Chapter 4: Translation

Suspension of rates

Countries might experience economic conditions from time to time that affect the free-market convertibility of the local currency. As a result, the exchangeability between two currencies might be temporarily unavailable at the transaction date or a subsequent balance sheet date. IAS 21 requires entities to use the rate on the first subsequent date at which exchanges could be made.

How should an entity translate a balance when rates have been suspended? Doubts as to convertibility might arise if, for example, an entity makes a long-term currency loan to an overseas supplier but restrictions on the remittance of funds are imposed by the overseas country sometime before the balance sheet date. Such restrictions might arise as a result of currency devaluation, political upheaval or severe exchange control regulations in the overseas country. Management should use the rate on the first subsequent date at which exchanges could be made following restoration of normal conditions.

Suspension of foreign exchange rates In October 20X3, entity A, which is incorporated in the UK, used surplus currency to make a long-term loan of FC15 million to its overseas supplier. The loan was made when the exchange rate was £1 = FC5.00 and is repayable on 30 September 20X5, which is entity A’s year end. Initially, the loan is translated and recorded in entity A’s books at £3 million. The amount that entity A ultimately receives depends on the rate of exchange ruling on the date when the loan is repaid. On 28 September 20X5, a few days before the due date of the loan’s repayment, the exchange rate was £1 = FC6.00. On the same date, the local government announced that a devaluation would occur on 2 October 20X5, and all foreign exchange transactions would be suspended until 3 October 20X5. On 2 October 20X5, foreign exchange transactions were executed but left unsettled until the following day, when a new rate was established. On 3 October 20X5, a new rate of £1 = FC7.50 was established and was effective for transactions left unsettled the previous day. An official exchange rate at 30 September 20X5 is temporarily unavailable. In this situation, the exchange rate was temporarily lacking, and the rate established on 3 October 20X5, the first subsequent date, is the appropriate rate to use for translating the monetary asset at the balance sheet date of 30 September 20X5. Therefore, entity A would record the loan receivable at £2 million and recognise a foreign exchange loss of £1 million in profit or loss.

Subsequent measurement

A foreign currency transaction might give rise to assets and liabilities that are denominated in a foreign currency. The procedure for translating such assets and liabilities into the entity’s functional currency at each balance sheet date will depend on whether they are monetary or non-monetary.

Translation of monetary items

Monetary items are units of currency held, and assets and liabilities to be received or paid in a fixed or determinable number of units of currency. The essential feature of a monetary item is a right to receive (or an obligation to deliver) a fixed or determinable number of units of currency. Examples are:

• Financial assets, such as cash, bank balances and receivables.
• Financial liabilities, such as debt and lease liabilities.
• Provisions that are settled in cash.
• Pensions and other employee benefits to be paid in cash and cash dividends that are recognised as a liability.
• Derivative financial instruments, such as forward exchange contracts, foreign currency swaps and options, are also monetary items, because they are settled at a future date.

Is a contract for a variable number of an entity’s own equity instruments a monetary item? It depends. For an item to qualify as a monetary item, it does not need to be recovered or settled in cash. A contract to receive (or deliver) a variable number of an 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 units of currency, is also a monetary item. In other words, an entity’s own equity instruments can be used ‘as currency’ in a contract that can be settled at a value equal to a fixed or a determinable amount. Such a contract is not an equity instrument, but a monetary financial asset or a liability. However, not all financial assets should be treated as monetary items. For example, an investment in an equity instrument is not a monetary item – there is no right to receive a fixed or determinable amount of cash.

IAS 21 requires entities to translate foreign currency monetary items outstanding at the end of balance sheet date using the closing rate. The closing rate is the spot exchange rate at the balance sheet date. An exchange rate that is fixed under the terms of the relevant contract cannot be used to translate monetary assets and liabilities.

Translating a monetary item at the contracted rate under the terms of a relevant contract is a form of hedge accounting that is not permitted under IAS 39 or IFRS 9.

Translation of non-monetary items

Non-monetary items are all items other than monetary items. In other words, the right to receive (or an obligation to deliver) a fixed or determinable number of units of currency is absent in a non-monetary item. Typical examples are:

• Intangible assets.
• Property, plant and equipment.
• Amounts pre-paid for goods and services.
• Equity investments.
• Provisions that are to be settled by the delivery of a non-monetary asset.

Are advances considered a monetary item? Advances paid and received (including pre-payments) can be difficult to classify as monetary or non-monetary. An example of a non-monetary item is an advance payment for goods that, absent a default by the counterparty, must be settled by the counterparty delivering the goods. This is consistent with IFRIC 22 which notes that advance consideration paid or received in a foreign currency is generally a non-monetary item. However, if an advance is refundable in circumstances other than a default by either party, this might indicate that it is a monetary item, because the item is receivable in units of currency.

Translation of non-monetary items depends on whether they are recognised at historical cost or at fair value. Non-monetary items that are measured in terms of historical cost in a foreign currency are translated using the exchange rate at the date of the transaction. This means that such assets are recorded at historical cost, and no re-translation of the asset is required at subsequent balance sheet dates.

However, if the asset is impaired, the recoverable amount is translated at the exchange rate ruling at the date when that value was determined (For example, the closing rate at the balance sheet date). Comparing the previously recorded historical cost with the recoverable amount might or might not result in recognising an impairment loss in the functional currency.

Will an impairment loss arise in an entity’s functional currency if there is an impairment loss on a foreign currency asset when measured in the foreign currency? Not always. Take, for example, an entity whose functional currency is sterling. A foreign currency asset costing FC925,000 is recorded at the date of purchase at £500,000, when £1 = FC1.85. At a subsequent balance sheet date, the asset’s recoverable amount in foreign currency is FC787,500, when £1 = FC1.50. Although there is impairment loss in foreign currency, no impairment loss is recognised, because the recoverable amount (at the balance sheet date) of £525,000 is higher than the carrying value.

Non-monetary assets that are measured at fair value in a foreign currency are translated using the exchange rates at the date when the fair value was determined. Changes in fair value include foreign exchange differences arising on the re-translation of the opening foreign currency fair value.

Recognition of exchange differences

Monetary items

Exchange differences arising on the settlement of monetary items, or on translating monetary items at rates different from those at which they were translated on initial recognition during the period or in previous financial statements, are recognised in profit or loss in the period in which they arise.

Where monetary items arise from a foreign currency transaction and there is a change in exchange rate between the transaction date and the date of settlement, an exchange difference results. Where a transaction is settled within the same accounting period at an exchange rate that differs from the rate used when the transaction was initially recorded, the exchange difference is recognised in the income statement of the period in which the settlement takes place.

It is appropriate to recognise such exchange differences as part of the profit or loss for that year, because the exchange difference will have been reflected in the cash flow at the time of the settlement.

Treatment of a foreign currency-denominated purchase of plant In March 20X5, a UK entity purchases plant for use in the UK from an overseas entity for FC1,980,000. At the date when the entity purchases the plant, the exchange rate is £1 = FC1.65. The purchase price is to be settled in three months, although delivery is made immediately. The UK entity records both the plant and the monetary liability at £1,200,000 (FC1,980,000/£1.65). The entity will not need to translate the plant again. At the settlement date, the exchange rate is £1 = FC1.75. The actual amount that the UK entity will pay to settle the liability is therefore £1,131,429. The entity should include the gain on exchange of £68,571 (that is, £1,200,000 – £1,131,429) in arriving at its profit or loss.

Where a monetary item arising from a foreign currency transaction remains outstanding at the balance sheet date, an exchange difference arises as a consequence of recording the foreign currency transaction at the rate ruling at the date of the transaction (or when it was translated at a previous balance sheet date) and the subsequent re-translation of the monetary item to the rate ruling at the balance sheet date. Such exchange differences are reported as part of the profit or loss for the year.

Monetary assets classified as fair value through other comprehensive income in accordance with IFRS 9 are carried at fair value; however, for the purpose of calculating foreign exchange differences, they are treated as if they were carried at amortised cost. The exchange differences resulting from changes in amortised cost are recognised in the income statement.

Other fair value gains and losses on financial assets classified as fair value through other comprehensive income are recognised in other comprehensive income.

Not all exchange differences on monetary items are reported in the income statement. There are a number of exceptions, as follows:

• A monetary item that is designated as a hedging instrument in a cash flow hedge.
• Any exchange difference that forms part of the gain or loss on the hedging instrument, to the extent that the hedge is effective, is recognised in other comprehensive income.
• A monetary item that is designated as a hedge of a net investment in consolidated financial statements.
• The exchange difference on the hedging instrument, to the extent that the hedge is effective, is recognised in other comprehensive income.
• A monetary item that forms part of the net investment in a foreign operation in the consolidated financial statements.

How should an entity report foreign exchange differences on monetary items measured at FVTPL that form part of the entity’s net investment in a foreign operation? An investor provided a long-term loan denominated in a foreign currency to its associate. The loan will not be settled in the foreseeable future and forms part of the net investment in the foreign associate. The loan’s cash flows do not represent solely payments of principal and interest. The loan is measured at fair value through profit or loss (FVTPL). Should the investor recognise foreign exchange differences on this loan in other comprehensive income or in profit or loss in its consolidated financial statements? Solution: The investor has the following accounting policy options to recognise the foreign exchange differences resulting from the loan carried at FVTPL and that forms part of the net investment in its foreign equity method investee: in profit or loss, as part of the gains or losses from changes in the fair value of the loan, or in other comprehensive income as part of the translation of the net investment in the foreign operation. The chosen policy should be applied consistently and disclosed if significant.

Definition of ‘foreseeable future’

IAS 21 does not specify a time period that might qualify as the ‘foreseeable future’. Therefore, the term does not imply a specific time period, but is an intent-based indicator, i.e. an intragroup receivable or payable may qualify as part of the net investment in the foreign operation when:

the parent does not intend to require repayment of the intragroup account (which cannot be represented if the debt has a maturity date that is not waived); and

the parent’s management views the intragroup account as part of its investment in the foreign operation.

A history of repayments is likely to be indicative that an advance or loan does not form part of the investment in a foreign operation.

Non-monetary items

When a gain or loss on a non-monetary item is recognised directly in other comprehensive income, any exchange component of that gain or loss is recognised directly in other comprehensive income.

Instruments for which gains or losses are directly recognised in other comprehensive income An example is where an entity purchases equity securities denominated in a foreign currency that are measured at fair value through other comprehensive income. Any changes in fair value that are recognised directly in other comprehensive income also include any related foreign exchange element. Another example is where a property purchased in a currency other than the entity’s functional currency is revalued. The revaluation gain is recognised directly in other comprehensive income and will include foreign exchange differences, because the property is re-translated at the rate of exchange at the valuation date.

Translation of a revalued foreign asset A UK entity with a sterling functional currency has a property located in the US, which it acquired at a cost of US$1.8 million when the exchange rate was £1 = US$1.60. The property was revalued to US$2.16 million at the balance sheet date, when the exchange rate was £1 = US$1.80. Ignoring depreciation, the amount that would be reported in other comprehensive income is: £ Value at balance sheet date = US$2,160,000 @ 1.8 = 1,200,000 Value at acquisition date = US$1,800,000 @1.6 = 1,125,000 Revaluation surplus recognised in other comprehensive income 75,000 The component parts of the revaluation surplus can be analysed as follows: Change in fair value = US$360,000 @ 1.8 = 200,000 Exchange component of change = US$1,800,000 @ 1.8 – US$1,800,000 @ 1.6                                      (125,000)

When a gain or loss on a non-monetary item is recognised in profit or loss, any exchange component is also recognised in profit or loss.

Translation of an impaired foreign asset A UK entity with a sterling functional currency has a property located in the US, which was acquired at a cost of US$1.8 million when the exchange rate was £1 = US$1.60. The property is carried at cost. At the balance sheet date, the recoverable amount of the property (as a result of an impairment review) amounted to US$1.62 million, when the exchange rate was £1 = US$1.80. Ignoring depreciation, the loss that would be reported in the income statement as a result of the impairment is: £ Carrying value at balance sheet date – US$1,620,000 @ 1.8 = 900,000 Historical cost – US$1,800,000 @ 1.6 = 1,125,000 Impairment loss recognised in profit or loss (225,000) The components parts of the impairment loss can be analysed as follows: Change in value due to impairment = US$180,000 @ 1.8 = (100,000) Exchange component of change = US$1,800,000 @ 1.8 − US$1,800,000 @ 1.6                                      (125,000)

Foreign currency translation of financial statements

Where foreign activities are undertaken through foreign operations, the financial statements of those foreign operations are translated so that they can be included in the reporting entity’s financial statements by consolidation or the equity method. The process of translation addresses the appropriate exchange rates to use for translating the income statement and the balance sheet of the foreign operation; it also addresses how the financial effects of changes in exchange rates are recognised in the reporting entity’s financial statements.

The standard permits an entity to present its financial statements in a currency other than its functional currency. The currency in which the financial statements are presented is referred to as the ‘presentation currency’. There is no requirement in the standard for an entity to present its financial statements in its functional currency, which most faithfully portrays the economic effect of transactions and events on the entity.

Although entities have a free choice in the selection of the presentation currency, they are likely to use the functional currency (that is, the currency used for measurement) as the presentation currency. If management uses an alternative currency, disclosure of the reasons for selecting a different currency is required.

Translation to the presentation currency

Selecting a presentation currency that is different from the functional currency requires a translation from the functional currency into the presentation currency. For example, where a group contains individual entities with different functional currencies, the results and financial position of each entity are expressed in a common currency, so that consolidated financial statements can be presented. IAS 21 prescribes a methodology for translating from the functional currency to a different presentation currency. This translation methodology seeks to ensure that the financial and operational relationships between underlying amounts established in the entity’s primary economic environment and measured in its functional currency are preserved when translated into a different presentation currency. A different translation methodology applies to an entity whose functional currency is the currency of a hyper-inflationary economy.

Translation methodology to presentation currency

Presenting the financial statements in a currency other than the functional currency An entity normally presents its financial statements in the same currency as its functional currency; however, an entity may choose to present its financial statements in a different currency. Presenting the financial statements in a currency other than the functional currency does not change the way in which the underlying items are measured. It merely expresses the underlying amounts, which are measured in the functional currency, in a different currency.

The translation methodology requires the results and financial position of an entity (whose functional currency is not the currency of a hyper-inflationary economy) to be translated into a different presentation currency using the following procedures:

• Assets and liabilities for each balance sheet presented (including comparatives) are translated at the closing rate at the balance sheet date.
• Income and expenses for each statement presenting profit or loss and other comprehensive income (including comparatives) are translated at exchange rates at the transaction dates. For practical reasons, a rate that approximates to the exchange rates at the transaction dates − For example, an average rate for the relevant period − is often used.
• All resulting exchange differences are recognised in other comprehensive income, and they are accumulated as a separate component of equity. This separate component of equity is often referred to as cumulative translation adjustment (CTA).

The exchange differences referred to in the last bullet point above comprise:

• Differences arising from translating the income statement at exchange rates at the transaction dates or at average rates, and assets and liabilities at the closing rate. Such exchange differences arise on items recognised in the income statement as well as in other comprehensive income.
• Differences arising on the opening net assets’ re-translation at a closing rate that differs from the previous closing rate.

CTA might also include differences on re-translation of equity items, depending on the policy choice made.

Choice of presentation currency

The most common use of a presentation currency is in the context of a consolidated group. When a group contains entities with different functional currencies, the results and financial position of each entity must be expressed in a common currency to produce the consolidated financial statements. The presentation currency of the consolidated financial statements of the group is often, but not always, the functional currency of the parent.

A corporate group may have extensive operations in many countries and conduct its business largely in international markets. It may be difficult to identify the most appropriate presentation currency. An international currency such as sterling, the US dollar or the euro might be used. For example, for entities that raise capital in international markets, the use of an international currency may be of benefit to the users of the financial statements.

Individual entities, or groups where all the entities have the same functional currency, may also choose to present their financial statements in a currency other than their functional currency. This option may be selected, for example: to provide information to overseas shareholders; or for the purpose of preparing statutory financial statements in some jurisdictions where entities are required to present their financial statements in the local currency even if this is not their functional currency; or by a subsidiary that wishes to present its financial statements in the functional currency of its parent when that is different from its own functional currency.

Recognition of exchange differences arising on translation to a presentation currency

IAS 21 explains that exchange differences resulting from translation into a presentation currency are not recognised in profit or loss because those changes in exchange rates have little or no direct effect on the present and future cash flows from operations.

The exchange differences arising on translation to the presentation currency result from:

• translating income and expenses at the exchange rates at the dates of the transactions and assets and liabilities at the closing rate; and
• translating the opening net assets at an exchange rate (closing rate) different from that at which they were previously reported.

The cumulative amount of the exchange differences is presented in a separate component of equity until disposal of the foreign operation.

Share capital and other equity reserves translated into a presentation currency

IAS 21 provides rules for the translation of income, expenses, assets and liabilities; however, it does not refer to the translation, or retranslation, of share capital or other equity reserves. IAS 21 requires that exchange differences arising from translation should be recognised in other comprehensive income and later reclassified to profit or loss on disposal or partial disposal; those amounts do not reflect any retranslation of share capital or other equity reserves.

Accordingly, the ‘foreign currency translation reserve’ should not include any amounts for the retranslation of share capital or other equity reserves.

Although IAS 21 does not specifically prohibit the retranslation of share capital and other equity reserves, such a retranslation would have no meaning for financial reporting purposes, because any ‘differences’ arising would never be reclassified to profit or loss.

Accordingly, it is generally considered most meaningful to translate share capital and other components of equity using the historical rate, i.e. the exchange rate at the date of issue of share capital, or at the date of the associated transaction for other equity reserves. In particular, if this approach is adopted:

• when translating share capital into the presentation currency, the rate at the date of issue would be used. Thus, more than one historical rate will apply when share capital is issued at different times: and
• when translating a revaluation reserve (e.g. when an item of property is revalued in accordance with IAS 16) into the presentation currency, the rate at the date of each revaluation would be used. Thus, more than one historical rate will apply when a revaluation reserve relates to assets that have been revalued at different times.

Appropriate exchange rate to use when translating into the presentation currency an amount reclassified from the cash flow hedge reserve to profit or loss

IFRS 9 requires an entity to recognise the portion of the gain or loss on the hedging instrument that is determined to be an effective hedge in OCI and to reclassify that amount to profit or loss when the forecast sale occurs. An entity will need to consider which exchange rate should be applied when translating the amount that is reclassified from the cash flow hedge reserve to profit or loss into the entity’s presentation currency.

IAS 21 requires that “income and expenses for each statement presenting profit or loss and other comprehensive income (i.e., including comparatives) shall be translated at exchange rates at the dates of the transactions“. IAS 21 defines the date of transaction as “the date on which the transaction first qualifies for recognition in accordance with IFRSs“.

However, IAS 21 does not define the term “transaction”, and thus the following two approaches are acceptable.

Approach 1 – Historical exchange rate (i.e. the rate as at the date of recognition of the revaluation of the hedging instruments in OCI)

This approach views the transaction as the gain or loss on the hedging instrument, which is first recognised when the fair value of the hedging instrument changes.

The reclassification of the gain or loss from the hedging reserve to profit or loss is not considered to be a transaction. Thus, the reclassification is translated at the rate used for the original transaction (i.e., the rate in effect when the gain(s) or loss(es) was first recognised).

Approach 2 – Spot exchange rate (i.e., the rate as at the date of reclassification of the hedge reserve to profit or loss)

This approach views the reclassification of the cash flow hedge reserve to profit or loss as a separate transaction, triggered by the hedged transaction. Thus, the reclassification is translated at the rate in effect when reclassification is triggered (i.e. the rate in effect on the date when the hedged transaction takes place).

Because this approach results in translating the reclassification of the cash flow hedge reserve at a rate different from the rate used when it was created, a movement arises within the foreign currency translation reserve. This gain or loss is recognised in OCI.

An entity should select one of these approaches as an accounting policy choice, to be applied consistently.

The following example provides an illustration of both of these approaches.

Entity A has its local currency (LC) as its functional currency but presents its financial statements in a foreign currency (FC). On 1 October 20X1, it forecasts a foreign currency sale that will occur on 1 April 20X2. The amount of the sale is forecast to be FC3 million. Entity A’s financial year end is 31 December.

On 1 October 20X1, Entity A enters a foreign currency forward contract that matures on 1 April 20X2 at which point it will receive LC4.95 million and pay FC3 million. The fair value of the foreign currency forward on 1 October 20X1 is nil. On that date, it designates the foreign currency forward in a cash flow hedge of the variability of the FC-denominated sale due to changes in the forward rate.

*

For simplicity, the average exchange rate for the 3-month period ending on that date is assumed to be the same as the spot rate.

The transaction takes place as forecast on 1 April 20X2. On that date the spot exchange rate is 1.50.

For illustrative purposes the effects of the foreign currency basis spreads are ignored and the hedge is expected to be 100 per cent effective in each period.

31 December 20X1

Journal entry for the period

Statement of financial position at that date (reflecting solely the amounts related to the relevant transactions)

31 March 20X2

Journal entry for the period

Statement of financial position at that date (reflecting solely the amounts related to the relevant transactions)

1 April 20X2

Journal entries for the period

*

See above for discussion of the two approaches.

Statement of financial position at that date (reflecting solely the amounts related to the relevant transactions)

**

The movement in the foreign currency translation reserve (between the amount reported on 31 March 20X2 and 1 April 20X2) is recognised in OCI for the period.

Financial statements of a foreign operation prepared to a different date – example A parent includes a foreign subsidiary’s financial statements for the year ended 30 November in the parent’s consolidated financial statements for the year ended 31 December. Between 30 November and 31 December, the functional currency of the subsidiary devalues significantly against the parent’s functional currency (which is also the presentation currency of the group). When the financial statements of a subsidiary used in the consolidated financial statements are prepared to a date different from that of the parent, IFRS 10 requires adjustments to be made for the effects of significant events or transactions that occur between that date and the date of the parent’s financial statements. The rate used for the translation of the foreign subsidiary’s financial statements should be the spot rate at 30 November, as required by IAS 21, but, separately, it is necessary to consider which assets and liabilities might be affected significantly by the devaluation. Different items may be affected in different ways. For example: a further adjustment may be required for significant non-monetary assets of the subsidiary to retranslate them using the rate at 31 December, with a corresponding adjustment to the exchange differences recognized in other comprehensive income; conversely, for any significant monetary assets of the subsidiary that are denominated in the functional currency of the parent, there may be little impact on the consolidated statement of financial position. However, a further adjustment may be required to recognize in profit or loss the exchange gains that arose on those items in the subsidiary during December, with a corresponding adjustment to the exchange differences recognized in other comprehensive income. The same approach is used in applying the equity method to associates and joint ventures in accordance with IAS 28.

Translation of a foreign subsidiary Entity A, a UK entity, whose accounting period ended on 30 September 20X5, has a wholly owned US subsidiary, S corporation, which was acquired for US$500,000 on 30 September 20X4. The fair value of the net assets at the date of acquisition was US$400,000, giving rise to goodwill of US$100,000. The exchange rate at 30 September 20X4 and 20X5 was £1 = US$2.00 and £1 = US$1.50 respectively. The weighted average rate for the year ended 30 September 20X5 was £1 = US$1.65. During the year, S corporation paid a dividend of US$14,000 when the rate of exchange was £1 = US$1.75. The foreign currency movements in this example have been exaggerated. In reality, if exchange rates were this volatile, it would not be appropriate to use average rates for translating the income statement. The summarised income statement of S corporation for the year ended 30 September 20X5, and the summarised balance sheets at 30 September 20X5 and 20X4 in dollars and sterling equivalents, are as follows: $’000 Exchange rate £’000 Operating profit 135 1.65 81.8 Interest paid (15) 1.65 (9.0) Profit before taxation 120 72.8 Taxation (30) 1.65 (18.2) Profit after taxation 90 54.6 Balance sheets of S corporation September 30 20X5 $’000 20X4 $’000 20X5 £’000 20X4 £’000 Closing exchange rate £1 = $1.50 $2.00 Property, plant and equipment Cost (20X5 additions: $30) 255 255 170.0 112.5 Depreciation (20X5 charge: $53) 98 45 65.3 22.5 Net book value 157 180 104.7 90.0 Current assets: Inventories 174 126 116.0 63.0 Debtors 210 145 140.0 72.5 Cash at bank 240 210 116.0 105.0 624 481 416.0 240.5 Current liabilities: Trade creditors 125 113 83.3 57.5 Taxation 30 18 20.0 9.0 155 131 103.3 65.5 Net current assets 469 350 312.7 175.0 Loan stock 150 130 100.0 100.0 Net assets 476 400 317.4 200.0 Share capital 200 200 100.0 100.0 Retained profits 276 200 217.4 100.0 Analysis of retained profits $’000 £’000 Pre-acquisition profit brought forward 200 100.0 Profit for the year 90 54.6 Dividends paid in the year * (14) (8.0) Exchange difference – 70.8 Retained profits 276 217.4 * Dividend paid during the year is translated at the actual rate of £1 = $1.75 Analysis of exchange difference: Arising on re-translation of opening net assets (excluding goodwill – see below) at opening rate — $400,000 @ $2.00 = £1 200.0 at closing rate — $400,000 @ $1.50 = £1 266.7 Exchange gain on net assets 66.7 Exchange gain arising from translating retained profits from average to closing rate – $90,000 @1.50 – £54.6 5.4 Exchange loss arising from translating dividend from actual to closing rate – $14,000 @1.50 – £8.0 (1.3) Total exchange difference arising on translation of S corporation 70.8 Exchange difference on goodwill of US$100,000 treated as a currency asset at opening rate — US$100,000 @ $2.00 = £1 50.0 at closing rate — US$100,000 @ $1.50 = £1 66.7 Exchange gain on goodwill included in consolidation 16.7 Total exchange difference included in consolidated balance sheet as a separate component of equity (see below) 87.5 It is assumed that parent entity A’s functional currency is the pound sterling. It has received a dividend from S corporation during the year. The summarised balance sheets of entity A at 30 September 20X4 and 20X5 are as follows: Entity A — Balance sheets 20X5 20X4 £’000 £’000 Investments in subsidiary S ($500,000 @ 2.00) 250 250 Cash 208 200 Net assets 458 450 Share capital 450 450 Retained profits (dividend received: $14,000 @ 1.75*) 8 – 458 450 *Actual rate on date dividend received The summarised consolidated income statement for the year ended 30 September 20X5, and the consolidated balance sheet as at the date prepared under the closing rate/net investment method, are as follows: Consolidated income statement for the year ended 30 September 20X5 £’000 Operating profit of S corporation 81.8 Operating profit of entity A 8.0 89.8 Elimination of inter-company dividend (8.0) Net operating profit 81.8 Interest paid (9.0) Profit before taxation 72.8 Taxation (18.2) Retained profit 54.6 Consolidated balance sheet as at 30 September 20X5 £’000 Non-current assets: Goodwill 66.7 Property, plant and equipment 104.7 171.4 Current assets: Inventories 116.0 Debtors 140.0 Cash (S corporation: £160; entity A: £208) 368.0 Total current assets 624.0 Current liabilities: Trade creditors 83.3 Taxation 20.0 Total current liabilities 103.3 Net current assets 520.7 Non-current liabilities: Loan stock 100.0 Net assets 592.1 Capital and reserves: Share capital 450.0 Retained profit 54.6 Cumulative translation adjustment 87.5 Total capital and reserves 592.1

When would it be inappropriate to use an average exchange rate to translate a foreign subsidiary? XYZ plc has a foreign subsidiary with a functional currency of FC. The consolidated financial statements are presented in GBP. IAS 21 permits the use of the average exchange rate to translate income and expense items. If, during the year, the exchange rate between FC and GBP has been very volatile, should XYZ plc use average exchange rates? No. IAS 21 requires the income and expenses of foreign subsidiaries to be translated into the group’s presentation currency using exchange rates applicable at the dates of the various transactions. An entity can use a rate that approximates to the actual rate (For example, an average rate), provided rates do not fluctuate significantly during that period. If exchange rates fluctuate significantly, the use of the average rate for a period will be inappropriate. It is unlikely that an entity would use an average rate where it has 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 an approximation of actual rates.

Once the foreign operation’s financial statements have been translated into the reporting entity’s presentation currency, its incorporation into the reporting entity’s consolidated financial statements follows normal consolidation procedures.

Non-performance statement items

The standard is silent on how to translate items that are recognised directly in equity (that is, items that have not been recognised through the performance statements). These will generally be recognised as a result of a transaction with a shareholder (such as share capital, share premium or treasury shares). As a result, we believe that management has a choice of using either the historical rate or the closing rate for these items. The chosen policy should be applied consistently.

How should non-performance statement items be translated? IAS 21 is silent on how to translate items that are recognised directly in equity. As a result, we believe that management has a choice of using either the historical rate or the closing rate for these items. The chosen policy should be applied consistently. If the historical rate is used, these equity items are not re-translated and the cumulative translation adjustment (CTA) will, therefore, only include the cumulative differences between opening and closing rates on total net assets, and average to closing rates on retained earnings and other performance statement items, such as revaluation gains or cash flow hedging reserves. If the closing rate is used, the exchange differences that result from retranslating equity items are recognised directly in equity as part of the CTA reserve. This effectively reduces the CTA that arises on re-translating the net assets. Any exchange differences arising on re-translating equity items are recognised directly in equity, with the result that the CTA movement in equity will not equal the CTA recognised in total comprehensive income. The policy choice has no impact on the amount of total equity. The regulatory framework in some jurisdictions might mandate one treatment.

How to account for multi-currency share capital? ABC Limited is a newly incorporated UK company. It prepares its accounts under IFRS and has pounds sterling as its functional currency. ABC Limited has issued two classes of share capital, denominated in pounds sterling and US dollars respectively. The shares denominated in dollars were issued to a US investor who is looking to exit the investment potentially within the first three years of the investment. How should ABC Limited account for the share capital denominated in dollars? Under UK law, companies can issue share capital denominated in a currency other than their functional currency. Foreign currency equity share capital is initially stated at the spot rate at the date of issue, but it is generally not re-translated under IAS 21. Some companies choose to re-translate their foreign currency share capital and take the translation differences to a separate component of equity. The overall effect on equity, taking the re-translated foreign share capital and the cumulative translation differences together, is as though the foreign currency share capital is carried at the original spot rate. Foreign currency share capital is generally redeemed or repurchased in the currency in which the shares are denominated. There will be a difference between the functional currency amount at redemption and the amount recorded at the issue of the shares. It seems logical that this difference should affect distributable profits. A debit difference will absorb distributable profits. A credit difference should also be taken to distributable profits, provided that the shares were originally issued for cash or near cash.

Change in presentation currency

An entity might choose to change its presentation currency (For example, when there is a change in its functional currency), although this is not required. The choice of presentation currency represents an accounting policy, and any change should be applied retrospectively in accordance with IAS 8, unless impracticable.

This means that the change should be treated as if the new presentation currency had always been the entity’s presentation currency, with comparative amounts being restated into the new presentation currency.

Since using a presentation currency is purely applying a translation method, and does not affect the underlying functional currency of the entity or any entities within a group, it is straightforward to apply a change in presentation currency to assets, liabilities and performance statement items.

Where an entity changes its presentation currency, it should present an additional balance sheet in accordance with IAS 1.

How does an entity account for a change in presentation currency? When an entity changes its presentation currency, all assets and liabilities are translated from their functional currency into the new presentation currency at the beginning of the comparative period, using the opening exchange rate and re-translated at the closing rate. Performance statement items are translated at an actual rate or at an average rate approximating to the actual rate. Retained earnings and similar reserves should be expressed in the new presentation currency as if it had always been the presentation currency. For individual items within equity (For example, share capital and share premium), management has a choice of translating these equity items from an entity’s functional currency into its presentation currency at either the closing rate or at the historical rate, with the balancing amount being reported in cumulative translation adjustment (CTA) in equity. Where equity items are translated at the historical rate and/or where a group has foreign operations, the individual equity items should also be re-expressed in the new presentation currency as if it had always been the presentation currency. This requires determining the amount of each individual equity balance on each earlier reporting date. For unvarying items of equity, such as share capital and premium, this might not be too difficult, although even this might be complicated by share issues and buybacks in different reporting periods. For retained earnings and other similar reserves, the amounts in functional currencies must be translated at the transaction dates with a resulting impact on the amount recognised in CTA (unless it is impracticable to do so, following IAS 8). Calculating the split between retained earnings and CTA might be onerous in practice. How difficult this is will be influenced by whether average rates can be used as an approximation for actual rates, the period over which these changes are to be calculated, as well as the number of transactions. It will usually be relatively straightforward to go back as far as the opening balance sheet of the first period presented in the comparatives. The effect of going back further (which will affect only the relative amounts reported in CTA and retained earnings) might not be material, although this will depend on factors such as: The size of assets and liabilities. The stability of the relevant exchange rates. Legal requirements around distributability of profits. The reclassification of the deferred foreign exchange gains and losses on the ultimate disposal of a foreign operation. Where an entity, on adopting IFRS, took the exemption to reset the CTA to zero in accordance with IFRS 1, we believe that it would not be necessary to restate beyond its transition date.

Change in both presentation and functional currencies – example Company A is preparing its financial statements for the year ended 31 December 20X8. In the previous reporting period ended 31 December 20X7, the euro was both the functional currency and the presentation currency of Company A. With effect from 1 January 20X8, because of changes in trading arrangements that meet the requirements of IAS 21, the functional currency of Company A is changed to the US dollar (US$). In accordance with IAS 21, Company A applies the new functional currency prospectively from 1 January 20X8. In addition, Company A chooses to change its presentation currency from the euro to US$ for the period ended 31 December 20X8. Unlike its functional currency, an entity’s presentation currency can be any currency of choice. Therefore, the change in the presentation currency is a change in accounting policy and, as a consequence, should be applied retrospectively in accordance with IAS 8. This contrasts with the change in functional currency which, in accordance with IAS 21, is accounted for prospectively from the date of the change. Therefore, in the financial statements of Company A for the year ended 31 December 20X8: for the 20X8 (current) period, US$ is both the functional and the presentation currency; whereas for the 20X7 (comparative) period, the functional currency remains the euro and the presentation currency is restated to US$. A retrospective change in presentation currency to US$ gives the same result as if the presentation currency had always been US$. This is achieved by applying the following rates of exchange: for the assets and liabilities of Company A at 31 December 20X7, the closing exchange rate at that date; for the statement of comprehensive income of Company, A for the reporting period ended 31 December 20X7, the exchange rates at the dates of the transactions or, if it offers a reasonable approximation, the average rate for the period; and for the opening equity of Company, A at 1 January 20X7, the historical rate (i.e., the rate at the date of issue of each equity instrument and average rate for each period in which retained earnings arose). The 20X8 financial statements will therefore include an exchange reserve in the comparative period, to reflect the fact that the presentation currency (US$) differs from the functional currency (euro) in that period. This exchange reserve is retained in the 20X8 period and in subsequent periods, regardless of the fact that from 1 January 20X8 the presentation currency is the same as the functional currency. The following detailed workings illustrate these principles. In its 20X7 financial statements, when the euro was both the functional and the presentation currency, Company A reported the following amounts. 20X7 Statement of financial position (€) 20X7 Income statement (€) Assets 1,000 180 Share capital Revenue 100 80 Expenses 20 Retained earnings(a) 20 Profit   800 Liabilities 1,000 1,000   100   100 (a) For simplicity, this example assumes that the only movement in retained earnings since the inception of Company A is the profit for the year 20X7; in practice, historical retained earnings for each period would have to be translated at the average exchange rate for that period. The relevant exchange rates are as follows. 31/12/20X6 Average 20X7 31/12/20X7 €/US$ 1.40 1.37 1.47 At the date of issue of the share capital of Company A (in 20X0), the euro/US dollar (US$) exchange rate was 1.60. Company A is required to perform the following steps to reflect the changes in functional and presentation currencies in its 20X8 financial statements. 1. Restate comparative reporting period (20X7) to US$ presentation currency The statement of financial position and statement of profit or loss (income statement) for the comparative period (20X7) are restated as follows. 20X7 Statement of financial position (US$) 20X7 Income statement (US$) (b) Assets(a) 1,470 288 Share capital(c) Revenue 137 110 Expenses (21) Exchange reserve(d) 27 Profit 27 Retained earnings(e) 1,176 Liabilities(a) 1,470 1,470   137   137 (a) Figures translated from euro to US$ using the closing exchange rate at 31/12/20X7 of 1.47. (b) Figures translated from euro to US$ using the average 20X7 exchange rate of 1.37. (c) Equity (share capital in this scenario) translated from euro to US$ using the historical exchange rate at the date of issue of 1.60. (d) The exchange reserve represents the sum of (1) the difference between all the equity reserves at the end of 20X6 (€180) translated at the relevant historical exchange rates, in this case this is just share capital at the date of its issue, (US$288) and the net assets at the end of 20X6 at the closing 20X6 exchange rate (US$252), and (2) the difference between the opening net assets at opening exchange rate (US$252) plus profit for the year at average exchange rate (US$27) and the closing net assets at closing exchange rate (US$294). The total in (2) (a credit of US$15) is recognized as an item of other comprehensive income. (e) Retained earnings will be each year’s profit at the average exchange rate for the year. 2. Change to US$ functional currency in current reporting period (20X8) Assume that Company A earns revenue of US$130 and incurs expenses of US$70 during 20X8 and that assets increased to US$1,654 and liabilities to US$1,300. The statement of financial position and the statement of profit or loss (income statement) for the current reporting period (20X8) are as follows. 20X8 Statement of financial position (US$) 20X8 Income statement (US$) Assets 1,654 288 Share capital(a) Revenue 130 70 Expenses 87 Retained earnings(b) 60 Profit (21) Exchange reserve(c) 1,300 Liabilities 1,654 1,654   130   130 (a) Equity (share capital in this scenario) translated from euro to US$ using the historical exchange rate at the date of issue. (b) Retained earnings made up of profit of US$60 for the current period plus profit from each of the previous periods of US$27. (c) The exchange reserve reported in 20X7 is retained in 20X8 (and in future accounting periods), regardless of the fact that from 1 January 20X8 the functional currency of Company A is the same as its presentation currency.

Consolidated financial statements

Different reporting dates

Where a foreign subsidiary’s financial statements are drawn up to a date that is different from that of the parent, the foreign subsidiary often prepares additional financial statements as of the same date as the parent for inclusion in the parent’s financial statements. Therefore, the foreign subsidiary’s financial statements are translated at the exchange rate at the parent’s balance sheet date.

Where additional financial statements are not prepared, IFRS 10 allows the use of a different reporting date that is not more than three months before or three months after the reporting entity’s balance sheet date. The foreign subsidiary’s financial statements are translated at the exchange rate ruling at the foreign operation’s balance sheet date.

However, if significant transactions or events occur between the date of the subsidiary’s financial statements and the date of the parent’s financial statements, adjustments are made. This might include changes to the exchange rate.

Translation of a foreign subsidiary with a different reporting date from that of the parent Entity A prepares its annual financial statements at 31 January. However, local regulations require one of its subsidiaries, entity B, to prepare its financial statements at 31 December. Entity A uses entity B’s results for the 12 months to 31 December for consolidation purposes, rather than having a second set of results audited to 31 January. The exchange rate between US dollars (used for group reporting) and entity B’s functional currency (LC) was US$1 = LC15,000 at 31 December 20X2, and US$1 = LC18,000 at 31 January 20X3. There were no significant transactions or other events affecting entity B during January 20X3. Entity B’s net assets at 31 December 20X2 were LC234 million which, using the exchange rate at 31 December 20X2, translated to US$15,600. The change in exchange rates between 31 December 20X2 and 31 January 20X3 is significant. Therefore, entity A uses the exchange rate at 31 January 20X3 for consolidation purposes. Accordingly, management should translate entity B’s balance sheet as at 31 December 20X2 using the 31 January 20X3 exchange rate. This results in the consolidation of a balance sheet with net assets of US$13,000. The same approach is used for foreign associates and joint ventures.

Multi-level consolidation – example A Swiss parent owns 100 per cent of a second-tier German subsidiary. The German subsidiary owns 100 per cent of a third-tier British subsidiary. The local currency is the functional currency for all entities, and the presentation currency of the consolidated entity is the Swiss franc. Each entity has third-party foreign-currency-denominated debt. The British and German subsidiaries recognize translation gains and losses on their respective third-party foreign-currency-denominated debt in their individual or separate financial statements using the closing rate at the end of the reporting period in accordance with IAS 21. The translation gains and losses are recognized in profit or loss and are not reversed out of profit or loss on consolidation. In its separate financial statements, the Swiss parent recognizes translation gains and losses on its third-party foreign-currency-denominated debt in profit or loss, just as its subsidiaries do for their foreign-currency-denominated debt. If an intermediate consolidation exercise is performed, the German subsidiary translates the British subsidiary’s sterling-denominated financial statements into euro-denominated financial statements. The sterling-to-euro exchange differences are recognized in other comprehensive income in the intermediate consolidated financial statements. The Swiss parent then translates the euro-denominated consolidated financial statements of the German subsidiary into Swiss francs and recognizes the resulting exchange differences in other comprehensive income in the ultimate consolidated financial statements. If an intermediate consolidation exercise is not performed, the Swiss parent translates the sterling-denominated financial statements of the British subsidiary and the euro-denominated financial statements of the German subsidiary into Swiss francs. The exchange differences arising are recognized in other comprehensive income.

Non-controlling interest

Where a foreign subsidiary is not wholly owned, the exchange differences that are attributable to the non-controlling interest are allocated to, and reported as part of, the non-controlling interest in the consolidated balance sheet.

Goodwill and fair value adjustments arising on an acquisition

Any goodwill and any fair value adjustments to the carrying amounts of assets and liabilities arising on a foreign operation’s acquisition are treated as the foreign operation’s assets and liabilities. They are expressed in the foreign operation’s functional currency and are translated at the closing rate.

Is the allocation of goodwill in IAS 21 always performed at the same level as for impairment purposes under IAS 36? No. Where a parent entity acquires businesses with many different functional currencies, the goodwill arising on acquisition is allocated to the level of each functional currency of the acquired foreign operation. This means that the level at which goodwill is allocated, for foreign currency translation purposes, might be different from the level at which goodwill is tested for impairment in accordance with IAS 36, ‘Impairment of assets.

Translation of goodwill and fair value adjustments On 30 June 20X5, a UK parent entity, with sterling as the functional currency, acquired a multinational group with operations in Canada, the US and Europe. All foreign operations are highly profitable. The functional currencies of the foreign operations are their respective local currencies. The total purchase consideration amounted to £3,000 million. The UK parent entity’s financial year ends on 31 December 20X5. The fair values of the net assets of the acquired businesses, including fair value adjustments and the relevant exchange rates at the date of acquisition and at the balance sheet date, are given below. The UK parent entity allocates the purchased goodwill to the acquired businesses on the basis of their relative adjusted fair values of the net assets acquired. Business acquired Canada US Europe Total Exchange rate at acquisition £1 = 2.19 1.66 1.42 Exchange rate at balance sheet date £1 = 2.29 1.80 1.45 C$’000 C$’000 €’000 €’000 Net assets – book value 1,200 1,500 2,000 150 50 (100) Adjusted fair values 1,350 1,550 1,900 £’000 £’000 £’000 £’000 Allocation of goodwill Translated at exchange rate at date of acquisition 616 934 1,338 2,888 Purchase consideration 3,000 Goodwill allocated on the basis of adjusted fair values 24 36 52 112 C$’000 $’000 £’000 Adjusted net assets as above 1,350 1,550 1,900 Goodwill treated as currency asset 53 60 74 Adjusted fair value + goodwill 1,403 1,610 1,974 Translation adjustment on opening net assets £’000 £’000 £’000 £’000 Adjusted net assets + goodwill @ closing rate 613 894 1,361 2,868 Adjusted net assets + goodwill @ opening rate 60 970 1,390 3,000 Exchange loss taken to other comprehensive income on consolidation (27) (76) (29) (132) Consolidated balance sheet at 31 December 20X5 £’000 £’000 £’000 £’000 Goodwill at closing rate 23 33 51 107 Net assets at closing rate 590 861 1,310 2,761 Cash outlay (3,000) Consolidated net assets (132) Translation adjustments in equity (27) (76) (29) (132)

Intra-group trading transactions

Where normal trading transactions take place between group companies located in different countries, exchange differences are reported in the entity’s income statement in the same way as gains or losses on transactions arising with third parties. The exchange difference arising simply reflects the risk of doing business with a foreign party, even though that party happens to be a group member.

Even where the transaction remains unsettled at the balance sheet date and the monetary asset (liability) in one group entity is eliminated against the corresponding liability (asset) in another group entity, the exchange difference reported in the group entity’s own income statement continues to be recognised in consolidated profit or loss. This is because the monetary item represents a commitment to convert one currency into another and exposes the reporting entity to gain or loss through currency fluctuations.

How does a group account for exchange differences on inter-company loans? An entity applies the treatment applicable to unsettled inter-company monetary items arising from trading transactions. Assume a case where a borrower has entered into an inter-company borrowing in a currency other than the borrower’s functional currency. The borrowing entity will initially record the foreign currency loan at the rate of exchange ruling at the date when the loan is made. At each balance sheet date thereafter, until it is repaid, the loan will be translated at the closing rate, and any exchange difference will be reported in the borrower’s income statement. On consolidation, the intra-group loan account will be eliminated, but the exchange difference reported in the borrower’s income statement continues to be recognised in consolidated profit or loss.

Exchange differences arising on intra-group trading transactions where account payable is settled in instalments A UK parent entity has a wholly owned subsidiary in the US. During the year ended 31 December 20X5, the US entity purchased plant and raw materials to be used in its manufacturing process from the UK parent. Details of the transactions are as follows: Exchange rate Purchased plant costing £500,000 on 30 April 20X5 £1 = US$1.48 Paid for plant on 30 September 20X5 £1 = US$1.54 Purchased raw materials costing £300,000 on 31 October 20X5 £1 = US$1.56 Balance of £300,000 outstanding at 31 December 20X5 £1 = US$1.52 Average rate for the year £1 = US$1.55 The following exchange gains/losses will be recorded in the US subsidiary’s income statement for the year ended 31 December 20X5: US$ US$ Plant costing £500,000 @ 1.48 740,000 Paid £500,000 @ 1.54 770,000 Exchange loss – settled transaction (30,000) Raw materials costing £300,000 @ 1.56 468,000 Outstanding £300,000 @ 1.52 456,000 Exchange gain – unsettled transaction 12,000 Net exchange loss recorded in income statement (18,000) The exchange loss of US$30,000, that arises as the inter-company payable for plant purchase is settled during the year, will flow through on consolidation when the US subsidiary’s results are incorporated in the consolidated financial statements. The inter-company payable of US$456,000 in the US subsidiary’s balance sheet that remains outstanding will be translated into sterling at the closing rate to £300,000, and will be eliminated against the receivable recorded in the UK parent’s inter-company account. However, the exchange gain of US$12,000 will not be eliminated on consolidation and will be reported as part of the consolidated results of the group. The rationale of keeping this gain in the group’s result is that, in order to repay the payable balance, the US subsidiary will at some point have to expend the number of US dollars necessary to acquire the required amount of the reporting currency. This exposes the group to a gain or loss on reconversion.

Unrealised profit on inventories

Intra-group profit arising from the transfer of assets between entities in the group should be eliminated in full in the group accounts, where such assets are still held in the undertakings included in the consolidation at the balance sheet date. This is because it does not represent profit to the group.

Elimination of intra-group profits or losses Entities within a group might enter into sale and purchase transactions of various assets, such as property, plant and equipment, intangible assets and inventory. These transactions might result in intra-group profits or losses. Such profits/losses need to be eliminated on consolidation until the profit or loss is realised (that is, when the asset is sold outside the group, depreciated, amortised or written off). What exchange rate is used to eliminate intra-group profits/losses when these are denominated in foreign currencies? IFRS 10 requires profits or losses from intra-group transactions to be eliminated in full. Accordingly, in the period of the transaction, the profit to be eliminated should reflect the income statement effect. Thus, the elimination of intra-group profits/losses arising from sales between entities that are consolidated should be based on the exchange rate at the date of the sale (spot rate). The use of reasonable approximations or averages is considered acceptable, provided that no material differences arise from the use of such approximations when compared to the spot rate. If the asset remains in the group at a subsequent balance sheet date and the selling and the purchasing entities have different functional currencies, how should the profit/loss be eliminated when measuring the asset? For subsequent balance sheet adjustments, IFRS 10 and IAS 21 are silent on whether the profit should be eliminated in the seller’s or the purchaser’s functional currency. One view is that the elimination should be denominated in the functional currency of the purchaser. Under this view, to eliminate the internal profit or loss included in the carrying amount of the asset, the elimination entry should be denominated in the same currency as the asset itself. If the purchaser’s functional currency is different from the group’s presentation currency, the elimination entry will therefore generate currency translation adjustments. This view is illustrated below. However, in the absence of specific guidance in IFRS 10 or IAS 21, other views might also be acceptable.

Elimination of intra-group trading transactions where the asset is still owned by the group Group A is a Norwegian airline with operations around Europe. On 01 January 20X5, the parent company (‘Parent’) sold intellectual property (‘IP’) to its subsidiary company in Ireland (‘Subsidiary’) for a total consideration of NOK2,000m. The parent’s functional currency and the group’s presentation currency is the Norwegian krone (NOK). The subsidiary’s functional currency is the euro (EUR). The NOK/EUR rates are as follows: Date Rate 01 Jan 20X5 10.0 31 Dec 20X5 9.0 Parent’s books The carrying value of the IP in the books of the parent is NOK500. The parent realises a gain of NOK1,500m as a result of the transaction. As at 31 December 20X5 the books of the parent would be as follows: NOK (m) IP asset – Gain on disposal 1,500 Subsidiary’s books The subsidiary will record the IP in its separate financial statements in its functional currency, the EUR, at the date of the transaction, which is EUR200m (NOK2,000m at a rate of 10.0). As at 31 December 20X5 the books of the subsidiary would be as follows: EUR NOK (m) (For use in the consolidated financial statements) IP asset 1 200 1,800 Currency translation difference reserve 2 – (200) 1 The asset will be translated in the presentation currency of the Group using the closing rate of 9, as at 31.12.20X5. Therefore, the asset will be recorded at NOK1,800m (EUR200m × 9.0) 2 The currency translation difference (for the asset alone) of NOK200m arises due to the difference between: (a) the value of the asset in NOK on the transaction date (NOK2,000m); and 1.      the value of the asset in NOK on the closing date (NOK1,800m). Consolidated financial statements IFRS 10 requires the elimination of intra-group transactions. Under the approach illustrated in this example, the intra-group profit arising from the transaction is eliminated on consolidation on the basis that this gain is denominated in the functional currency of the purchasing entity, that is, the subsidiary. Parent NOK (m) Subsidiary NOK (m) Adjustment NOK (m) Consolidation NOK (m) Assets: IP1 – 1,800 (1,350) 450 Equity: Currency translation difference reserve2 – (200) 150 (50) Profit or loss: Gain on disposal3 1,500 – (1,500) – 1The gain in the parent’s functional currency was NOK1,500m, on the date of the transaction. The euro equivalent is EUR150m (NOK1,500m at a rate of NOK/EUR of 10.0). As at the year end the gain included in the asset’s carrying amount in the books of the subsidiary would be translated into NOK for elimination purposes using the closing rate. Therefore, the elimination of the profit against the IP would be recorded at NOK1,350m (EUR150m × 9.0). 2 The currency translation difference reserve should effectively represent the change in the location of the asset. The asset was initially recorded in the parent’s financial statements at NOK500m. Had the asset been transferred to the subsidiary at no gain or loss, it would have been recorded in the subsidiary’s financial statements at EUR50m (NOK500m at a rate of 10.0). As at the year-end, the same asset would have been translated back to NOK for presentation purposes at a rate of 9.0, resulting in a value of NOK450m (EUR50m × 9.0). The change in the asset’s location effectively results in a decline of NOK50m in the value of the asset because of the decline in the EUR exchange rate post transaction. A net adjustment of NOK50m should be recorded. The asset itself creates a gross adjustment of NOK200m. The offsetting adjustment of NOK150m arises from the elimination of the uplift in the value of the asset that arose from the intra group transaction. 3 The intra group profit on disposal should be eliminated in full.

Even if intra-group transactions do not give rise to intra-group profit, there could still be an effect on asset values.

Intra-group trading transaction at cost A UK parent has a wholly owned subsidiary in Poland. The functional currency of the subsidiary is Pol. The net assets of the group at 31 March 20X5 are £54,000, consisting of cash £24,000 held in the UK parent, and inventory held in the Poland subsidiary costing Pol 3 million. This was included in the consolidated balance sheet at the closing rate of £1 = Pol 100. On 30 September 20X5, the subsidiary transfers the goods to its UK parent at cost price, when the rate of exchange is £1 = Pol 125. The transaction is settled in cash, and the goods are included in the parent’s inventory at £24,000. At 31 March 20X6, the goods are still in inventory. The Pol has weakened further against sterling, and the exchange rate at the balance sheet date is £1 = Pol 150. No gain or loss is recorded by either entity on the transfer, so there are no inter-company profits to be eliminated. 31 March 20X5 £ Net assets: Inventory 3m @ 100 (held by subsidiary) 30,000 Cash (held by parent) 20,000 54,000   31 March 20X6 £ Net assets: Inventory 3m @ 100 (held by subsidiary) 24,000 Cash (held by parent) 20,000 44,000 Exchange difference on re-translation of opening net assets of foreign subsidiary: 3m @ 100 = 30,000 3m @ 150 = 20,000 10,000 54,000 No exchange difference is included in the consolidated income statement, because there is no trading gain or loss. However, switching inventory around the group affects the asset’s carrying value. If the inventory had not been transferred, the net assets would still have decreased by £10,000, but the reduction would have been entirely in the inventory value, with the cash balance unchanged. The result of moving the inventory and cash around the group is that there is a decrease of £6,000 in the inventory value and a decrease of £4,000 in the group’s cash position. This reflects the fact that the group’s foreign currency exposure is centred on different assets.

Monetary items forming part of net investment in a foreign operation

The net investment that a reporting entity has in a foreign operation is its interest in the net assets of that operation. In some circumstances, a monetary item that is receivable from or payable to a foreign operation (such as long-term loans and receivables and long-term payables) might be regarded as an extension of, or reduction in, the reporting entity’s net investment in that foreign operation.

The inclusion of long-term loans and receivables as part of the net investment in the foreign operation is only permitted where settlement is neither planned nor likely to occur in the foreseeable future.

In those situations, it might not be appropriate to include the resulting exchange differences arising on the re-translation of such monetary items in consolidated profit or loss, where exchange differences arising on equivalent financing with equity capital would be taken to other comprehensive income on consolidation.

When can a monetary item form part of a net investment in a foreign operation? A loan to a foreign entity that is repayable on demand might seem to be a short-term item, rather than part of capital. However, if there is demonstrably no intent or expectation to demand repayment (For example, the short-term loan is allowed to be continuously rolled over, whether or not the subsidiary is able to repay it), the loan has the same economic effect as a capital contribution. On the other hand, a long-term loan with a specified maturity (say, 10 to 15 years) does not automatically qualify to be treated as being part of the net investment simply because it is of a long duration, unless management has expressed its intention to renew the note at maturity. The burden is on management to document its intention to renew by auditable evidence, such as board minutes. Otherwise, in the absence of management’s intention to renew, the loan’s maturity date implies that its settlement is planned in the foreseeable future.

Could inter-company accounts of a trading nature be considered as part of a net investment in a foreign operation? No. Some might argue that inter-company accounts of a trading nature should qualify as part of a net investment in a foreign operation because, although individual transactions are settled, the accounts’ aggregate balance never drops below a specified minimum. In other words, because a minimum amount is permanently deferred, they believe that an appropriate amount of the resulting exchange difference should also be deferred in equity. However, the standard does not apply to trade receivables and payables. The rationale is that, because each individual transaction included in the overall inter-company balance is settled and replaced by a new transaction, settlement is always contemplated; therefore, exchange gains and losses arising on such active accounts do not qualify for deferral treatment in equity.

Exchange differences arising on a monetary item that forms part of a reporting entity’s net investment in a foreign operation that is a subsidiary, associate or joint venture should be treated as follows:

• In the separate financial statements of the reporting entity (or the individual financial statements of the foreign operation, as appropriate), such exchange differences are recognised in the income statement.
• In the financial statements that include the foreign operation and the reporting entity (For example, consolidated financial statements where the foreign operation is a subsidiary), such exchange differences are recognised initially in a separate component of other comprehensive income and, on disposal of the net investment, in profit or loss.

What accounting treatment should be followed, on consolidation, for inter-company loans that form part of an entity’s net investment in a foreign operation? This example illustrates a number of scenarios setting out the treatment that management is required to follow, on consolidation, where inter-company loans are made between various members of a group. Parent A is the reporting entity that has two foreign subsidiaries, B and C. In all the scenarios that follow, loans made between group entities are permanent in nature (that is, settlement is neither planned nor likely to occur). Scenario 1 Parent A has a loan receivable from or payable to its subsidiary C that is denominated in either sterling or US dollars. The loan would be regarded as an extension to or a reduction of parent A’s net investment in subsidiary C, as appropriate. An exchange difference is recognised in parent A’s income statement if the loan receivable or payable is denominated in US dollars. An exchange difference will be recognised in subsidiary C’s income statement if the loan receivable or payable is denominated in sterling. Any exchange difference recognised in either entity’s profit or loss is recognised in other comprehensive income on consolidation. The above situation is dealt with in the following examples: Currency loan made by parent A to subsidiary C Parent A, with sterling as its functional currency, is preparing its financial statements to 30 September 20X5. It has a loan receivable of US$1 million from its subsidiary C that has been outstanding for some time. The parent notified the subsidiary at the beginning of the financial year that no repayment of the amount will be requested for the foreseeable future. The relevant exchange rates are as follows: 30 September 20X5 30 September 20X4 £1 = US$1.82 US$ 1.45 The following exchange differences will arise in the financial statements of the individual entities if the loan is re-translated at the closing rate: Subsidiary C No exchange difference arises in the foreign subsidiary, because the loan payable is denominated in its functional currency. Parent A Exchange difference on long-term loan receivable: £ On closing rate – US$1m @ 1.82 549,450 On opening rate – US$1m @ 1.45 689,655 Exchange loss 140,205 In parent A’s separate financial statements, the loan is regarded as a monetary item, and any exchange difference is taken to profit or loss. On consolidation, the re-translated long-term loan is regarded as part of the net investment in subsidiary C, and so the related exchange loss is recognised in other comprehensive income and accumulated as a separate component of equity. There would also be a corresponding exchange gain included in other comprehensive income, arising as part of the re-translation of the net assets (which include the US dollar loan creditor) of subsidiary C under the closing rate/net investment method. Sterling loan made by parent A to subsidiary C The facts are the same as in the above example, except that parent A has a loan receivable from subsidiary C of £200,000 that has been outstanding for some time. The loan is treated by parent A as forming part of its net investment in subsidiary C. In the financial statements of the individual entities, the following exchange differences will arise if the loan is re-translated at the closing rate. Parent A There is no exchange difference in the parent’s financial statements in respect of the loan, because it is denominated in sterling. Subsidiary C Exchange difference on long-term loan payable: US$ On closing rate – £200,000 @ 1.82 364,000 On opening rate – £200,000 @ 1.45 290,000 Exchange loss 74,000 Exchange loss translated at the closing rate @ 1.82 £40,659 The exchange loss of US$74,000 on the sterling loan is recognised in subsidiary C’s income statement, because the subsidiary is exposed to the foreign currency risk. On consolidation, the inter-company loan will cancel out. However, because the long-term loan is regarded as part of the net investment in the subsidiary, the exchange loss of £40,659 is recognised in other comprehensive income and accumulated as a separate component of equity in the consolidated financial statements. There is a corresponding exchange gain included in other comprehensive income, arising as part of the retranslation of the net assets of subsidiary C. The effect is that the consolidated income statement will not reflect any exchange difference on the loan, which is consistent with the fact that the loan has no impact on group cash flows, unless the investment is sold. The two examples above consider the accounting implications when a loan is made by the parent entity to an overseas subsidiary. In the case of a foreign currency upstream loan (For example, a borrowing by a parent entity from its overseas subsidiary in the subsidiary’s functional currency), the treatment of exchange differences in the consolidated financial statements will depend on whether the upstream loan is regarded as part of the net investment in the foreign operation. If that is the case, the treatment will be the same as identified above – that is, the exchange difference arising on the currency loan’s re-translation in the parent’s income statement is classified to a separate component of equity in the consolidated financial statements. On the other hand, if the loan is not regarded as part of the net investment, the exchange difference will continue to be recognised in consolidated profit or loss. Scenario 2 Subsidiary B makes a loan denominated in sterling to subsidiary C (‘sister-entity loan’) Subsidiary C recognises an exchange difference in its own income statement. The question is whether the exchange difference can be recognised in other comprehensive income and accumulated as a separate component of equity on consolidation. It is not necessary for the lender or the borrower to have the net investment in the foreign operation for the exchange differences on translation of the monetary item to be classified within equity. The entity that has the monetary item receivable from or payable to a foreign operation can be any member of the group.

Under IAS 21, a monetary item that meets the criteria to be part of an entity’s net investment in a foreign operation is similar to an equity investment in a foreign operation. Hence, the accounting treatment in the consolidated financial statements does not depend on the currency in which the monetary item is denominated.

Exchange differences on translation of such a monetary item should be recognised in other comprehensive income in the consolidated financial statements, irrespective of the currency of the monetary item.

Does the accounting treatment for monetary items forming part of a net investment in a foreign operation depend on the currency in which the monetary item is denominated? No. The accounting treatment in the consolidated financial statements does not depend on the currency in which the monetary item is denominated. Consider the situation in the group structure set out, where parent A, whose functional currency is the pound sterling, makes a loan denominated in euros to subsidiary C, whose functional currency is US dollars. If the euro loan meets the criteria to be regarded by parent A as part of its net investment in subsidiary C, the exchange differences that arise from re-translating the loan receivable in sterling in parent A’s income statement and the loan payable in US dollars in subsidiary C’s income statement are recognised in other comprehensive income in the financial statements that include the foreign operation and the reporting entity (that is, parent A’s consolidated financial statements).

What is the appropriate accounting treatment to be adopted in the year in which the parent designates a long-term loan as part of its net investment in its foreign operation? Consider the background where the long-term US dollar loan made by parent A was designated as being part of its net investment in subsidiary C from the beginning of the accounting period. If the parent did this partway through the financial year ended 30 September 20X5 (say, at 31 March 20X5), it recognises any exchange difference arising in profit or loss up to that date, and it reclassifies any exchange difference that arises subsequently, following the designation to the separate component in other comprehensive income, in the consolidated financial statements.

Should monetary items forming part of the net investment in a foreign operation be subsequently re-assessed? Yes. The designation of an inter-company loan as part of the net investment in a foreign operation is periodically re-assessed. This is because management’s expectations and intentions might change due to a change in circumstances. Such changes in circumstances are carefully evaluated to determine that management’s previous assertions for not requiring repayment remain valid. Where, as a result of a change in circumstances, a previously designated ‘net investment’ loan is intended to be settled, the loan is de-designated. Because the loan is no longer regarded as part of the net investment, and depending on the entity’s chosen accounting policy, a partial disposal of the net investment might have occurred, and reclassification of the cumulative translation adjustment might be required. There is no explicit guidance in IAS 21 about the timing of reclassification in the circumstances described above. As such, there is an accounting policy choice to apply the reclassification either when the loan is no longer considered to form part of the net investment in the foreign operation, or when the loan is actually repaid. The selected policy should be applied consistently to all of the entity’s ‘net investment’ loans and to all of its investments in foreign operations.

Recycling cumulative translation adjustment when receiving a dividend paid out from a foreign operation A parent entity might receive dividends out of a foreign operation’s post acquisition reserves or the balance exceeding those reserves. IAS 21 does not distinguish between pre-acquisition and post-acquisition dividends. At the same time, the payment of a dividend is not automatically a disposal event under IAS 21. However, where such a dividend is, in substance, paid as part of a process to fully liquidate an investment in a subsidiary, this would constitute a disposal under IAS 21 and the relevant proportion of the cumulative translation adjustment would have to be recycled to profit or loss.

Inter-company dividends

Where a foreign subsidiary pays a dividend to its parent entity, the dividend is charged directly to equity in its financial statements; because the dividend is paid in the functional currency of the foreign subsidiary, no exchange difference arises.

However, if the dividends are payable in a currency that is different from the subsidiary’s functional currency, exchange rate fluctuations between the dividend being recognised as a liability and being paid will produce foreign exchange gains or losses impacting profit or loss.

In the parent entity’s financial statements, the dividend is translated at the rate in effect on declaration (that is, the transaction date). An exchange gain or loss will arise if the exchange rate moves between the date of declaration and the payment date.

This exchange difference is reported in the parent’s income statement as a normal inter-company transaction exchange gain or loss, and it is also reported in the consolidated financial statements.

Treatment of foreign exchange gains or losses on inter-company dividends A subsidiary, with dollars as its functional currency, declared a dividend of $100,000 to its parent, which has euros as its functional currency, on 31 August 20X5 for the year ended 31 December 20X5. The dividend was appropriately authorised and recognised by the subsidiary as a liability at 31 August 20X5. The parent prepares consolidated financial statements for the year ended 31 December 20X5 in its presentation currency of euros. The following exchange rates are relevant: 31 August 20X5 $1.50 = €1 31 December 20X5 $1.50 = €1 15 January 20X6 $1.50 = €1 Dividend paid on 15 January 20X6 The dividend remains outstanding at the balance sheet date. The dividend is recorded in the subsidiaries and the parent’s separate and consolidated financial statements as follows: In subsidiary’s balance sheet (as translated for consolidation) Dividend payable – $100,000 @ 1.75 € 57,142 In parent’s income statement Initially recorded at rate when dividend is declared – $100,000 @ 1.50 (transaction date) 66,667 Exchange loss on receivable recognised in the income statement (9,525) In parent’s balance sheet – Dividend receivable at year end rate – $100,000 @ 1.75 57,142 In consolidated income statement In the consolidated financial statements, the dividend receivable of €66,667 is reclassified to consolidated retained earnings, and it offsets the dividend payable in the subsidiary’s retained earnings that is translated at the year-end rate @ 1.75 = €57,142. The difference of €9,525 (€66,667 – €57,142) comprises a loss recorded in the parent’s income statement, and no further exchange difference arises. The inter-company receivable and payable cancel out. Some might argue that the exchange difference of €9,525 included in the parent’s income statement should be removed from consolidated income and reclassified to equity, because it relates to dividends that are initially charged to equity. We believe that this treatment is not appropriate, because the exchange difference arises on a monetary asset and would affect group cash flows when it is settled. Such an exchange difference should, therefore, remain in consolidated income.

Allocation of goodwill arising from the acquisition of a foreign operation (interaction between IAS 21 and IAS 36) – example Company A, a French entity with the euro as its functional currency, acquires Company S, a Swiss entity. Following the acquisition, the functional currency of Company S continues to be the Swiss franc (CHF). One of Company A’s other subsidiaries, Company D (also located in France with the euro (€) as its functional currency) is expected to benefit from the synergies of the acquisition. Company D represents a cash-generating unit (CGU) as defined in IAS 36. Consequently, in accordance with IAS 36, part of the goodwill arising on the acquisition of Company S is allocated to Company D’s CGU for the purpose of impairment testing. The goodwill allocated to Company D is a euro-denominated asset. IAS 21 states that “goodwill arises only because of the investment in the foreign entity and has no existence apart from that entity. …When the acquired entity comprises a number of businesses with different functional currencies, the cash flows that support the continued recognition of goodwill are generated in those different functional currencies”. While one would generally expect that the ‘foreign’ operation supporting the continued recognition of goodwill is part of the foreign operation acquired, this is not always the case. In allocating a portion of the goodwill to Company D, Company A has determined that it is the cash flows of a CGU with a euro functional currency (Company D), rather than those of the Swiss entity, that will support the continued recognition of the goodwill. Therefore, goodwill should be treated as an asset of Company D for the purposes of IAS 21. The goodwill allocated to Company D should be translated at the rate in effect on the date of its allocation to Company D (i.e., the date of acquisition).

Reallocation of goodwill to a foreign operation – example Company A, a French entity with the euro as its functional currency, acquires Company B, a UK entity (functional currency sterling). In accordance with IAS 36, the goodwill arising on the acquisition is allocated to Company A’s various UK operations (including Company B) that are expected to primarily benefit from the synergies of the combination. In accordance with IAS 21, the goodwill is considered a sterling asset and is translated at the closing rate. Several years later, Company A undertakes an internal reorganization and some of the UK operations are transferred to France. In accordance with IAS 36, Company A reallocates a portion of the goodwill originally generated on the acquisition of Company B to its French operations using a relative value approach. In allocating a portion of the goodwill to operations with a euro functional currency, Company A has determined that it is the cash flows of its French operations that will support the continued recognition of that portion of the goodwill following the reorganization. Therefore, that portion of the goodwill should be treated as an asset of the French operations and should be converted from sterling at the rate in effect on the date of the reallocation (in this case on the date of the internal reorganization) to determine the euro carrying amount going forward.

Goodwill arising from a foreign operation accounted for using the equity method – example Entity A, a Japanese entity with Japanese Yen as its functional currency, has a 20 per cent investment in Entity F, which is the parent entity of Group F. Entity F is domiciled in Europe with the euro as its functional currency and it meets the definition of a foreign operation in accordance with IAS 21. Entities within Group F have diverse global operations and different functional currencies. Entity A applies the equity method to account for its investment in Entity F. In accordance with IAS 28, when the investment is first acquired, the difference between Entity A’s initial investment and 20 per cent of the net fair value of the identifiable assets and liabilities of Group F at the acquisition date (‘goodwill’) is included in the carrying amount of Entity A’s investment in Entity F. IAS 21 requires that any goodwill arising on the acquisition of a foreign operation should be treated as an asset of the foreign operation and, consequently, expressed in the functional currency of the foreign operation and translated at the closing rate at each reporting date. The goodwill element of Entity A’s investment in Entity F should be expressed in euro (Entity F’s functional currency) and translated at each reporting date at the euro/Yen closing rate. It would not be appropriate to allocate the goodwill among the entities in Group F to be expressed in different functional currencies. This is consistent with IAS 28 which requires the carrying amount of an associate (including any goodwill forming part of that carrying amount) to be tested for impairment as a single asset.