IAS 21 adopted the functional currency approach that requires the foreign entity to present all of its transactions in its functional currency.
Translation is the process of converting transactions denominated in its functional currency into the investor's presentation currency. If an entity's transactions are denominated in other than its functional currency, the foreign transactions must first be adjusted to their equivalent functional currency value before translating to the presentation currency (if different than the functional currency). Three different situations that can arise in translating foreign currency financial statements are illustrated in the following example:
Example
Foreign entity's local currency
Foreign entity's functional currency
Investor's presentation currency
Translation method Exchange differences
Euro Euro Canadian dollar Translation to the presentation currency at the closing rate for all assets and liabilities
Other comprehensive income (OCI) and equity Euro Canadian dollar Canadian dollar Translation to the functional currency (which is also the
presentation currency) at the closing rate for all monetary items
Gain (or loss) in profit or loss
Swiss franc Euro Canadian dollar 1. Translation to the functional currency (€) 2. Translation to the presentation currency (Can $)
Gain (or loss) in profit or loss OCI and equity IAS 21 prescribes two sets of requirements when translating foreign currency financial statements. The first of these deals with reporting foreign currency transactions by each individual entity, which may also be part of reporting group (e.g., consolidated parent and subsidiaries) in the individual entities’ functional currencies or remeasuring the foreign currency financial statements into the functional currency. The second set of requirements is for the translation of entities’ financial statements (e.g., those of subsidiaries) from the functional currency into presentation currency (e.g., of the parent). These matters are addressed in the following paragraphs.
Translation of Functional Currency Financial Statements into a Presentation Currency
If the investor's presentation currency (e.g., Canadian dollar) differs from the foreign entity's functional currency (e.g., euro), the foreign entity's financial statements have to be translated into the presentation currency when preparing consolidated financial statements. In accordance with IAS 21, the method used for translation of the foreign currency financial statements from the functional currency into the presentation currency is essentially what is commonly called the current (closing) rate method under US GAAP. In general, the translation methods under both IFRS and US GAAP are the same, except for the translation of financial statements in hyperinflationary economies (see Chapter 35).
Under the translation to the presentation currency approach, all assets and liabilities, both monetary and non‐monetary, are translated at the closing (end of the reporting period) rate, which simplifies the process compared to all other historically advocated methods. More importantly, this more closely corresponds to the viewpoint of financial statement users, who tend to relate to currency exchange rates in existence at the end of the reporting period rather than to the various specific exchange rates that may have applied in prior months or years.
However, financial statements of preceding years should be translated at the rate(s) appropriately applied when these translations were first performed (i.e., these are not to be updated to current closing or average rates). This rule applies because it would cause great confusion to users of financial statements if amounts once reported (when current) were now all restated even though no changes were being made to the
underlying data, and, of course, the underlying economic phenomena, now one or more years in the past, cannot have changed since initially reported upon.
The theoretical basis for this translation approach is the “net investment concept,” whereby the foreign entity is viewed as a separate entity that the parent invested into, rather than being considered as part of the parent's operations. Information provided about the foreign entity retains the internal relationships and results created in the foreign environments (economic, legal and political) in which the entity operates. This approach works best, of course, when foreign‐denominated debt is used to purchase the assets that create foreign‐denominated revenues; these assets thus serve as a hedge against the effects caused by changes in the exchange rate on the debt. Any excess (i.e., net) assets will be affected by this foreign exchange risk, and this is the effect that is recognised in the parent company's statement of financial position, as described below.
The following rules should be used in translating the financial statements of a foreign entity:
1. All assets and liabilities in the current year‐end statement of financial position, whether monetary or non‐monetary, should be translated at the closing rate in effect at the date of that statement of financial position.
2. Income and expense items in each statement of comprehensive income should be translated at the exchange rates at the dates of the transactions, except when the foreign entity reports in a currency of a hyperinflationary economy (as defined in IAS 29), in which case they should be translated at the closing rates.
3. All resulting exchange differences should be recognised in other comprehensive income and reclassified from equity to profit or loss on the disposal of the net investment in a foreign entity.
4. All assets and liabilities in prior period statements of financial position, being presented currently (e.g., as comparative information) whether monetary or non‐monetary, are translated at the exchange rates (closing rates) in effect at the date of each of the statements of financial position.
5. Income and expense items in prior period statements of income, being presented currently (e.g., as comparative information), are translated at the exchange rates as of the dates of the original transactions (or averages, where appropriate).
Under the translation to the presentation currency approach, all assets and liabilities are valued: (1) higher, as a result of a direct exchange rate increase, or (2) lower, as a result of a direct rate decrease. Since the liabilities offset a portion of the assets, constituting a natural hedge, only the subsidiary's net assets (assets in excess of liabilities) are exposed to the risk of fluctuations in the currency exchange rates. As a result, the effect of the exchange rate change can be calculated by multiplying the foreign entity's average net assets by the change in the exchange rate.
On the books of the parent, the foreign entity's net asset position is reflected in the parent's investment account. If the equity method is applied, the investment account should be adjusted upward or downward to reflect changes in the exchange rate; if a foreign entity is included in the consolidated financial statements, the investment account is eliminated. (See “Comprehensive example: translation into the presentation currency” later in this chapter.)
Translation (Remeasurement) of Financial Statements into a Functional Currency
When a foreign entity keeps its books and records in a currency other than its functional currency, translation of foreign currency items presented in the statement of financial position into functional currency (remeasurement) is driven by the distinction between monetary and non‐monetary items. Foreign currency monetary items are translated using the closing rate (the spot exchange rate at the end of the reporting period). Foreign currency non‐monetary items are translated using the historical exchange rates. There is a presumption that the effect of exchange rate changes on the foreign operation's net assets will directly affect the parent's cash flows, so the exchange rate adjustments are reported in the parent's profit or loss.
For example, branch sales offices or production facilities of a large, integrated operation (e.g., the European field operation of a US corporation, which is principally supplied by the home office, but which occasionally also enters into local currency transactions) would qualify for this treatment.
Since the US dollar influences sales prices, most (but not all) of its sales are US dollar denominated, and most of its costs, including
merchandise, are the result of US transactions, the application of the previously mentioned criteria would conclude that the functional currency of the European sales office is the US dollar, and translation of foreign currency‐denominated assets and liabilities, and transactions would follow the monetary/non‐monetary distinction noted above with the effect of exchange rate differences reported in profit or loss.
In general, translation of non‐monetary items (inventory, plant assets, etc.) is done by applying the historical exchange rates. The historical rates usually are those in effect when the asset was acquired or (less often) when the non‐monetary liability was incurred, but if there was a subsequent revaluation, if this is permitted under IFRS, then using the exchange rate at the date when the fair value was determined.
When a gain or loss on a non‐monetary item is recognised in profit or loss (e.g., from applying lower of cost or realisable value for inventory), any exchange component of that gain or loss should be recognised in profit or loss. When, on the other hand, a gain or loss on a non‐monetary item is recognised under IFRS in other comprehensive income (e.g., from revaluation of plant assets, or from fair value adjustments made to financial assets classified at fair value through other comprehensive income securities investments), any exchange component of that gain or loss should also be recognised in other comprehensive income.
As a result of conversion into functional currency, if a foreign unit is in a net monetary asset position (monetary assets in excess of monetary liabilities), an increase in the direct exchange rate causes a favourable result (gain) to be reported in profit or loss; if it is in a net monetary liability position (monetary liabilities in excess of monetary assets), it reports an unfavourable result (loss). If a foreign unit is in a net monetary asset position, a decrease in the direct exchange rate causes an unfavourable result (loss) to report, but if it is in a net monetary liability position, a favourable result (gain) is reported.
In cases when an entity keeps its books and records in a currency (e.g., Swiss franc) other than its functional currency (e.g., euro), and other than the presentation currency of the parent (e.g., Canadian dollar), the two‐step translation process would be required: (1) translation of the financial statements (e.g., from Swiss franc) into the functional currency (e.g., euro) and (2) translation of the functional currency (e.g., euro) into the reporting currency (e.g., Canadian dollar).
Net Investment in a Foreign Operation
A special rule applies to a net investment in a foreign operation. According to IAS 21, when the reporting entity has a monetary item that is receivable from or payable to a foreign operation for which settlement is neither planned nor likely to occur in the foreseeable future, this is, in substance, a part of the entity's net investment in its foreign operation. This item should be accounted for as follows:
1. Exchange differences arising from translation of monetary items forming part of the net investment in the foreign operation should be reflected in profit or loss in the separate financial statements of the reporting entity (investor/parent) and in the separate financial statements of the foreign operation; but
2. In the consolidated financial statements, which include the investor/parent and the foreign operation, the exchange difference should be recognised initially in other comprehensive income and reclassified from equity to profit or loss upon disposal of the foreign operation.
Note that when a monetary item is a component of a reporting entity's net investment in a foreign operation and it is denominated in the functional currency of the reporting entity, an exchange difference arises only in the foreign operation's individual financial statements. Conversely, if the item is denominated in the functional currency of the foreign operation, an exchange difference arises only in the reporting entity's separate financial statements.
Consolidation of Foreign Operations
The most commonly encountered need for translating foreign currency financial statements into the investor entity reporting currency is when the parent entity is preparing consolidated financial statements, and one or more of the subsidiaries have reported in their respective (local) currencies. The same need presents itself if an investee or joint venture's financial information is to be incorporated via the proportionate consolidation or the equity methods of accounting. When consolidating the assets, liabilities, income and expenses of a foreign operation with those of the reporting entity, the general consolidation processes apply, including the elimination of intragroup balances and intragroup transactions. Goodwill and any fair value‐based adjustments to the carrying amounts of foreign operation's assets and liabilities should be expressed in the functional currency and translated using the closing rate.
Taxation Effect
Gains and losses on foreign currency transactions and exchange differences arising on translating the results and financial position of an entity, including its foreign operations, into a different currency may have tax effects. IAS 12, Income Taxes, applies to these tax effects.
Comprehensive example: Translation into the presentation currency
Assume that a US company has a 100%‐owned subsidiary in Germany that began operations in 20XX. The subsidiary's operations consist of utilising company‐owned space in an office building. This building, which cost €5,000,000, was financed primarily by German banks, although the parent did invest €2,000,000 in the German operation. All revenues and cash expenses are received and paid in euros. The subsidiary also maintains its books and records in euros, its functional currency.
The financial statements of the German subsidiary are to be translated (from the functional currency euros to the presentation currency US dollars) for incorporation into the US parent's financial statements. The subsidiary's statement of financial position at December 31, 20XX, and its combined statement of income and retained earnings for the year ended December 31, 20XX, are presented below in euros.
German Company Statement of Financial Position December 31, 202X (in thousands of €)
Assets Liabilities and shareholders’ equity
Cash €500 Accounts payable €300
Note receivable €200 Unearned rent €100
Land €1,000 Mortgage payable €4,000
Building €5,000 Ordinary shares €400
Accumulated depreciation (€) Additional paid‐in capital €1,600
Retained earnings €200
Total assets €6,600 Total liabilities and shareholders’ equity €6,600
German Company Combined Statement of Profit or Loss and Retained Earnings For the Year Ended December 31, 202X (in thousands of €)
Revenues €2,000
Operating expenses (including depreciation expense of €100) 1,700
Profit for the year 300
Add retained earnings, January 1, 202X‐1 –
Deduct dividends (100)
Retained earnings, December 31, 202X‐1 €200
Various assumed exchange rates for 202X are as follows:
€1 = $0.90 at the beginning of 202X (when the ordinary shares were issued and the land and building were financed through the mortgage)
€1 = $1.05 weighted‐average for 202X
€1 = $1.10 at the date the dividends were declared and the unearned rent was received
€1 = $1.20 closing (December 31, 202X)
The German company's financial statements must be translated into US dollars in terms of the provisions of IAS 21 (i.e., by the current rate method). This translation process is illustrated below.
German Company Statement of Financial Position Translation December 31, 202X (in thousands)
Euros € Exchange rates US dollars $ Assets
Cash 500 1.20 600
Accounts receivable 200 1.20 240
Land 1,000 1.20 1,200
Building (net) 4,900 1.20 5,880
Total assets €6,600 $7,920
Liabilities and shareholders’ equity
Accounts payable 300 1.20 360
Unearned rent 100 1.20 120
Mortgage payable 4,000 1.20 4,800
Ordinary shares 400 0.90 360
Additional paid‐in capital 1,600 0.90 1,440
(see combined income and retained earnings statement translation)
Retained earnings 200 205
Cumulative exchange difference (translation adjustments) – – 635
Total liabilities and shareholders’ equity €6,600 $7,920
German Company Combined Statement of Profit or Loss and Retained Earnings Translation For the Year Ended December 31, 202X (in thousands)
Euros Exchange rates US dollars
Revenues 2,000 1.05 2,100
Expenses (including €100 depreciation expense) 1,700 1.05 1,785
Profit for the year 300 315
Add retained earnings, January 1 – – –
Deduct dividends (100) 1.10 (110)
Retained earnings, December 31 €200 $205
German Company Statement of Cash Flows Translation For the Year Ended December 31, 202X (in thousands) Euros Exchange rates US dollars Operating activities
Profit for the year 300 1.05 315
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation 100 1.05 105
Increase in accounts receivable (200) 1.05 (210)
Increase in accounts payable 300 1.05 315
Increase in unearned rent 100 1.10 110
Net cash provided by operating activities 600 635
Investing activities
Purchase of land (1,000) 0.90 (900)
Purchase of building (5,000) 0.90 (4,500)
Net cash used by investing activities (6,000) (5,400)
Financing activities
Ordinary shares issue 2,000 0.90 1,800
Mortgage payable 4,000 0.90 3,600
Dividends paid (100) 1.10 (110)
Net cash provided by financing 5,900 5,290
Effect on exchange rate changes on cash N/A 75
Increase in cash and equivalents 500 600
Cash at beginning of year – –
Cash at end of year €500 1.20 $600
The following points should be noted concerning the translation into the presentation currency:
1. All assets and liabilities are translated using the closing rate at the end of the reporting period (€1 = $1.20). All revenues and expenses should be translated at the rates in effect when these items are recognised during the period. Due to practical considerations, however, weighted‐average rates can be used to translate revenues and expenses (€1 = $1.05) only if such weighted‐average rates approximate actual rates that were ruling at the time of the transactions.
2. Shareholders’ equity accounts are translated by using historical exchange rates. Ordinary shares were issued at the beginning of 202X‐2 when the exchange rate was €1 = $0.90. The translated balance of retained earnings is the result of the weighted‐average rate applied to revenues and expenses and the specific rate in effect when the dividends were declared (€1 = $1.10).
3. Cumulative exchange differences (translation adjustments) result from translating all assets and liabilities at the closing (current) rate, while
shareholders’ equity is translated by using historical and weighted‐average rates. The adjustments have no direct effect on cash flows;
however, changes in exchange rate will have an indirect effect on sale or liquidation. Prior to this time, the effect is uncertain and remote.
Also, the effect is due to the net investment rather than the subsidiary's operations. For these reasons, the translation adjustments balance is reported as “other comprehensive income item” in the statement of comprehensive income and as a separate component in the shareholders’ equity section of the US company's consolidated statement of financial position. This balance essentially equates the total debits of the subsidiary (now expressed in US dollars) with the total credits (also in dollars). It may also be determined directly, as shown next, to verify the translation process.
4. The cumulative exchange differences (translation adjustments) credit of $635 is calculated as follows:
Net assets at the beginning of 202X‐2 (after ordinary shares were issued and the land and building were acquired through mortgage financing)
€2,000 (1.20 − 0.90)
= $600 credit
Profit for the year €300 (1.20 −
1.05)
= 45 credit
Dividends €100 (1.20 −
1.10) = 10 debit
Exchange difference (translation adjustment) $635
credit 5. Since the net exchange differences (translation adjustment) balance that appears as a separate component of shareholders’ equity is
cumulative in nature, the change in this balance during the year should be disclosed in the financial statements. In the illustration, this balance went from zero to $635 at the end of 202X‐1. The analysis of this change was presented previously. The translation adjustment has a credit balance because the German entity was in a net asset position during the period (assets in excess of liabilities) and the spot exchange rate at the end of the period is higher than the exchange rate at the beginning of the period or the average for the period.
In addition to the foregoing transactions, assume that the following occurred during 202X+ 1:
German CompanyStatement of Financial PositionDecember 31, 202X+1(in thousands of €) 202X 202X‐1 Increase/(decrease) Assets
Cash €1,000 €500 €500
Accounts receivable – 200 (200)
Land 1,500 1,000 500
Building (net) 4,800 4,900 (100)
Total assets €7,300 €6,600 €700
Liabilities and shareholders’ equity
Accounts payable €500 €300 €200
Unearned rent – 100 (100)
Mortgage payable 4,500 4,000 500
Ordinary shares 400 400 –
Additional paid‐in capital 1,600 1,600 –
Retained earnings 300 200 100
Total liabilities and shareholders’ equity €7,300 €6,600 €700
German CompanyCombined Statement of Profit or Loss and Retained EarningsFor the Year Ended December 31, 202X+1(in thousands of €)
Revenues €2,200
Operating expenses (including depreciation expense of €100) 1,700
Profit for the year 500
Add: Retained earnings, January 1, 202X 200
Deduct dividends (400)
Retained earnings, December 31, 202X €300
Exchange rates were:
€1 = $1.20 at the beginning of 202X+1
€1 = $1.16 weighted‐average for 202X+1
€1 = $1.08 closing (December 31, 202X+1)
€1 = $1.10 when dividends were paid in 202X and land bought by incurring mortgage The translation process for 202X+1 is illustrated below.
German CompanyStatement of Financial Position TranslationDecember 31, 202X+1(in thousands)
Euros Exchange rates US dollars
Assets
Cash 1,000 1.08 1,080
Land 1,500 1.08 1,620
Building 4,800 1.08 5,184
Total assets €7,300 $7,884