Chapter 28 17/09/2016. Accounting for foreign currency transactions. Introduction to accounting for foreign currency transactions

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1 Chapter 28 Accounting for foreign currency transactions 28-1 Introduction to accounting for foreign currency transactions Two general issues to be considered in foreign currency translations 1. Where debts, receivables or other monetary items are denominated in currencies other than domestic currency there is a need to convert them into a single currency (not necessarily Australian dollars) unless transactions converted into a common currency, financial statements would include account balances in different currencies the aggregate would not make sense 2. Where an entity controls a foreign subsidiary, the financial statements of that subsidiary need to be translated into a common currency before the consolidation process (addressed in Chapter 29) 28-2 Foreign currency transactions Exchange rate defined as (AASB 121): the ratio of exchange for two currencies Exchange rates frequently change (daily) and this results in the need for the translation of transactions. This involves transactions: denominated in a foreign currency, or requiring settlement in a currency other than the functional currency of the entity Examples of foreign currency transactions Acquisition of goods from a foreign supplier where the transaction is denominated in a foreign currency Sale of goods to a foreign customer where the transaction is denominated in a foreign currency Loan from foreign lender denominated in a foreign currency

2 Foreign currency transactions (cont.) Accounting entry at date of original transaction AASB 121 (par. 21) A foreign currency transaction shall be recorded, on initial recognition 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 Key terms Spot exchange rate: the exchange rate for immediate delivery Functional currency: the currency of the primary economic environment in which the entity operates important as this identifies what currency the transactions will be converted into 28-4 Foreign currency transactions (cont.) Key terms (cont.) Functional currency note AASB 121 (par. 9) The primary economic environment in which an entity operates is normally the one in which it primarily generates and expends cash. An entity considers the following factors in determining functional currency: (a) The currency (i) that mainly influences sales prices for goods and services (this will often be the currency in which sales prices for its goods and services are denominated and settled), and (ii) of the country whose competitive forces and regulations mainly determine the sales prices of its goods and services (b) The currency that mainly influences labour, material and other costs of providing goods and services (this will often be the currency in which such costs are denominated and settled) 28-5 Foreign currency transactions (cont.) Key terms (cont.) Presentation currency the currency in which the financial statements are presented note AASB 121 (par. 38) An entity may present its financial statements in any currency (or currencies). If the presentation currency differs from the entity s functional currency, it translates its results and financial position into the presentation currency. For example, when a group contains individual entities with different functional currencies (perhaps there are a number of different subsidiaries operating within different countries and with different functional currencies), the results and financial position of each entity are expressed in a single common currency so that consolidated financial statements may be presented

3 Foreign currency transactions (cont.) Key terms (cont.) Therefore, where consolidated financial statements are prepared, transactions will first be translated into a particular functional currency, and then prior to consolidation, the subsidiaries financial statements will all be translated into the group s single presentation currency 28-7 Illustration 1 On 1 June 2019, XYZ Ltd acquired goods on credit from a UK supplier. The goods were shipped FOB London on 1 June The cost of the goods was , and remained unpaid at 30 June On 1 June 2019 the exchange rate was $1.00 = On 30 June 2019 it was $1.00 = Illustration 1 Solution As at 1 June, the debt would be equal to $ (which is /0.50). It is converted at the spot rate. As at 30 June, the debt would be equal to $ (which is /0.55 using the reporting date spot rate). AASB 121 requires that: A foreign currency transaction shall be recorded, on initial recognition 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. Hence, the initial entry on 1 June 2019 would be: Dr Inventory Cr Accounts payable

4 End of reporting period adjustments AASB 121 requires that foreign currency monetary items (which includes payables and receivables) outstanding at the end of the reporting period shall be translated at the spot rate at reporting date (referred to as the closing rate ). AASB 121 requires that the exchange differences relating to monetary items shall be brought to account as part of profit or loss in the financial year in which the exchange rates change. Hence, the entry on 30 June 2019 would be: Dr Accounts payable Cr Exchange gain Note that the adjustment goes to profit or loss, and not to inventory Foreign currency transactions: reporting date adjustments Foreign currency monetary items outstanding at the end of the reporting period must ALL be translated using the closing rate Closing rate the spot exchange rate at the reporting date Foreign currency monetary items include accounts payable and receivable; cash; interest, notes, loans and dividends receivable; bank overdraft; income taxes, wages, notes and/or debentures payable Any exchange differences (foreign exchange gains or losses) are generally then brought to account as part of profit or loss in the reporting period in which the exchange rates change Foreign currency transactions: reporting date adjustments (cont.) Exception to rule that foreign currency monetary items outstanding at the end of the reporting period must be translated at spot rate at reporting date: instances of contractual arrangement the exchange rate has been fixed for a particular transaction General principle applied, however, is that exchange differences relating to monetary items are to be recognised as income or expenses in reporting period in which the exchange rates change Exceptions to this rule (addressed later): qualifying assets certain types of hedging arrangements (cash flow hedges)

5 Determining functional currency and presentation currency Number of issues to consider in determining functional currency (AASB 121) Consideration needs to be given to the currency in which the general purpose financial statements are prepared If the entity s shareholders reside primarily within Australia the expectation is that the presentation currency would be Australian dollars Presentation currency may not be the same as functional currency, for example parent company residing in Australia controls a subsidiary company residing in a foreign country (e.g. South Africa) If subsidiary operates within South Africa and sells its goods and purchases its raw materials in Rand, the functional currency is South African rands For the purposes of translating the results for Australian purposes, the presentation currency would be Australian dollars Refer to Worked Example 28.2 Determination of functional currency and presentation currency Worked Example 28.3 Translation of a non-current liability On 1 July 2018, Noosa Ltd enters into an agreement to borrow from Fistral plc (UK). Fistral plc sends the loan money to Noosa Ltd s Australian bank account. The loan is for five years and requires the payment of interest at the rate of 10 per cent on 30 June each year. Noosa Ltd s reporting date is 30 June. The relevant exchange rates are: 1 July 2018 A$1.00 = June 2019 A$1.00 = 0.40 REQUIRED Provide the journal entries in the books of Noosa Ltd for the year ending 30 June 2019 to account for the above transaction Worked Example 28.3 Solution 1 July 2018 Dr Cash Cr Loan payable (to recognise the foreign currency loan at the 1 July 2018 spot rate: = Again, remember that throughout the period the transactions are recorded in the entity s functional currency) 30 June 2019 Dr Interest expense Cr Cash (to recognise year-end interest payment = ( %) 0.40) Dr Foreign exchange loss Cr Loan payable (to recognise the effect of retranslation of the loan at the 30 June 2019 spot rates; the increase in the amount of the loan payable is to be treated as an expense in the period in which the exchange rate moves) Balance of payable at 1 July 2018: $ $ Balance of payable at 30 June 2019: $ $ Increase in loan payable $

6 Qualifying assets Exception to the general rule that exchange differences relating to monetary items (current and non-current) are to be brought to account as expenses or revenues in the period in which the exchange rate changes Defined in AASB 123 Borrowing Costs as an asset that necessarily takes a substantial period of time (considered to be greater than 12 months) to get ready for its intended use or sale Examples (AASB 123) Inventories that require a substantial period of time to bring them to a saleable condition, manufacturing plants, power generation facilities and investment properties Other investments and those inventories that are routinely manufactured or otherwise produced in large quantities on a repetitive basis over a short period of time are not qualifying assets. Assets that are ready for their intended use or sale when acquired are also not qualifying assets Qualifying assets (cont.) Exchange differences that lead to an increase in the cost of an asset are considered to be borrowing costs under AASB 123 For qualifying assets, AASB 123 requires the borrowing costs to be capitalised as part of the cost of the asset (borrowing costs that are directly attributable to acquisition, construction or production of a qualifying asset shall be capitalised as part of the cost of that asset) Exchange differences included in cost of qualifying assets for the financial year are the amounts that would otherwise have been credited/debited to profit or loss Amount capitalised as the cost of the asset not to exceed its recoverable amount If exchange differences cause the recoverable amount of a qualifying asset to be exceeded, the excess should be expensed to the income statement Illustration 2 Foreign currency transaction relating to a qualifying asset On 1 July 2018, AB Ltd entered into a binding agreement with a Singapore company to construct an item of plant. The cost of the plant was $ Singapore. The plant was completed on 30 June 2019 and shipped FOB Singapore on that date. The debt was unpaid at 30 June The exchange rates at the relevant dates were: 1 July 2018: $1 Aus = $1.20 Singapore 30 June 2019: $1 Aus = $1.10 Singapore

7 Illustration 2 Solution (cont.) Being under construction, the item would appear to be a qualifying asset for the period from 1 July 2018 to 30 June July 2018 Dr Plant Cr Accounts payable ( /1.20) 30 June 2019 Dr Plant Cr Accounts payable ( /1.10) Any subsequent changes in the accounts payable balance due to fluctuating exchange rates shall go to profit or loss as either a gain or loss on foreign exchange Hedging transactions Where amounts are owed to, or owed by, entities in foreign currencies, entities are exposed to the risk of losses, which might be generated by movements in exchange rates To minimise the risk associated with foreign currency monetary items, an entity may enter a hedging contract Hedging Action taken, whether by entering a foreign currency contract or otherwise, with the objective of avoiding or mitigating possible adverse financial effects of movements in exchange rates Agreement entered into that takes a position opposite to the original transaction AASB 121 does not address foreign currency hedges Need to refer to AASB 9 Financial Instruments Hedging transactions (cont.) When there is a hedge, the foreign exchange gains or losses on one transaction (e.g. hedge contract, also referred to as the hedging instrument) will be offset by gains or losses on another (e.g. transaction with a purchaser of the entity s inventory, also referred to as the hedged item) If the exchange rate falls, a gain will be made on the sale to overseas purchaser (hedged item) but a loss will be made on the contract with the bank (hedging instrument) because the overseas currency has increased in value the entity had already agreed to a forward rate with the bank If the exchange rate rises (in the same scenario) the opposite will hold Perfectly hedged hedge agreement completely eliminates the consequences of adverse exchange rate fluctuations otherwise, partially hedged

8 Hedging transactions (cont.) Accounting for hedge transactions Hedge accounting Recognises the offsetting effects on profit or loss of changes in the fair values of the hedging instrument and the hedged item Hedge instrument A designated derivative or (for a hedge of the risk of changes in foreign currency exchange rates only) a designated non-derivative financial asset or nonderivative financial liability whose fair value or cash flows are expected to offset changes in the fair value of cash flows of a designated hedged item Hedging transactions (cont.) Accounting for hedge transactions (cont.) Hedged item An asset, liability, firm commitment, highly probable forecast transaction or net investment in a foreign operation that exposes the entity to risk in changes of fair value or future cash flows Hedge accounting Attempts to match the timing of the profit or loss recognition on the hedging instrument with the profit and loss on the hedged item only when the hedging instrument meets specific requirements Hedging transactions (cont.) Accounting for hedge transactions (cont.) Three types of hedges identified in AASB 9 1. Fair value hedges (addressed in Chapter 14) 2. Cash flow hedges (addressed in Chapter 14) 3. Hedges of net investments of foreign operations Need to account separately for: the hedging transaction (i.e. the hedging instrument ), for example, forward rate agreement with a bank, and the transaction that led to the need for the hedge, for example original purchase or sales arrangement with an overseas entity (i.e. the hedged item)

9 Fair value hedge For a fair value hedge (which might be undertaken to mitigate the risks associated with changes in the fair values of particular assets, such as an entity s share portfolio), AASB 9 requires both the hedged item and the hedging instrument to be valued at fair value, with any gains or losses owing to fair value adjustments to be treated as part of the period s profit or loss If the gains or losses on the hedged item are perfectly hedged the gains or losses on the hedging instrument will offset the gains or losses on the hedged item so that the net effect on the period s profit or loss could be $nil Cash flow hedge In a cash flow hedge, the risk being hedged is potential volatility in future cash flows The cash flows might relate to a particular asset or liability, for example, future expected sales in a foreign currency or future floating interest payments on a recognised liability Any gain or loss that is determined to be associated with an effective cash flow hedge (i.e. the gain or loss on the hedging instrument) is initially recognised in equity. This ensures that any volatility in the profit or loss is avoided in the period during which the gains or losses on the hedged item (e.g. an amount payable on an overseas purchase of inventory) are not yet recognised in the entity s profit or loss In order to match the gains or losses of the hedged item and the hedging instrument, the changes in the fair value of the hedging instrument recognised in equity are removed from equity and recognised in the entity s profit or loss (a reclassification adjustment) at the same time as the cash flows from the hedged item are recognised in profit or loss Worked Example Cash flow hedge where hedging arrangement is organised after the purchase of inventory On 1 March 2019, Koala Ltd, an Australian entity, purchases UK 1.2 million of inventory from Nigel Incorporated, a UK entity. The amount is payable on 1 August A forward exchange contract for the delivery of UK 1.2 million is taken out with ABC Bank on 1 May ABC Bank requires delivery of the foreign currency on 1 August Koala Limited has a 30 June end of reporting period. Additional information The relevant exchange rates are as follows: Spot Forward Date rate rate 1 March May June August REQUIRED Prepare the journal entries for Koala Ltd to account for the hedge and provide evidence of whether or not hedge accounting in the above situation was beneficial

10 Worked Example Solution Receivable Amount payable Fair value Gain/(loss) Spot Forward on forward on forward of forward on forward Date rate rate contract contract contract contract 1 March May June August It is a requirement of AASB 9 that a fair value be attributed to the hedging instrument. In this situation, the fair value will change as the available forward rate being offered by the bank changes. For example, when the contract is originally negotiated, the bank is assumed to be offering the forward rate of A$1.00 = 0.35 for the delivery of UK on 30 June 2019 to any interested parties. Therefore, the contract itself has no fair value. However, if on 31 December the bank is only prepared to offer a forward rate for delivery of UK of A$1.00 = 0.34 if Koala Ltd was able to transfer its contract to another party needing UK on that date, then given the other options available to that other party, that party would be prepared to pay up to $ for the contract, which equates to ($ ) ($ ). The fair value of the contract would be deemed to be $ Worked Example Solution (cont.) 1 March 2019 Dr Inventory Cr Accounts payable May 2019 Dr Foreign exchange loss Cr Accounts payable [(UK ) (UK ) = $ ] 30 June 2019 Dr Forward contract Cr Gain on forward contract [because the entity is recognising the gains or losses on the accounts payable then the gain or loss on the forward contract will also be taken to profit or loss at the same time to offset the gains or losses on the inventory purchase] Dr Foreign exchange loss Cr Accounts payable [(UK ) (UK ) = $90,090; Test $ $ = 89%] Worked Example Solution (cont.) 1 August 2019 Dr Forward contract Cr Gain on forward contract Dr Foreign exchange loss Cr Accounts payable [(UK ) (UK ) = $ ] Dr Accounts payable Cr Forward contract Cr Cash Settlement of forward rate contract and accounts payable

11 Worked Example Solution (cont.) Foreign exchange loss incurred $ Amount paid on 1 August Accounts payable as at 1 March 2019 (date of purchase) Total foreign exchange loss ( ) Foreign exchange loss recorded For reporting period ending 30 June 2019 Foreign exchange loss on accounts payable on 1 May 2019 ( ) Foreign exchange gain on forward contract on 30 June Foreign exchange loss on accounts payable on 30 June 2019 (90 090) ( ) For year ending 30 June 2020 Foreign exchange gain on forward contract on 1 August Foreign exchange loss on accounts payable on 1 August 2019 ( ) ( ) Total foreign exchange loss recorded ( ) If the purchased was not hedged Amount paid on 1 August 2019 ($ ) Accounts payable as at 1 March 2019 (date of purchase) Total foreign exchange loss Worked Example Cash flow hedge where hedging arrangement is organised before the purchase of inventory Cornish Ltd exports surfboards to Newquay (UK) plc. Newquay (UK) plc placed the order on 1 April The consignment of surfboards was sold FOB Byron Bay (NSW) on 1 May The sales price was UK 1 million payable on 1 August A sell hedge forward-rate contract was entered into on 1 April 2019 (before the date of the sale) with ABC Bank for the delivery of Australian dollars in exchange for UK1 million on 1 August The forward rate of the contract is $AUS1.00 = UK 0.40 on 1 April Cornish Ltd uses cash flow hedge accounting. Additional information: Spot Forward Date rate rate 1 April May June August Cornish Ltd s end of reporting period is 30 June REQUIRED Prepare the journal entries for Cornish Ltd Worked Example Solution Receivable Amount payable Fair value Gain/(loss) Spot Forward on forward on forward of forward on forward Date rate rate contract contract contract contract 1 April May ( ) ( ) 30 June ( ) ( ) 1 Aug ( ) April 2019 No journal entries because right and obligation are the same 1 May 2019 Dr Accounts receivable Cr Sales Recording sales (UK ) Dr Cash flow hedge reserve (part of OCI) Cr Forward contract (financial liability) Recording loss on accounts receivable. The forward contract would represent a liability rather than an asset. Once the overseas sale is made the gains or losses on the hedging instrument would thereafter be taken directly to profit or loss (not to a reserve) to offset the gains or losses on the account receivable that is denominated in a foreign currency Dr Sales Cr Cash flow hedge reserve Transferring hedge reserve to sales account

12 Worked Example Solution (cont.) 30 June 2019 Dr Accounts receivable Cr Foreign exchange gain [(UK = $ ) (UK = $ ) = $ ] Dr Loss of forward contract Cr Forward contract August 2012 Dr Foreign exchange loss Cr Accounts receivable [(UK = $ ) (UK = $ ) = $ ] Dr Forward contract Cr Gain from forward contract Dr Cash Dr Forward contract Cr Accounts receivable Receiving payments and fulfilling forward contract Worked Example Solution (cont.) In this example, the sales proceeds of UK 1.0 million have been fully hedged. As the forward-rate contract was entered into before the date of the sale, any costs or gains associated with the hedge contract are adjusted against the sales price. Ultimately, the entity receives the amount it had locked in with the bank, this being $ Effectively, the entity is receiving $ from the overseas customer of which $ goes to the bank for the amount owing on the hedging instrument. The amount that is paid to the bank at the end of the contract represents the difference between UK 1.0 million divided by the negotiated forward rate ( ) and UK 1.0 million divided by the spot rate on 1 August 2012 ( ) Foreign currency swaps Commonly used swaps are: interest rate swaps, for example where a fixedinterest-rate obligation is swapped for a variable-rate obligation (refer to Chapter 15) foreign currency swaps where the obligation related to a loan denominated in one currency is swapped for a loan denominated in another currency

13 Foreign currency swaps (cont.) Reasons for foreign currency swaps If an organisation has a number of receivables denominated in a foreign currency, to hedge against exchange fluctuations it may convert some domestic loans into foreign currency loans, in the same denomination as that of the receivables For example, if an organisation has some receivables that are denominated in US dollars and a loan in Australian dollars then it is exposed to foreign currency risks. However, if it swaps its domestic loan for a loan denominated in US dollars then it will have both receivables and payables in the same currency and gains on one will offset losses on the other Need to find another entity that is prepared to swap its foreign currency loans for the organisation s domestic currency loans Contractual obligations of foreign currency swaps The other parties to the loans may not know about the swap arrangements Contractual relationship between entity and lending institution remains unchanged Should one party to the swap default on the arrangement, the obligation for repayment vests with the primary borrower