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Foreign currency transactions

Cash in bank

12/15/X1, XYZ exchanged 18,060 units of its local currency (LC) for 20,000 units of foreign currency A (FCA).

LC - local currency: the currency of the jurisdiction the entity is located.

IAS 21.8 does not define a local currency.

One reason, it is obvious.

Another reason, it is not pertinent.

As stated in IAS 21.8 (edited, emphasis added): [a] foreign currency is a currency other than the functional currency of the entity.

Consequently, the guidance provided by IAS 21 depends on how the functional, not local, currency is defined.

It also implies, a local currency could be a foreign currency if an entity's functional currency is not its local currency.

For example, ABC is a contractor domiciled in Switzerland.

Most of its construction projects are in neighboring countries. Consequently, not only does it get paid mostly EUR, the euro zone’s competitive forces and regulations mainly determine the amount of EUR it collects. Likewise, since most of its projects occur in euro zone countries, most of its labour, material and other costs are incurred in EUR. In addition, as the projects are managed at the project level, its euro zone operations are conducted with a high degree of autonomy.

As a result, as outlined in IAS 21.9 to 14, ABC designates the EUR as its functional currency, making its local currency (the Swiss Franc) a foreign currency for IFRS purposes.

ASC 830-20 defines the local currency as "the currency of a particular country being referred to."

To be accurate, the topic should refer to a jurisdiction, but that is just being pedantic.

While subsidiaries are invariably set up (registered as separate legal entities) on a national level, it is not uncommon for a company domiciled in one eurozone country to do business in several eurozone countries making the EUR a regional, rather than national, currency.

While this does not make much difference from a (consolidated) US GAAP perspective if the jurisdiction is a country or region, from a national GAAP / tax perspective how a business is structured can alter (sometimes dramatically) the results.

More importantly, how the local currency is defined is not pertinent.

As stated in ASC 830-20 (edited, emphasis added): [a foreign curency is] a currency other than the functional currency of the entity being referred to (for example, the dollar could be a foreign currency for a foreign entity)...

Consequently, the guidance provided by ASC 830 depends on how the functional, not local, currency is defined.

It also implies, a local currency could be a foreign currency if an entity's functional currency is not its local currency.

For example, ABC, a contractor, moved its headquarters to the US when it listed on a US exchange.

After the listing, more than 50% of its shares were held by US investors.

As its headquarters was in the US and the majority of its executive officers and directors were US citizens or residents, it did not qualify for the SEC's foreign private issuer exemption (link: SEC) so could not use IFRS.

As it was established in Europe, most of its projects continue to be in euro zone countries. So, not only does it get paid mostly EUR, the euro zone’s competitive forces and regulations mainly determine the amount of EUR it collects. Likewise, most of its labour, material and other costs are incurred in EUR. In addition, as it finances its projects at the local level, practically all of its liabilities are in EUR.

Fortunately, most normal US companies do not find themselves in this predicament.

Most US based companies have no foreign operations (many do not even sell to non-US customers or buy from non-US suppliers). Those that do invariably set up a subsidiary (or several) in each jurisdiction.

So, while keeping track of local, accounting, reporting and functional currencies may require some judgment at the subsidiary level, it is a non-issue at the parent level.

As outlined in ASC 830-10-55-5, ABC would designate the EUR as its functional currency making the USD (its local currency) a foreign currency from a GAAP perspective.

Hopefully, it would decide to its keep books EUR so it would not need to remeasure them as outlined in ASC 830-10-45-17.

But, regardless of how it keeps its books, as outlined in ASC 830-30-45-3, it would still need to translate its EUR results into USD so it could report them to the stock market (and SEC).

So, for a normal US company, the local, accounting, reporting and functional currencies are the USD with any currency not the USD being a foreign currency.

FC - foreign currency: a currency different from the entity's functional currency.

Both IAS 23.8 and ASC 830-20 define the foreign currency by reference to the functional currency.

This implies the local currency could be a foreign currency if an entity's functional currency is not its local currency.

For example, ABC is a contractor domiciled in Switzerland. Most of its construction projects are in neighboring countries. Consequently, not only does it get paid mostly EUR, the euro zone’s competitive forces and regulations mainly determine the amount of EUR it collects. Likewise, since most of its projects occur in euro zone countries, most of its labour, material and other costs are incurred in EUR. In addition, as the projects are managed at the project level, its euro zone operations are conducted with a high degree of autonomy.

As a result, as outlined in IAS 21.9 to 14, ABC designates the EUR as its functional currency, making its local currency (the Swiss Franc) a foreign currency for IFRS purposes.

While theoretically possible for a US company to find itself in this situaiton, for most, any currency not the USD is a foreign currency.

For example, ABC, a contractor, moved its headquarters to the US when it listed on a US exchange.

After the listing, more than 50% of its shares were held by US investors.

As its headquarters was in the US and the majority of its executive officers and directors were US citizens or residents, it did not qualify for the SEC's foreign private issuer exemption (link: SEC) so could not use IFRS.

As it was established in Europe, most of its projects continue to be in euro zone countries. So, not only does it get paid mostly EUR, the euro zone’s competitive forces and regulations mainly determine the amount of EUR it collects. Likewise, most of its labour, material and other costs are incurred in EUR. In addition, as it finances its projects at the local level, practically all of its liabilities are in EUR.

Fortunately, most normal US companies do not find themselves in this predicament.

Most US based companies have no foreign operations (many do not even sell to non-US customers or buy from non-US suppliers). Those that do invariably set up a subsidiary (or several) in each jurisdiction.

So, while keeping track of local, accounting, reporting and functional currencies may require some judgment at the subsidiary level, it is a non-issue at the parent level.

As outlined in ASC 830-10-55-5, ABC would designate the EUR as its functional currency making the USD (its local currency) a foreign currency from a GAAP perspective.

Hopefully, it would decide to its keep books EUR so it would not need to remeasure them as outlined in ASC 830-10-45-17.

But, regardless of how it keeps its books, as outlined in ASC 830-30-45-3, it would still need to translate its EUR results into USD so it could report them to the stock market (and SEC).

So, for a normal US company, the local, accounting, reporting and functional currencies are the USD with any currency not the USD being a foreign currency.

AC - accounting currency (a.k.a. CR - currency of record): the currency in which the entity keeps its books.

In this illustration, AC = LC.

While neither IAS 21 nor ASC 830 specifically define an accounting currency (currency of record), they do discuss it.

In both IAS 21.34 and ASC 830-10-45-17, it is the currency in which the company keeps its books and records.

RC - reporting currency (a.k.a. PC - presentation currency): the currency in which the entity reports its financials.

In this illustration, RC = LC.

Not that the RC is pertinent to the issue illustrated in this example.

The RC only becomes important when drafting financial reports.

While the LC, AC and FuncC affect how items denominated in an FC (cash, receivables, payables and other monetary items), are accounted for, the RC only comes into play if financial statements need to be translated from one currency to another.

Specifically:

as outlined in IAS 21.23 | ASC 830-20-35-2, items denominated in an FC are adjusted (a.k.a. remeasured).

Although ASC 830-20-35-2 specifies a currency "shall be adjusted," as this adjustment involves measuring the FC item using a different exchange rate than was used to previously measure the item, remeasurement is the more semantically accurate term.

as outlined in IAS 21.38 to 47 | ASC 830-30-45-3, elements of FC financial statements are translated.

Somewhat confusingly, IAS 21 uses the same term (translation) for both situations.

In contrast, ASC 830 refers to the former as an adjustment and the latter as a translation.

But, for the sake of completness, it does need to be mentioned.

Note: IAS 21.8 uses the term presentation currency | ASC 830-10-20 reporting currency.

FuncC - functional currency: the currency in which the entity (mostly) conducts its business.

In this illustration, FuncC = LC.

Simply put, the functional currency is the currency in which the entity generates revenue (most of its revenue), incurs expenses (most of its expenses) and secures financing (most of its financing).

Either because it sells in that currency or because its sales prices are derived from that currency.

For example, XYZ issues invoices in EUR but incurs expenses in GBP. It passes the currency risk to its customers by first calculating the invoiced amount in GBP, then remeasuring to EUR using a month end exchange rate.

In this situation, while the receipts are nominally in EUR, they are factually denominated in GBP.

Many subsidiaries are financed (directly or indirectly) by their parent organization. In this situation, only liabilities to third parties (not the parent or different subsidiaries) should be considered.

Note: while different in form, the guidance provided by IAS 21.9 to 14 and ASC 830-30-55-5 is comparable in substance in that both outline numerous factors but, in the end, acknowledge determining a functional currency is more about judgment than hard and fast rules.

Factors to consider according to IAS 21:

  • Paragraph 9.a.i - sales prices
  • Paragraph 9.a.ii - competitive forces
  • Paragraph 9.b – cash expenses (labour, material, etc.)
  • Paragraph 10.a - financing
  • Paragraph 10.b - sales receipts
  • Paragraph 11.a - autonomy of the business unit
  • Paragraph 11.b - proportion of FC transactions
  • Paragraph 11.c - effect of FC on overall cash flows
  • Paragraph 11.d - if FC cash flows can service FC debt

Factors to consider according to ASC 830-10-55-5:

  1. affect of a subsidiary's cash flows on the parent's cash flows
  2. a subsidiary's sales
  3. Are the subsidiary's sales prices determined by local conditions (local competition or local government regulation) or by international conditions?

    In other words, does the subsidiary price its sales in its LC or an FC (i.e. the parent's LC)?

  4. how active is the FC market
  5. a subsidiary's cash expenses (labor, materials, etc.)
  6. a subsidiary's financing
  7. the volume of transactions between a subsidiary and parent

IAS 21.12 (edited, emphasis added) states: When the above indicators are mixed and the functional currency is not obvious, management uses its judgement to determine the functional currency that most faithfully represents the economic effects of the underlying transactions, events and conditions...

ASC 830-10-55-4 (edited, emphasis added) states: ... In those instances in which the indicators are mixed and the functional currency is not obvious, management's judgment will be required to determine the functional currency that most faithfully portrays the economic results of the entity's operations and thereby best achieves the objectives of foreign currency translation...

12/15/X1 | 15.12.X1

   

FX rate

FC

Cash in bank (FCA)

18,064

 

N/A

20,000

 

Cash in bank

 

18,064

 

 


Initially, as long as the FC is acquired in a market transaction, the exchange rate is implicit.

IAS 21.8 defines the spot exchange rate as the exchange rate for immediate delivery while IAS 21.21 specifics that foreign currency transactions are initially recorded by applying this spot rate.

ASC 830-20-20 defines the exchange rate as the ratio between a unit of one currency and the amount of another currency for which that unit can be exchanged at a particular time and ASC 830-20-30-1 specifies that foreign currency transactions are initially measured using the exchange rate on the date of the transaction.

If an entity acquires a foreign currency in market transaction (from a bank or on a forex market), the rate implied by the transaction fulfills this guidance.

However, if the entity is in a group and acquires the FC in an intercompany transaction (i.e. from a corporate cash pool), the rate implied by the transaction does not fulfill this guidance and needs to be determined as outlined below.

12/31/X1, XYZ's reporting date, the exchange rate between the LC and FCA was 1:0.8851.

12/31/X1 | 31.12.X1

   

FX rate

FC

Foreign currency transaction loss

362

     

 

Cash in bank (FCA)

 

362

0.8851

20,000


Subsequently, at each reporting date, the exchange rate must be determined.

As outlined in IAS 21.23.a, monetary items (i.e. FC in bank) are translated by applying the closing exchange rate.

IAS 21.9 defines: Monetary items are units of currency [a.k.a. cash] held and assets and liabilities to be received or paid in a fixed or determinable number of units of currency.

Note: IFRS does not (in contrast to US GAAP) consider equity instruments to be monetary items.

Specifically, while monetary item are "... assets and liabilities to be received or paid in a fixed or determinable number of units of currency" and equity securities will only yield units of currency (dividends, cash received from the sale of the security or residual cash received from the liquidation of the company) that are (especially if the securities are market traded) determinable, as outlined in IFRS 9.B5.7.3, an investment in equity instruments is not a monetary item.

While this seems odd to some, it is actually helpful when remeasuring FC equity securities to fair value as, unlike monetary items, when non-monetary items are remeasured, the associated gain or loss does not need to be bifurcated into the gain / loss related to the change in market value and the gain / loss related to the change in exchange rates.

IAS 21.8 defines the closing rate as the spot rate and the spot rate as the rate for immediate delivery.

When applied to subsequent measurement, it is the rate for immediate delivery on the balance sheet date.

Rather than momentary items, ASC 830-20-35-2 discusses items denominated in a foreign currency. However, as only monetary items are denominated, its guidance is comparable.

ASC 830-20-35-2 refers to items denominated in a foreign currency specifying that the rate to be used is the rate at which the related receivables or payables could be settled.

The ASC master glossary defines monetary items using cash, receivables and payables as examples.

Thus, while the ASC does not (like IAS 21) explicitly state: monetary items are remeasured / non-monetary items are not remeasured, this is implied by the guidance it provides.

Note: since ASC 830-20 does refer to monetary / non-monetary items, it does not discuss how to distinguish the two. Fortunately, both ASC 830-10-45-18 and ASC 255 do provide some additional guidance.

While ASC 830-10-45-18 addresses the remeasurement of the books of record into the FunC, it provides a useful list of common non-monetary balance sheet items and related revenue, expense, gain, and loss accounts:

  1. Equity securities without readily determinable fair values...
  2. Inventories carried at cost
  3. Prepaid expenses such as insurance, advertising, and rent
  4. Property, plant, and equipment
  5. Accumulated depreciation on property, plant, and equipment
  6. Patents, trademarks, licenses, and formulas
  7. Goodwill
  8. Other intangible assets
  9. Deferred charges and credits, except policy acquisition costs for life insurance companies
  10. Deferred income
  11. Common stock
  12. Preferred stock carried at issuance price
  13. Revenues and expenses related to nonmonetary items, for example:
    1. Cost of goods sold
    2. Depreciation of property, plant, and equipment
    3. Amortization of intangible items such as patents, licenses, and so forth
    4. Amortization of deferred charges or credits except policy acquisition costs for life insurance entities.

While not mentioned by ASC 830-10-45-18, monetary items include:

  • Cash
  • Cash equivalents
  • Securities (traded)
  • Receivables: accounts, notes, loans
  • Refundable deposits, holdbacks
  • Accounts payable
  • Loans, notes, bonds, leases and other financial liabilities
  • Contingent liabilities requiring cash settlement

As this guidance addresses changing prices, it is less useful then ASC 830-10-45-18.

Nevertheless, ASC 255-10-20 does define monetary assets as money or a claim to receive money / liabilities obligations to pay money, that is fixed or determinable without reference to future prices of goods or services.

ASC 255-50-51 & 52 then discuses nonmonetary assets and liabilities specifying they include goods held for resale or assets held to provide services, claims to cash based on future prices of goods or services, goodwill, equity and similar residual interest, obligations to furnish goods or services denominated in quantity not price, and obligations to pay for goods or services based on their future prices.

Also note: while US GAAP considers equity instruments (other than those listed above) to be monetary items, IFRS considers them non-momentary items.

While ASC 830-20-35-1 and 2 do not explicitly state that a closing rate should be used, this is how the "the ratio between a unit of one currency and the amount of another currency for which that unit can be exchanged at a particular time" is commonly determined.

Consequently, a closing rate is appropriate for both IFRS and US GAAP purposes.

The best way to determine this rate is by referencing a currency market.

Companies that do not have a currency trading account can use market data providers such as Bloomberg.

While not a closing rate, reference rates (i.e. link ECB) are also often used.

While using reference rates brings benefits, it also involves a cost: reference rates are not the rates outlined in IAS 21.8 or ASC 830-20-35-1 and 2.

As both current and historical data is available to online, determining a declared rate is simple. As anyone can access the same data, verifying a particular day's reference rate is equally simple so there is no question that the company and (for example) auditor will use the same rate.

Another (practical) advantage, declared rates are often required for national GAAP / tax purposes.

For companies domiciled in jurisdictions where they are required to draft national GAAP financial statements ()i.e. for income tax purposes) using a reference rate eliminates one of the differences that need to be eliminated if national GAAP the national GAAP rep[ort is to be reconciled to a IFRS and/or US GAAP report.

Whether these benefits (ease of use, verifiability and consistency with a national GAAP) outweigh the costs (misapplying the letter of the guidance), is something each company (together with its independent auditor) must decide for itself.

Note: if an entity uses a spot rate for IFRS | US GAAP purposes in a jurisdiction where national GAAP requires a reference rate, it can either reconcile its financial reports or use parallel accounts.

If that national GAAP is also used for tax purposes, it will also need to contend with the resulting tax implications.

In XYZ's accounting jurisdiction, companies are required to use a declared rate (“national bank middle”) for national GAAP / tax reporting purposes. The declared rate was 0.90, 0.89 and 0.91 and tax rate 20%. For illustration purposes, the tax effect is recognized perpetually. In practice, it is generally recognized periodically as a single, period-end adjustment.

12/15/X1 | 15.12.X1: IFRS/US GAAP book

In currency of record

In foreign currency

Cash in bank: FC

18,064

 

 

20,000

Income tax payable

13

 

 

 

 

Cash in bank

 

18,064

 

 

 

Income tax expense

 

13

 

 

12/15/X1 | 15.12.X1: national GAAP book

 

 

221 002 (cash in bank): FC

18,000

 

 

20,000

563 (foreign exchange expenses)

64

 

 

 

 

221 001 (cash in bank): LC

 

18,064

 

 


12/31/X1 | 31.12.X1: IFRS/US GAAP book

 

 

Foreign currency remeasurement loss

362

 

 

 

Income tax payable

40

 

 

 

 

Cash in bank: FC

 

362

 

 

 

Income tax expense

 

40

 

 

12/31/X1 | 31.12.X1: national GAAP book

 

 

563 (foreign exchange expenses)

200

 

 

 

 

221 002 (cash in bank): FC

 

200

 

 


1/15/X2 | 15.1.X2: IFRS/US GAAP book

 

 

Cash in bank: FC

444

 

 

 

Equipment

18,146

 

 

 

Income tax expense

80

 

 

 

 

Foreign currency remeasurement gain

 

444

 

 

 

Cash in bank: FC

 

18,146

 

(20,000)

 

Income tax payable

 

80

 

 

12/31/X1 | 31.12.X1: national GAAP book

 

 

221 002 (cash in bank): FC

400

 

 

 

022 (tangible movable things and their groups)

18,200

 

 

 

 

664 (foreign exchange income)

 

400

 

 

 

221 002 (cash in bank): FC

 

18,200

 

(20,000)


If national GAAP requirements cause different asset acquisition costs (as in this example), the tax base of the asset should also be adjusted to reflect the difference.

1/15/X2, it paid FCA 20,000 for equipment acquired from foreign supplier.

1/15/X2 | 15.1.X2

   

FX rate

FC

Cash in bank (FCA)

444

 

0.9073

20,000

Equipment

18,146

 

 

 

 

Foreign currency transaction gain

 

444

0.9073

 

 

Cash in bank (FCA)

 

18,146

 

20,000


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