimate parent had consolidated the subsidiary individually. In this second case (the direct method), the exchange differences on translation of the subsidiary would have been measured based on the functional currency of the subsidiary and the presentation currency used by the ultimate parent. This is illustrated in the following example.

Although the Interpretations Committee has indicated that the direct method is conceptually correct, IFRIC 16 permits the use of either approach as an accounting policy choice (see 6.1.5 above).

In certain situations, the methods of consolidation seem to result in more extreme differences. For example, consider the disposal of a US subsidiary by a US intermediate holding company (both of which have the US dollar as their functional currency) within a group headed by a UK parent (which has sterling as its functional and presentation currency). The US subsidiary that is disposed of is a foreign operation so exchange differences accumulated in the separate component of equity relating to it should be reclassified from equity to profit or loss on its disposal. Under the direct method of consolidation, this amount will represent exchange differences arising from translating the results and net assets of the US subsidiary directly into sterling. However, under the step-by-step method, these exchange differences will be entirely attributable to the intermediate parent undertaking and so there would be no reclassification from equity to profit or loss.