Chapter 5: Foreign currency

The cash receipts or cash payments arising from transactions denominated in a foreign currency should be translated into the entity’s functional currency at the rate ruling at the date on which the cash receipt or payment is received or paid. IAS 21 permits the use of a weighted average rate for the period that approximates to the actual exchange rate to be used when recording transactions (For example, a monthly average). Therefore, for consistency, IAS 7 also permits such an approximate rate to be used for the purposes of the cash flow statement.

An entity might also conduct foreign operations through a subsidiary, associate, joint venture or branch that has a functional currency that is different from the reporting entity’s functional currency. Similar to the translation of income and expense items, for consolidation the foreign subsidiary’s cash flow statement is translated at the exchange rates in effect at the dates of the cash flows. The use of a weighted average rate for the period is also permitted.

Exchange rates used for translation Question: Is it appropriate to use different weighted average rates for the translation of a foreign operation’s cash flow statement and its income statement? Answer: It is possible, although unusual, to use different weighted average rates for the translation of a foreign operation’s cash flow statement and its income statement. For example, consider a foreign operation with annual subscriptions running from January to December. Cash is mainly received during January of each year, with revenue recognized over the whole year. It might be appropriate to use different exchange rates for the translation of the income statement and the cash flow statement if there are large exchange rate movements over the course of the year, such that the exchange rate for January is significantly different from the average rate for the year. The use of different rates for the translation of the income statement and the cash flow statement would give rise to a reconciling item in the consolidated cash flow statement.

Foreign currency: consolidated cash flow statement including foreign subsidiaries A reporting entity will find it simpler to require each of its foreign subsidiaries to prepare a cash flow statement, with supporting notes, in its functional currency. This cash flow statement can be translated into the reporting entity’s presentation currency. The presentation currency equivalent of each subsidiary’s cash flow statement can then be consolidated with the reporting entity’s cash flow statement, after eliminating intra-group items such as dividends and inter-group loans. Consider the following example, where FCU is the functional currency of the foreign subsidiary, and CU is the presentation currency of the reporting entity. Entity A, a UK entity whose accounting period ended on 30 September 20X7, has a wholly owned US subsidiary, S corporation, that was acquired for FCU600,000 on 30 September 20X6. The fair value of the net assets at the acquisition date was FCU500,000, resulting in goodwill of FCU100,000. During the year ended 30 September 20X7, S corporation paid a dividend to entity A of FCU14,000. Entity A prepares financial statements in CU. The exchange rate at 30 September 20X6 and 20X7 was CU1 = FCU2.00 and CU1 = FCU1.50 respectively. The average rate for the year ended 30 September 20X7 was CU1 = FCU1.65. The exchange rate on the day that the dividend was paid was CU1 = FCU1.75. The summarized balance sheet at 30 September 20X6 and 20X7, an analysis of the profit for the year ended 30 September 20X7 and the statement of changes in equity for the year ended 30 September 20X7 of S corporation, extracted from the consolidation returns, in FCU and CU equivalents, are as follows: S corporation – summarized balance sheet at 30 September 20X6 and 20X7 20X7 20X6 20X7 Pre 20X6 FCU’000 FCU’000 FCU’000 FCU’000 Closing FCU1.50 Closing FCU2.00 Assets Non-current assets Property, plant and equipment: Cost (20X7 additions: FCU30) 255 255 170.0 112.5 Depreciation (20X7 charge: FCU53) (98) (45) (65.3)  (22.5) Net book value 157 180 104.7 90.0 Current assets Investments 250 100 166.6 50.0 Inventories 174 126 116.0 63.0 Debtors 210 145 140.0 72.5 Cash and cash equivalents 240 210 160.0 105.0 874 581 582.6 290.5 Total assets 1,037 761 687.3 380.5 Equity and liabilities Capital and reserves Share capital 300 300 150.0 150.0 Reserves                Pre-acquisition 200 200 100.0 100.0                Post-acquisition 76 – 46.6 –                Exchange differences – – 87.4 – 576 500 384.0 250.0 Current liabilities Bank overdraft 150 – 100.0 – Trade payables 125 113 83.3 56.5 Taxation 30 18 20.0 9.0 305 131 203.3 65.5 Non-current liabilities Loan stock 150 130 100.0 65.0 Total equity and liabilities 1,031 761 687.3 380.5 Where entity A regards S corporation as a foreign operation, it should use the average rate for translating S corporation’s income statement. The summarized consolidated income statement for the year ended 30 September 20X7 and the summarized consolidated balance sheet at that date are as follows: S corporation – analysis of the profit for the year ended 30 September 20X7 FCU’000 FCU’000 Average FCU1.65 Profit from operations 135 81.8 Interest paid (15) (9.1) Taxation (30) (18.1) Profit for the period 90 54.6 Working Exchange difference: Total opening assets (FCU761/1.50 – FCU761/2.00) 126.8 Total opening liabilities (FCU261/1.50 – FCU261/2.00) (43.5) Profit for the year (FCU90/1.50 – FCU90/1.65) 5.4 Dividends (FCU14/1.50 – FCU14/1.75*) (1.3) 87.4 *Actual rate on date when dividend received S corporation – statement of changes in equity for the year ended 30 September 20X7 FCU’000 FCU’000 FCU’000 FCU’000 FCU’000 FCU’000 FCU’000 Share capital Accumulated profits Total Share capital Accumulated profits Translation reserve Total Balance as at 1 October 20X6 300 200 500 150 100.0 – 250.0 Currency translation differences – – – – – 87.4 87.4 Net income recognized in OCI – – – – – 87.4 87.4 Profit for the period – 90 90 – 54.6 – 54.6 Total comprehensive income for the period – 90 90 – 54.6 87.4 142.0 Dividends paid for 20X6 – (14) (14) – (8.0) – (8.0) Balance at 30 September 20X7 300 276 576 150 146.6 87.4 384.0 It is further assumed that entity A does not trade on its own, and that its only income is dividends received from S corporation. Entity A’s summarized balance sheet at 30 September 20X6 and 20X7 is as follows: Entity A – summarized balance sheet at 30 September 20X6 and 20X7 20X7 Pre 20X6 CU’000 CU’000 Assets Non-current assets Investment in subsidiary (FCU600,000 @ 2.00) 300 300 Current assets Cash 208 200 Total assets 508 500 Equity Share capital 500 500 Accumulated profits (dividend received FCU14,000 @ 1.75*) 8 – Total equity 508 500 * Actual rate on date when dividend received Where entity A regards S corporation as a foreign operation, it should use the average rate for translating S corporation’s income statement. The summarized consolidated income statement for the year ended 30 September 20X7 and the summarized consolidated balance sheet at that date are as follows: Consolidated income statement for the year ended 30 September 20X7 C’000 C’000 Profit of entity A 8.0 Profit of S corporation 54.6 Adjustment for inter-company dividend (8.0) Profit for the period 54.6 Consolidated balance sheet as at 30 September 20X7 CU’000 Assets Non-current assets Property, plant and equipment 104.7 Goodwill (FCU100,000 @ 1.50 – see below) 66.7 Current assets Investments 166.6 Inventories 116.0 Debtors 140.0 Cash and cash equivalents (Entity A: CU208,000; S corporation: CU160,000) 368.0 790.6 Total assets 962.0 Equity and liabilities Capital and reserves Share capital 500.0 Accumulated profits 54.6 Translation reserve (see below) 104.1 658.7 Current liabilities Bank overdraft 100.0 Trade payables 83.3 Taxation 20.0 203.3 Non-current liabilities Loan stock 100.0 Total equity and liabilities 962.0 IAS 21 requires goodwill arising on the acquisition of a foreign operation to be treated as a currency asset and translated at the closing rate. Therefore, the translation reserve comprises the exchange difference relating to the subsidiary of CU87,400 (as previously calculated), and a further exchange difference of CU16,667 (FCU100,000 @ 2.00 − FCU100,000 @ 1.50) arising on the translation of the goodwill, a total of CU104,067. The consolidated cash flow statement, drawn up using the average rate for the year, and the related notes to the cash flow statement are as follows: Consolidated cash flow statement for the year ended 30 September 20X7 Cash flows from operating activities CU’000 CU’000 Profit 54.6 Adjustments for: Depreciation (FCU53,000 @ 1.65) 32.1 Interest expense 9.1 Tax expense 18.1 Increase in inventories (FCU48,000 @ 1.65) (29.1) Increase in debtors (FCU65,000 @ 1.65) (39.4) Increase in creditors (FCU12,000 @ 1.65) 7.3                Cash generated from operations 52.7 Interest paid (FCU15,000 @ 1.65) (9.1) Taxation paid (FCU18,000 @ 1.65) (10.9) Net cash flow from operating activities 32.7 Cash flows from investing activities Purchase of property, plant and equipment (FCU30,000 @ 1.65) (18.1) Purchase of current asset investments (FCU150, 000@1.65) (90.9)                Net cash flow used in investing activities (109.0) Cash flows from financing activities Issues of loan stock (FCU20,000 @ 1.65) 12.1                Net cash flow from financing activities 12.1 Effects of exchange rates on cash and cash equivalents (see workings below) 27.2 Net decrease in cash and cash equivalents (37.0) Cash and cash equivalents at the beginning of the period 305.0 Cash and cash equivalents at the end of the period 268.0 Notes to the cash flow statement Cash and cash equivalents consist of cash-in-hand balances and bank overdrafts repayable on demand. Cash and cash equivalents included in the cash flow statement comprise the following balance sheet amounts: 20X7 Pre 20X6 CU’000 CU’000 Cash-in-hand balances 368 305 Bank overdrafts (100) –                Cash and cash equivalents 268 305 (Note – The comparative cash-in-hand balances of CU305,000 is made up of cash and cash equivalents in S corporation of CU105,000 (FCU210,000 @ 2.00) and in entity A of CU200,000.) The effect of the foreign exchange rate changes on the cash and cash equivalents balance is included in the cash flow statement, as part of the reconciliation of opening to closing cash and cash equivalents, and is calculated as follows: Effect of foreign exchange rate changes on cash and cash equivalents C’000 Cash at bank Opening balance (FCU210 @ 1.50 – FCU210 @ 2.00) 35.0 Increase (FCU30 @ 1.50 – FCU30 @ 1.65) 1.8 Bank overdraft Opening balance – Increase (FCU150 @ 1.50 – FCU150 @ 1.65) (9.1) Exchange difference on inter-company dividend (FCU14 @ 1.75 – FCU14 @ 1.65) (0.5) Effects of exchange rates on cash and cash equivalents 27.2 The exchange difference on the inter-company dividend arises due to the fact that the subsidiary’s income statement and cash flows are translated at an average rate, whereas the dividend payment is translated at the rate on the cash receipt date. As a result, the intra-group dividend paid and received does not cancel out in the consolidated cash flow statement, and so it needs to be adjusted. The movement in working capital, in arriving at operating cash flows, can also be obtained by taking the difference between the closing and the opening balance sheet figures and adjusting the result to eliminate the non-cash effects of exchange rate adjustments; but this method is rather cumbersome, as illustrated below for inventories. CU’000 Inventories at 30 September 20X7 (FCU174 @ 1.50) 116.0 Inventories at 30 September 20X6 (FCU126 @ 2.00) 63.0 Increase in inventories (FCU48) 53.0 Exchange difference: On opening balance (FCU126 @ 1.50 – FCU126 @ 2.00) (21.0) On movement (FCU48 @ 1.50 – FCU48 @ 1.65) (2.9) Increase in inventories as per reconciliation above 29.1 If the full movement in inventories of CU53,000 is used for the reconciliation, a further adjustment would be required in the reconciliation, to eliminate the CU23,900 exchange movement.

Foreign currency: intra-group transactions Question: When is an adjustment of exchange differences on intra-group transactions necessary? Answer: Transactions between members of a group which operate in different currencies might not cancel out on consolidation, due to exchange differences. These exchange differences are usually reported in the income statement, particularly if they relate to intra-group trading transactions. For consolidated cash flow statements, these intra-group cash flows will only cancel out if the actual rate at the transaction date is used for translation. Consider an intra-group transaction that takes place between a parent and its subsidiary: a dividend payment is declared and paid on the same day. The dividend paid by the subsidiary is translated, for consolidation purposes, at the rate of exchange on the cash receipt date, and it is also recorded at that rate by the parent. Therefore, no exchange difference arises in the consolidated income statement. This does not mean that the exchange difference has been eliminated in the consolidated cash flow statement. Where the profits in the subsidiary have been recorded using the average rate for the period, an additional adjustment is required, to reflect the decrease in the foreign currency cash balance for the dividend payment that was recorded at the rate on the transaction date, rather than the average rate for the period. For example, if a dividend payment of FCU14,000 was declared and paid by a subsidiary to a parent which prepares its financial statements in CU on a date when the exchange rate is CU1 = FCU1.75, the amount recorded by the parent and its subsidiary is CU8,000 (FCU14,000 @ 1.75). However, if the average exchange rate for the period is CU1 = FCU1.65, the net change in unremitted cash in the subsidiary would have been recorded as CU8,500 and so a difference of CU500 (FCU14,000 @ 1.75 – FCU14,000 @ 1.65) needs to be adjusted in the reconciliation of cash and cash equivalents for foreign exchange differences. It could be argued that it makes more sense to report these exchange rate differences in the reconciliation of profit to operating cash flows. This is because, in the example above, the subsidiary’s cash has gone down by CU8,500 and the parent entity’s cash has gone up by CU8,000, resulting in a real economic loss to the group that would normally be recognized in the consolidated income statement. However, IAS 7 requires the income statement and the cash flow statement to be treated in a consistent way. There is no adjustment for the exchange difference in the reconciliation of profit to operating cash flows, because profit does not include any exchange difference on the intra-group dividend. So, this exchange difference is reported in the reconciliation between the opening and closing balances of cash and cash equivalents. An adjustment is also necessary where an intra-group loan is denominated in FCU between entity A, the lender, which has a functional currency of FCU and entity B, the borrower, which has a functional currency of CU. As the exchange rate fluctuates, entity B is required to translate the loan balance at the period end as foreign currency monetary items need to be translated to its functional currency using the closing rate, whereas no such adjustment is required for entity A as the loan is already denominated in its functional currency. Unless the foreign loan is part of a designated net investment hedge, the impact of this exchange fluctuation will generally be seen in the group income statement upon consolidation. An adjustment is made to eliminate this non-cash movement in the reconciliation to operating cash flow to the extent that there is no cash flow as a result of this exchange movement. Where there is a cash flow impact, this should be dealt with consistently with the cash movement on foreign exchange intra-group dividends as discussed above. Notes to the cash flow statement