IAS 21 Foreign Currency

CHAPTER 7:
Foreign Currency in Individual Financial Statements

(IAS 21)
Question 1:
Have you ever wondered how a transaction made
in a foreign currency is reported by a company in
its financial statements?
IAS 21 The effects of changes in foreign
exchange rates:
IAS 21 deals with:
 The definition of functional and presentation currencies.
 Accounting for individual transactions in a foreign currency.
 Translating the financial statements of a foreign operation.
Functional currencies:
Functional currency is the ‘currency of the primary economic environment
where the entity operates’ (IAS 21, para 8).
IAS 21 (para 9) says that an entity should consider the following primary
factors when determining its functional currency:
 The currency that mainly influences sales prices for goods and services.
 The currency of the country whose competitive forces and regulations
mainly determine the sales price of goods and services.
 The currency that mainly influences labour, materials and other costs of
providing goods and services.
Functional currencies (Cont’d):
If the primary factors are inconclusive then the following secondary factors
should also be considered:
 The currency in which funds from financing activities are generated.
 The currency in which receipts from operating activities are retained.
Presentation currency:
The presentation currency is defined by IAS 21 as the currency in which the
entity presents its financial statements. This can be different from the
functional currency.
Test 1:
Zenfo is an entity located in a country whose currency is dollars ($). 70% of
Zenfo’s sales are denominated in dollars and 30% of them are denominated
in sterling (£). Zenfo does not convert receipts from customers into other
currencies. Zenfo buys most of its inventories, and pays for a large
proportion of operating costs, in sterling. Zenfo has two bank loans
outstanding. Both of these loans are denominated in dollars.
Required: What is the functional currency of Zenfo?
How can we account for individual transactions
designated in a foreign currency?
Where an entity enters into a transaction denominated in a currency other

than its functional currency, that transaction must be translated into the
functional currency before it is recorded.
The exchange rate used to initially record transactions should be either:
 The spot exchange rate on the date the transaction occurred, or
 An average rate over a period of time, providing the exchange rate has
not fluctuated significantly.
Cash settlement:
When cash settlement occurs, such as when cash is received from an
overseas credit customer, the settled amount should be translated into the
functional currency using the spot exchange rate on the settlement date. If
this amount differs from that used when the transaction occurred, there will
be an exchange difference.
Exchange differences on settlement:
 IAS 21 requires that exchange gains or losses on settlement of individual
transactions are recognized in profit or loss in the period in which they
arise.
 However, IAS 21 is not definitive in stating where in profit or loss any
such gains or losses are classified. It would seem reasonable to regard
them as items of operating expense or income.
Illustration: Exchange difference on settlement
On 7 May 2006 an entity with a functional currency of dollars ($) sold goods
to a German entity for €48,000. On this date, the rate of exchange was $1 =
€ 3.2.
The sale is translated into the functional currency using the exchange rate in
place on the transaction date.
Receivables (€48,000/3.2)……………….$15,000
Revenue……………………………………………………….$15,000
On 20 July 2006 the customer paid the outstanding balance. On this date, the
rate of exchange was $1 = €3.17.
Illustration: Exchange difference on settlement
The settlement is translated into the functional currency using the

exchange rate in place on the settlement date.
Cash (€48,000/3.17)……………………….$15,14
Receivables…………………………………………
$15,000
Profit or loss (exchange gain)………………..$142
The $142 exchange gain forms part of the profit for the year.
Treatment of year-end balances:
The treatment of any overseas items remaining in the statement of financial position at the
year-end will depend on whether they are monetary or non-monetary items. The rules in
IAS 21 (para 8) stipulate the following:
Units of currency held and assets

Retranslate using
and liabilities to be received or Monetary
the closing rate
paid in a fixed or determinable Items
(year-end
number of units of currency, e.g.
exchange rate)
cash, receivables, payables, loans
IAS 21 requires that exchange differences arising on retranslation of monetary assets and liabilities must be
recognized in profit or loss.
Treatment of year-end balances:
 Do not retranslate
Other items in the statement of Non-  If an item is
financial position, e.g. non- monetary carried at fair
Items value, the fair
current assets, inventory
value should be
translated on the
date it was
determined.
Illustration: Monetary Items
On 7 May 2006 an entity with a functional currency of dollars ($) sold goods
to a German entity for €48,000. On this date, the rate of exchange was $1 =
€ 3.2.
The sale is translated into the functional currency using the exchange rate in
place on the transaction date.
Receivables (€48,000/3.2)……………….$15,000
Revenue……………………………………………………….$15,000
By the reporting date of 31 July 2006, the invoice had not been settled. On
this date, the rate of exchange was $1 = € 3.4.
Illustration: Monetary Items
Receivables are a monetary item so must be retranslated into the entity’s
functional currency at the year end using the closing exchange rate.
The receivable at year end should therefore be held at $14,118
(€48,000/3.4). The following entry is required:
Profit or loss (exchange loss)…………..$882
Receivables ($15,000-$14,118)…………..$882
Criticisms of IAS 21
 Lack of theoretical underpinning: It is not clear why foreign exchange gains and losses
on monetary items are recorded in profit or loss, yet foreign exchange gains and losses
arising on consolidation of a foreign operation are reported in other comprehensive
income.
 Long-term items: It is argued that retranslating long-term monetary items using the
closing rate does not reflect economic substance. This is because a current exchange
rate is being used to translate amounts that will be repaid in the future.
 The average rate: IAS 21 does not stipulate how to determine the average exchange
rate in the reporting period.
 Monetary/non-monetary: The distinction between monetary and non-monetary items
can be ambiguous.
 Foreign operations: IAS 21 uses a restrictive definition of a ‘foreign operation’. IAS 21
should use a definition of a foreign operation that is based on substance rather than legal
form.
End of Chapter 7

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CHAPTER 7:

Foreign Currency in Individual Financial Statements

Where an entity enters into a transaction denominated in a currency other

The settlement is translated into the functional currency using the

Units of currency held and assets

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