Introduction

Foreign currency transactions are transactions denominated in a currency other than the entity’s functional currency. The functional currency amount at which transactions denominated in foreign currencies should initially be recognised will be determined by using the exchange rate appropriate to the transaction.

This is the spot rate between the functional currency and the foreign currency at the date of the transaction. The date of the transaction is the date on which the transaction first qualifies for recognition in accordance with IFRS Standards.

Initial recognition

A foreign currency transaction is recorded, on initial recognition, at the spot exchange rate between the functional currency and the foreign currency at the date of the transaction. This process is known as ‘translation’ − that is, financial data denominated in one currency is expressed in terms of another currency.

What are the challenges with initial recognition of foreign currency transactions? The requirements for initial recognition of foreign currency transactions appear straightforward, but their application could create problems, including determining the date of the transaction, which might not always be obvious; determining an average rate as an approximation to the actual rate (for revenues, expenses, gains and losses; and the selection of an appropriate rate for translating foreign currency transactions where there is more than one rate in operation.

Use of average rate that approximates the actual rate

For practical reasons, a rate that approximates the actual rate at the date of the transaction is often used. For example, an average rate for a week or a month might be used for all transactions in each foreign currency occurring during that period. If exchange rates fluctuate significantly, however, the use of the average rate for a period is inappropriate.

Use of average rate on initial recognition

It is common practice for entities that engage in a large number of foreign currency transactions to fix, for a period, the rate of exchange used to measure those transactions in their accounting records and to disregard day-to-day fluctuations in exchange rates. When this approach is used, care must be taken to ensure that the carrying amount of non-monetary assets (e.g. inventories or property, plant and equipment) is not materially different from what it would have been if actual rates had been used for translation.

The actual rates should be used if a material difference would arise compared to average rates (e.g. to measure large one-off transactions such as the acquisition of property, plant and equipment or if there is a significant and unexpected movement in exchange rates).

IAS 21 clearly acknowledges that some degree of approximation is acceptable. It will be a matter of judgement, on the basis of an entity’s specific facts and circumstances, whether it is appropriate to derive an average rate for the entire year or whether the year should be analysed into shorter periods (e.g. quarterly periods, months or weeks) with an average rate determined for each.

Exchange rates in Venezuela In recent years, the Venezuelan government has maintained a regime of strict currency controls. Multinational companies continue to face significant difficulties in repatriating earnings from Venezuelan entities. There is significant uncertainty about exchange rates, the amount that can be repatriated at a given exchange rate, and the timing of repatriation. During 2017, two currency exchange mechanisms were in place, namely the DIPRO and DICOM mechanisms. At the end of January 2018, and with the aim of establishing a unified system, the Venezuelan government: relaunched the DICOM mechanism, which applies to all foreign exchange transactions from 26 January 2018; and eliminated the DIPRO mechanism, which was used previously for imports of goods and services identified as critical or priority. In August 2018, the Venezuelan government announced a monetary reconversion, which created a new currency, the Sovereign Bolivar (VES), that replaces gradually from 20 August 2018 the previous currency (VEF) at a conversion rate of VES 1 to VEF 100,000. Entities need to adapt their systems and processes to the new currency. In September 2018, the government also introduced certain changes to the currency exchange system. The new exchange system would introduce the possibility for financial institutions to exchange foreign currency, which is in practice exchanged at a single rate regulated by the Venezuelan Central Bank (VCB). However, the relevant regulator has not yet issued the rules and regulations that would enable the application of the new exchange system. Therefore, DICOM continues to operate. Measuring assets and liabilities denominated in foreign currency IAS 21 requires the use of closing rates. In determining whether a rate is a closing rate, an entity should consider whether currency is obtainable at an official quoted rate and whether the quoted rate is available for immediate delivery. In practice, a normal administrative delay in obtaining funds would be acceptable. Where exchangeability between two currencies is temporarily unavailable at a transaction date or a subsequent balance sheet date, paragraph 26 of IAS 21 requires entities to use the rate on the first subsequent date at which exchanges could be made. The DICOM exchange rate published by the VCB can be considered a spot rate, and it can be used to translate monetary assets and liabilities. However, each entity will need to determine, considering their specific circumstances, whether the official exchange rate meets the definition of a closing rate (see below for further references to the IFRS IC agenda decision issued in September 2018). Entities should disclose the rate used and the effect on the amounts reported in the financial statements. Any significant accounting policies and judgements made in determining the rate should be disclosed in accordance with the requirements in IAS 1, ‘Presentation of financial statements. Management should also consider disclosing the sensitivity of using a different exchange rate in accordance with IAS 1, as part of the disclosures of sources of estimation uncertainties (required by IAS 1). Net assets of a subsidiary in Venezuela Parent companies typically use the dividend remittance rate to translate the net assets of a foreign operation, because this is usually the rate that would apply if funds from the foreign operation were remitted to the parent at the reporting date. Management should consider the particular circumstances (including, where relevant, the views of the relevant regulator), and might also consider taking legal advice over the rate that will be available for the payment of dividends. Management should also consider the IFRS IC agenda decision issued in September 2018 addressing the determination of the exchange rate in the extreme circumstances that currently exist in Venezuela. The circumstances described in the agenda decision consider situations where: the exchangeability of the currency is administered by exchange mechanisms, and the authorities set the exchange rates; and the currency is subject to a long-term lack of exchangeability, which results in an entity being unable to access foreign currencies using the exchange systems in place. The IC concluded that, in the situations described, entities need to determine if the official exchange rate or rates meet the definition of the closing rate (which is the spot exchange rate at the end of the reporting period). Since economic conditions change frequently in Venezuela, the IC also observed that entities need to reassess, at each period end, any relevant changes in circumstances. The rate used in translation, and the impact of that rate, should be disclosed. Any significant accounting policies and judgements made in determining the rate should be disclosed in accordance with the requirements in IAS 1. Management should also consider disclosing the sensitivity of using a different exchange rate in accordance with IAS 1, as part of the disclosures of sources of estimation uncertainties (required by IAS 1). The IC agenda decision referred to these disclosure requirements, and also observed that any significant restrictions on the ability to access or use assets and settle liabilities of operations in Venezuela should be disclosed in accordance with IFRS 12. Cash balances Management should also consider disclosing, under IAS 7, ‘Statement of cash flows’, the effect of the exchange controls in Venezuela on whether cash balances are available for general use by the group.

The date of transaction is the date on which the transaction first qualifies for recognition in accordance with IFRS. For revenues, expenses, gains and losses, the spot exchange rate at the dates on which those elements are recognised should be used; however, this might be impracticable in practice.

Management might, therefore, use a rate that approximates to the actual rate (such as an average rate). IFRIC 22 provides additional guidance for determining the date of transaction, for the purposes of determining an exchange rate at initial recognition for a related asset, income or expense where an entity receives or pays the consideration in a foreign currency in advance.

In this case, the date of transaction is the date of initial recognition of the advance consideration, unless the related asset, income or expense is measured at fair value at the date of initial recognition, or at the fair value of a date different from the date of the receipt or payment of the consideration.

If there are multiple receipts or payments in advance, a date of transaction is established for each of them. An entity need not apply IFRIC 22 to income taxes, insurance contracts or reinsurance contracts.

IFRIC 22 Foreign Currency Transactions and Advance Consideration

IFRIC 22 clarifies the appropriate exchange rate to use when the consideration for a transaction is denominated in a foreign currency and is paid or received in advance, giving rise to a non-monetary asset or non-monetary liability (e.g. a prepayment or accrual).

IAS 21 requires an entity to record a transaction denominated in a foreign currency, initially, at the spot rate “at the date of the transaction” which is defined in IAS 21 as “the date on which the transaction first qualifies for recognition in accordance with IFRSs”.

IFRIC 22 focuses on how to determine that date when an entity pays or receives consideration in advance in a foreign currency. In such circumstances, a non-monetary asset or non-monetary liability is generally recognised when the advance consideration is received – recognition of the related asset, expense or income comes later when recognition criteria are met in accordance with relevant IFRS Standards.

This issue arises frequently, for example in the context of foreign-currency denominated:

• revenue from contracts with customers;
• purchases and sales of property, plant and equipment;
• purchases and sales of intangible assets;
• purchases and sales of investment property;
• purchases of inventory;
• purchases of services;
• entering into lease contracts; and
• receipt of some government grants.

Scope of IFRIC 22

IFRIC 22 applies to a foreign currency transaction (or part of it) when an entity pays or receives consideration in advance of recognising the related asset, expense, or income, giving rise to a non-monetary asset or non-monetary liability in the intervening period.

Therefore, the Interpretation applies to foreign currency transactions or parts of transactions when:

• there is consideration that is denominated or priced in a foreign currency;
• the entity recognises a prepayment asset or a contract liability (deferred income) in respect of that consideration, in advance of the recognition of the related asset, expense or income; and
• the prepayment asset or contract liability (deferred income) is non-monetary.

An advance payment or receipt may give rise to a monetary asset or liability instead of a non-monetary asset or liability (e.g., when the transaction involves a cash advance that is refundable –. IAS 21 is clear that exchange differences arising between the transaction date and the date of settlement in such circumstances are recognised in profit or loss; consequently, such transactions are not affected by IFRIC 22.

Advance consideration may be in a form other than cash (e.g., an entity may receive equity instruments or inventories as consideration for services rendered). IFRIC 22 applies equally to such non-cash transactions.

IFRIC 22 does not apply when the related asset, expense or income is measured on initial recognition either:

• 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 arising from the payment or receipt of consideration in advance (e.g., the measurement of goodwill when applying IFRS 3).

Specifically excluded from the scope of IFRIC 22 are:

• income taxes; and
• insurance contracts (including reinsurance contracts) that an entity issues and reinsurance contracts that an entity holds.

The ‘date of the transaction’ for transactions within the scope of IFRIC 22

When an entity makes a payment of, or receives, advance consideration that gives rise to a non-monetary asset or non-monetary liability (e.g., a prepayment or accrual), the date of the transaction for the purposes of determining the exchange rate to use on initial recognition of the related asset, expense or income (or part of it) is the date that the entity initially recognises the non-monetary asset or non-monetary liability.

Examples of monetary and non-monetary items

The following table lists a number of the most common monetary and non-monetary items.

In practice, it is usually appropriate to regard a defined benefit asset or obligation as a monetary item. But it is possible to argue that some components, particularly relating to equity securities, should be regarded as non-monetary.

However, for most entities, this would lead to a level of complexity that is unwarranted. It is relatively uncommon for a defined benefit arrangement to be denominated in a currency other than the functional currency of the entity.

A contract to receive (or deliver) a variable number of the entity’s own equity instruments or a variable amount of assets in which the fair value to be received (or delivered) equals a fixed or determinable number of currency units is also a monetary item.

For example, an issued US$100,000 loan note repayable in ordinary shares to the value of US$100,000 meets the definition of a monetary item.

When preference shares are classified as debt by the issuer, they are typically a monetary liability for the issuer and a monetary asset for the holder. When preference shares are classified as equity by the issuer, they are recognised in equity by the issuer, typically using the exchange rate on the date that they were issued.

They are a non-monetary asset for the holder and, on initial recognition, are typically recognised using the exchange rate on the date that they were acquired. Such assets may often subsequently be measured at fair value and the fair value should reflect the exchange rate at the date of the valuation.

How does an entity determine the average rate? Management can use an average rate for a period for recording foreign currency transactions as a proxy to the actual rate prevailing at the date of each transaction, provided that the rate approximates to the actual rate. This will be appropriate only if there is no significant change in rates during that period. An average rate is unlikely to be used by entities undertaking few transactions in a foreign currency. It is also unlikely to be used for translating large, one-off transactions that would be recorded at the actual rate. The flexibility allowed in IAS 21 is likely to be most beneficial to entities that enter into a large number of transactions in different currencies, or that maintain multi-currency ledgers. However, no guidance is provided in the standard as to how such a rate is determined. Determining an average rate, and its use in practice, depends on a number of factors, such as: the frequency and value of transactions undertaken; the period over which the rate will apply; the extent of any seasonal trade variation; the desirability of using a weighting procedure; the acceptable level of materiality; and the nature of the entity’s accounting systems. There are a number of different methods by which an average rate can be calculated. These range from simple monthly or quarterly averages to more sophisticated methods using appropriate weighting that reflects changes both in exchange rates and in the volume of business. The choice of the period to be used for calculating the average rate will depend on the extent to which daily exchange rates fluctuate in the period selected. If exchange rates are relatively stable over a period of one month, for example, the average exchange rate for that month can be used as an approximation to the daily rate. If, however, there is volatility of exchange rates, it might be appropriate to calculate an average rate for a shorter period, such as a week. Whatever period is chosen, materiality is likely to be an important factor. An entity might use an actual average rate or an estimated average rate, depending on the circumstances. An actual average rate is likely to be used where there is some delay between the date when the transactions occurred and the date when they are recorded. In other situations, it might be necessary for an entity to use an estimated average rate for a period, rather than wait for the period to end in order to calculate an actual average rate. This estimate might be based on the average of daily exchange rates for the previous period or the closing rate of the previous period. Whichever basis is used, it will be necessary to ensure that the estimated average rate is a close approximation of the actual rates prevailing during the period. If it is not, the rate should be revised accordingly.

Average rate versus actual rate Blossom plc is preparing its IFRS consolidated accounts for the year ended 31 December 20X1. The Blossom group has several overseas subsidiaries. In preparing the consolidated accounts, Blossom plc understands that it should translate the foreign subsidiaries’ income and expenses using the actual exchange rates applicable to each of the various transactions. Blossom plc has considered whether it can instead translate the income and expenses using an annual average foreign currency rate. IAS 21 recognises that translation using actual exchange rates for many transactions is generally impractical. It therefore permits an entity to use a rate that approximates to the actual rate – For example, an average rate – provided there is no significant change in rates during that period. If exchange rates fluctuate significantly, the use of the average rate for a period is inappropriate. The volatility in the currency markets in the first half of 20X1 should be considered when determining whether an average foreign currency rate is appropriate to record transactions or translate the results of foreign subsidiaries. It is unlikely that an entity would use an average rate where it has only a few transactions in a foreign currency. Similarly, an average rate should not be used for translating large, one-off transactions. In other cases, including where averaging is performed automatically by accounting systems or consolidation packages, judgement will be required to determine whether the period over which an average exchange rate is calculated has experienced such volatility that that average rate has ceased to be a reasonable approximation of actual rates.

Accounting for foreign currency-denominated interest flows in accordance with IFRS 9 and IAS 21 Where interest is denominated in a foreign currency, which exchange rate should be used to translate interest payment/receipts and accruals? Accruals related to interest flows denominated in a foreign currency should be recorded at the daily rates prevailing on each day to which elements of the accrual relate. For practical purposes, an average can be used as a proxy, provided this constitutes a reasonable approximation. The resulting accrual is then revalued to the closing rate on the balance sheet date, with the resulting exchange difference being recorded as a foreign exchange gain or loss and not as interest expense.

What is the date of transaction for the purpose of determining an exchange rate at the initial recognition of an asset, where the consideration for the asset is paid in advance? An Australian mining company pays US$1,000 on 1 May 20X7 to purchase a new machine, for delivery on 30 November 20X7. When the machine is recognised on 30 November 20X7, what is the date which should be used to determine the exchange rate to translate the cost of the machine into Australian Dollars? The 1 May 20X7 US Dollar to Australian Dollar exchange rate should be used to determine the Australian Dollar value of the machine on 30 November 20X7. This is because, on 1 May 20X7, the transaction first qualifies as being recognised as a prepayment under IAS 1. If the company paid in advance in instalments, the date of each instalment would be used to apply an exchange rate at each date on which a payment was made.

Impact of foreign currency borrowings on functional currency – example Company K’s functional currency is the euro. Company K accounts for its 43 per cent investment in Company M, a Mexican entity, using the equity method of accounting. Company M’s functional currency is the Mexican peso. During the current year, Company M entered into a 200-million-euro third-party borrowing denominated in euro. Most of Company M’s operations, labour costs and purchases are denominated in the peso and incurred in the domestic market. It is not appropriate for Company M to change its functional currency from the peso to the euro. Because the majority of Company M’s operations, sales, purchases, labour costs etc. are denominated in the Mexican peso, and Mexico is the country that drives the competitive forces and regulations of that entity, Company M should continue using the Mexican peso as its functional currency. Although, in accordance with IAS 21, a large third-party financing in a different currency may in some circumstances provide evidence to support a change in functional currency, greater weight must be given to the factors discussed in IAS 21 (sales, purchases, labour costs etc.). Accordingly, in the circumstances described, the new financing is not sufficient, in and of itself, to justify a change in the functional currency from the peso to the euro.

Single payment in advance for purchase of a single item – example Entity A, which has a functional currency of Japanese yen (JPY), enters into a contract to purchase a single item of inventory from Entity B on 1 August 20X3 for a fixed price of US$500 which is paid on 15 August 20X3. The inventory is delivered to Entity A on 30 September 20X3. The exchange rate on 15 August 20X3 is US$1 = JPY90. The exchange rate on 30 September 20X3 is US$1 = JPY95. On 15 August 20X3, Entity A recognizes a prepayment (non-monetary asset) using the exchange rate on that date as follows. JPY JPY Dr Prepayment (US$500 × 90) 45,000 Cr Cash (US$500 × 90) 45,000 The prepayment is a non-monetary asset and consequently, in accordance with IAS 21, it is not subsequently retranslated. On 30 September 20X3, when the inventory is delivered, Entity A derecognizes the prepayment and recognizes inventory in the statement of financial position. In accordance with IFRIC 22, Entity A recognizes inventory using the exchange rate at the date of initial recognition of the non-monetary asset (i.e., US$1 = JPY90) as follows. JPY JPY Dr Inventory 45,000 Cr Prepayment 45,000

Date at which change in functional currency is recognized A change in functional currency should be reported as of the date it is determined that there has been a change in the underlying events and circumstances relevant to the reporting entity that justifies a change in the functional currency. This could occur on any date during the year. For convenience, and as a practical matter, there is a practice of using a date at the beginning of the most recent period (annual or interim, as the case might be).

Multiple exchange rates

Some countries might operate more than one exchange rate. Where a country has multiple exchange rates, judgement is often required to determine which exchange rate qualifies as a spot rate that can be used for translation under IAS 21.

In determining whether a rate is a spot rate, an entity should consider whether currency is obtainable at an official quoted rate and whether the quoted rate is available for immediate delivery. In practice, a normal administrative delay in obtaining funds would be acceptable.

Where several exchange rates are available, the rate used to translate and record the foreign currency transactions and balances is that at which the future cash flows represented by the transaction or balance could have been settled if those cash flows had occurred at the measurement date.

Multiple exchange rates: assets and liabilities expected to be settled at a specific rate, and net investments When measuring assets and liabilities denominated in foreign currency, there might be specific assets and liabilities that management expects will be settled at a specific rate. In such a case, that rate should be used. In other circumstances, management should use judgement to determine the rate at which the balance could have been settled at the measurement date. When translating a net investment under IAS 21, the rate used is often the dividend remittance rate, but another rate might be more appropriate if the proceeds would, in practice, be remitted in another way. The rate (or rates) used and the implications should be disclosed clearly. The rate (or rates) used might also be a significant accounting judgement to be disclosed under IAS 1, and management should consider disclosing the sensitivity of using a different exchange rate.