Monetary conversion in IFRS
Monetary conversion in IFRS summarises the guidance in IAS 21 The Effects of Changes in Foreign Exchange Rates and IAS 29 Financial Reporting in Hyperinflationary Economies.
IAS 21 Changes in FX Rates
A ‘foreign currency transaction‘ is a transaction that is denominated or requires settlement in a currency other than an entity’s functional currency (i.e. in a foreign currency). Before applying this definition and the guidance on foreign currency transactions, and entity first considers whether there is a foreign curency or other embedded derivative that requires separation.
Key principles
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IAS 21 should be applied in:
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Recognition
Initial recognition
A foreign currency transaction should be recorded in the functional currency, by applying to the foreign currency amount the spot exchange rate between the functional currency and the foreign currency at the date of the transaction. (IAS 21.20-22)
Subsequent measurement
At the end of each reporting period:
- Foreign currency monetary items should be translated using the closing rate
- Non-monetary items that are measured in terms of historical cost in a foreign currency should be translated using the exchange rate at the date of the transaction and
- Non-monetary items that are measured at fair value in a foreign currency should be translated using the exchange rates at the date when the fair value was measured. (IAS 21.23-26)
Presentation currency
The entity may present its financial statements in a currency other than its functional currency (presentation currency). The entity that translates its financial statements into a presentation currency other than its functional currency uses the same method as for translating the financial statements of a foreign operation. (IAS 21.38-43)
Disposal or partial disposal of a foreign operation
- If an entity disposes of its entire interest in a foreign operation or loses control over a foreign subsidiary, or retains neither joint control nor significant influence over an associate or joint arrangement as a result of partial disposal, then the cumulative amount of the exchange differences relating to that foreign operation, recognised in Other Comprehensive Income (OCI) and accumulated in the separate component of equity, should be reclassified from equity to the statement of profit and loss (as a reclassification adjustment) when the gain or loss on disposal is recognised.
- A partial disposal of a foreign subsidiary without the loss of control leads to proportionate reclassification of the cumulative exchange differences from OCI to Non-Controlling Interest (NCI).
Supplementary financial information
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An entity may present supplementary financial information in a currency other than its presentation currency if certain disclosures are made.
IAS 21 Practical guidance
Determination of functional currency
Often situations arise where a company may have two or more distinct business with different functional currencies. The accounting principles in IAS 21 provide that functional currency is the currency of the primary economic environment in which the entity operates.
The functional currency needs to be identified at the entity level, considering the economic environment in which the entity engages, and not at the level of a business, a division of group of companies in a consolidation (see below presentation currency).
IAS 21 provides additional guidance with respect to factors which an entity should consider while determining its functional currency. These factors include the following:
- Currency that influences sales prices for goods and services and is of a country whose competitive forces and regulations determine the sales prices of its goods and services
- Currency that influences labour, material and other costs of providing goods or services
- Currency in which funds from financing activities are generated and
- Currency in which receipts from operating activities are usually retained.
In determining the functional currency of a foreign operation and whether its functional currency is the same as the reporting entity (the reporting entity in this context being the entity that has the foreign operation as its subsidiary, branch, associate or joint venture):
- whether its activities are an extension of the reporting entity’s activities rather than involving significant degree of autonomy;
- the proportion of its transactions that are with the reporting entity;
- whether its cash flows directly affect those of the reporting entity and are readily distributable to it; and
- whether its cash flows are sufficient to service its existing and normally expected debt obligations without funding assistance from the reporting entity.
Determination of presentation currency for Consolidation purposes
Entities within a group may have different functional currencies. IAS 21 requires each entity to determine its functional currency and translate foreign currency items into functional currency and report effects of such translation in the financial statements. IAS 21 also permits an entity to use a presentation currency for reporting its financial statements that differs from its functional currency.
IAS 21 provides specific guidance on translating the results and balance sheet of an entity into a different presentation currency.
Disclosure of foreign exchange differences separately from other fair value changes
Generally, IFRS 9 requires a gain or loss on a financial asset that is measured at fair value to be recognised in profit or loss*. In the case of a financial asset denominated in a foreign currency and measured at Fair Value Through Profit or Loss (FVTPL), the fair value is determined in the following two steps:
- Firstly, the fair value is determined in the relevant foreign currency
- Next, it is translated into the functional currency in accordance with the requirements of IAS 21.
* The exceptions to this general principle are as follows:
- It is a part of hedging relationship
- It is an investment in an equity instrument and the entity has elected to present gains and losses on that investment in OCI
- It is a financial liability designated as at FVTPL and the entity is required to present the effects of changes in the liability’s credit risk in OCI
- It is a financial asset measured at Fair Value through Other Comprehensive Income (FVOCI) and the entity is required to recognise some changes in fair value in OCI.
Thus, as explained above, the change in fair value of such a financial asset during a period arises due to following two factors:
- Change in fair value expressed in terms of foreign currency
- Change in exchange rate.
For example, an entity, P Ltd. holds an investment in debenturesX denominated in a foreign currency. These debentures are measured at FVTPL in accordance with IFRS 9, and the functional currency of P Ltd. is INR.
x This investment is not designated as a hedging instrument in a cash flow hedge of an exposure to changes in foreign currency rates. Accordingly, the view was that it would not be covered within the exceptions to the general principle enunciated in IFRS 9 but would be measured at FVTPL.
IASB considered the issue whether the foreign exchange difference is required to be presented separately from other fair value changes in the statement of profit and loss.
IAS 21 specifically excludes financial instruments measured at FVTPL from its requirement of disclosure of the amount of the amount of exchange differences recognised in profit or loss.
Further, IFRS 9 does not contain any requirement for separation of change in fair value of a foreign- currency denominated financial asset measured at FVTPL into the two constituent parts (i.e. change in fair value expressed in terms of foreign currency and change in exchange rate).
Accordingly, in the given case, IASB clarified that P Ltd is not required to present change in fair value of the investment in debentures on account of change in relevant foreign exchange rate separately from other changes in the fair value of the investment.
Exchange differences
Any exchange difference arising on the settlement of a monetary item or on translating monetary items at rates different from those in which they were translated on initial recognition during the period or in previous financial statements, are included in profit or loss in the period in which they arise unless it relates to exchange differences arising on a monetary item that forms part of a reporting entity’s net investment in a foreign operation.
These exchange differences are recognised in the profit or loss in the separate financial statements of the reporting entity or the individual financial statements of the foreign operation as appropriate. In the financial statements that includes the foreign operation and the reporting entity (e.g. the consolidated financial statements when the foreign operation is a subsidiary), such exchange differences are recognised initially in other comprehensive income and reclassified from equity to profit or loss on disposal of the net investment.
When a gain or loss on a non-monetary item is recognised in other comprehensive income, any exchange component of that gain or loss is recognised in other comprehensive income. Conversely, when a gain or loss on a non-monetary item is recognised in profit or loss, any exchange component of that gain or loss shall be recognised in profit or loss.
Translation into presentation currency
An entity may elect to present its financial report in any currency (referred to as the presentation currency). For operations where the functional currency is not the presentation currency:
- assets and liabilities for each statement of financial position presented (including comparatives) are translated to the presentation currency using the closing rate at the date of that statement of financial position;
- income and expenses for each statement presenting profit or loss and other comprehensive income (including comparatives) are translated using the exchange rate at the transaction dates; and
- any resulting exchange difference are recognised in other comprehensive income.
For groups, translation of each entity within the group to the group’s presentation currency is performed before preparing the consolidated financial report. A similar process is also adopted in an individual entity’s financial statements where, for example, there is a branch operation with a different functional currency.
IAS 29 Financial Reporting in Hyper inflationary Economies
IAS 29 requires the financial statements of any entity whose functional currency is the currency of a hyperinflationary economy to be restated for changes in the general purchasing power of that currency so that the financial information provided is more meaningful.
The Standard lists factors that indicate an economy is hyperinflationary. One of the indicators of hyperinflation is if cumulative inflation over a three year period approaches, or is in excess of, 100 per cent.
IAS 29 applies to the financial statements of any entity from the beginning of the reporting period in which it identifies the existence of hyperinflation in the country in whose currency it reports.
Mechanics of restatement in IAS 29
IAS 29 requires amounts in the Statement of Financial Position, that are not already expressed in terms of the measuring unit current at the end of the reporting period, are restated by applying a general price index. In summary (IAS 29 5-10):
- assets and liabilities linked by agreement to changes in prices, such as index linked bonds and loans, are adjusted
in accordance with the agreement - non-monetary items carried at amounts current at the end of the reporting period, such as net realisable value and fair value, are not restated
- all other non non-monetary assets and liabilities are restated
- monetary items are not restated because they are already expressed in terms of the monetary unit current at the end of the reporting period. Monetary items are money held and items to be received or paid in money
- all items in the statement of comprehensive income are expressed in terms of the measuring unit current at the end of the reporting period. Therefore, all amounts need to be restated from the dates when the items of income and expenses were initially recorded in the financial statements, and
- a gain or loss on the net monetary position is included in profit or loss. The gain or loss on the net monetary position may be derived as the difference resulting from the restatement of non non-monetary assets, owners’ equity and items in the statement of comprehensive income and the adjustment of index linked assets and liabilities.
Indexation
IAS 29.37 requires amounts in the statement of financial position that are not already expressed in terms of the measuring unit current at the end of the reporting period to be restated by applying a general price index. It further notes it is preferable that all entities report in the currency of the same hyperinflationary economy apply this Standard from the same date.
Restatement of prior year comparatives
When a country becomes hyperinflationary, IAS 29 requires corresponding figures for the previous reporting period to be restated by applying a general price index so that the comparative financial statements are presented in terms of the measuring unit current at the end of the reporting period. (IAS 29.34)
IAS 21 however sets out specific requirements for the purpose of presenting comparative amounts in a different presentation currency (see later section).
Restatement of prior quarterly information
IAS 29 applies to the financial statements of any entity from the beginning of the reporting period in which it identifies the existence of hyperinflation in the country in whose currency it reports.
For example, if a country became hyperinflationary from 1 July 2020, calendar year entities that prepare quarterly interim financial statements will therefore need to apply IAS 29’s guidance for the quarter ended 30 September 2020.
It follows that the year to date figures for the nine months ended 30 September 2020 will be on an IAS 29 basis (ie with amounts being re indexed for the effects of hyperinflation from 1 January 2020). The Standard is less clear however on whether the figures for the first and second quarters of the year (which a quarterly filer will already have reported) need to be restated to an IAS 29 basis before determining the figures for the three months ended 30 September 2020.
Depending on which approach is taken, the effect on profit or loss will vary.
- If the figures for the first and second quarters of the year are restated to an IAS 29 basis then part of the catch up effect produced by IAS 29 will be accounted for as a restatement of earlier quarters, adjusting the opening equity for the figures for the three months ended 30 September 2020.
- Alternatively, if the first and second quarters are not restated then the entire catch up effect for the nine months year to date figures would be reported in the figures for the three months ended 30 September 2020.
Given the lack of clarity in the Standard and this issue arises only on first time application of IAS 29, either approach is considered acceptable. Entities should be aware though that the approach taken will also have an impact in terms of the comparatives that will be presented in the 2021 quarterly financial statements.
Impact on deferred taxation
In many situations, applying IAS 29 will result in the creation of additional temporary differences under IAS 12 ‘Income Taxes’. This is because the restatement of item under IAS 29 will often lead to adjustments to the carrying amounts of items without corresponding changes to their tax bases. For example, prior to the application of IAS 29.32 the tax base of an asset may be close to 100% of its book value but after IAS 29’s application the tax base may be a much smaller percentage. The effect of such temporary differences will need to be recognised in profit or loss under IAS 12.
Impact on impairment testing
IAS 29 requires the restated amount of a non-monetary item to be reduced, in accordance with appropriate IFRS, when it exceeds its recoverable amount. It is possible then that assets may need to be written down following the restatement of amounts in the statement of financial position in accordance with IAS 29, even if those assets were not previously considered impaired under historical cost accounting.
Entities should also consider whether the restatement of asset carrying values affects the results of impairment tests that have been conducted in previous reporting periods. Similarly, entities should consider whether there are any indicators of impairment for assets that were not tested for impairment in previous periods.
Group reporting
Hyperinflationary parent with subsidiaries that report in a hyperinflationary currency A parent entity that reports in a hyperinflationary currency which has subsidiaries that also report in the same currency should restate the financial statements of those subsidiaries in accordance with IAS 29 as part of the consolidation process. (IAS 29.35-36)
Where a subsidiary reports in the currency of a different hyperinflationary currency, then its financial statements should first be restated by applying a general price index of the country in which it reports. The restated financial statements should then be translated at closing rates.
Refer below for two issues discussed by the IFRIC on this topic, where agenda decisions were made in March 2020,
regarding:
- translating a hyperinflationary foreign operation and presenting exchange differences
- accounting for cumulative exchange differences before a foreign operation becomes hyperinflationary.
Hyperinflationary parent with subsidiaries that do not report in a hyperinflationary currency
The financial statements of subsidiaries that do not report in a hyperinflationary currency are translated initially in accordance with the requirements of IAS 21 ‘The Effects of Changes in Foreign Exchange Rates’. Applying those requirements results in:
- items included in comprehensive income being translated at the rates on the dates of transactions (or an average rate)
- balance sheet items being translated at the closing rates.
The general view is that for items included in comprehensive income that are first translated in accordance with IAS 21, entities may, but are not required, to restate them in accordance with IAS 29 from the transaction date.
Non-hyperinflationary parent with subsidiaries that report in a hyperinflationary currency
IAS 21 states that when the results and financial position of an entity whose functional currency is the currency of a hyperinflationary economy are translated into the currency of a non non-hyperinflationary economy, comparative amounts shall be those that were presented as current year amounts in the relevant prior year financial statements ( ie not adjusted for subsequent changes in the price level or subsequent changes in exchange rates).
Some people have nevertheless taken the view that IAS 21 does not specifically address the initial period when IAS 29 is applied and that it is therefore possible to restate the comparative prior year in that initial period when hyperinflationary accounting is first applied.
The general view however is that the requirements of IAS 21 are clear and accordingly restatement of the comparative prior year is not appropriate in the period that hyperinflationary accounting is first applied. This will be the case for Iran and Lebanon, who in 2020 are being deemed hyperinflationary economies for the first time. As noted below in the third matter on accounting for hyperinflation considered by IFRIC in March 2020, where IFRIC has now signalled it supports the general view.
IFRIC decisions hyperinflationary
The IFRS Interpretations Committee (IFRIC) considered three issues at the beginning of 2020, with agenda decisions being made at the March 2020 meeting. These matters are very relevant given Iran and Lebanon are considered hyperinflationary for the first time.
Translating a hyperinflationary foreign operation and presenting exchange differences
This request surrounded the application of IAS 21 and IAS 29, and where a foreign operation (whose currency is hyperinflationary) is restated and translated in the group financial statements. The committee concluded the entity does not recognise any exchange differences in equity, rather the entity presents in OCI any exchange difference resulting from the translation of a hyperinflationary foreign operation. The restatement effect resulting from restating the entity’s interest in the equity of the hyperinflationary foreign operation is shown in OCI if the combination of the restatements and translation meets the definition of an exchange difference in IAS 21, if it does not, the restatement is recognised in equity equity.
Accounting for cumulative exchange differences before a foreign operation becomes hyperinflationary
This issue questioned whether the entity reclassifies within equity the cumulative exchange differences (pre-hyperinflation) when the foreign operation becomes hyperinflationary, effectively transferring the cumulative pre-hyperinflation exchange differences to a component of equity that is not subsequently reclassified to profit or loss. The committee concluded that entity does not reclassify within equity the cumulative pre-hyperinflation exchange differences once the foreign operation becomes hyperinflationary.
Presenting comparative amounts when a foreign operation first becomes hyperinflationary
This matter questioned whether an entity should restate comparative amounts presented in a foreign operation in the annual financial statements for the period that the foreign operation becomes hyperinflationary and the first interim set of financial statements reported under IAS 29. The committee concluded entities should not restate comparatives in their interim or annual financial statements for the first periods reporting under IAS 29.
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