Singapore Polytechnic

Singapore Polytechnic

SP Business SchoolDiploma in Accountancy

Advanced Financial Accounting I (2015/16)

Accounting for the Effects of Changes in Foreign Exchange Rates

Lecture Outline1. Introduction

2. Exchange Rate Quotations3. Types of Exchange Rate Exposures4. Accounting for Foreign Currency Transactions

5. Translation of Foreign Currency Financial Statements

References1A Practical Guide to Financial Reporting Standards (Singapore) (5th Ed)Ng Eng Juan

2

FRS 21 The Effects of Changes in Foreign Exchange Rates

ASC

1. IntroductionIn the past, most currencies are pegged to the US dollar, which was pegged to the price of gold (fixed exchange rate system). In 1974, there was a worldwide shift to the floating rate system, in which currencies fluctuate in response to changing supply and demand for currency. Countries like US and Canada adopt free float but other countries adopt a managed float approach, where the central bank will buy and sell currency to maintain it at a certain rate.

2.Exchange Rate QuotationsExchange rate is the price of a currency expressed in another currency.

(a) Direct quote: expresses the price of one unit of foreign currency in terms of domestic currency

SGD1.30/USD 1SGD0.41/MYR 1SGD1.31/AUD 1

(b) Indirect quote expresses one unit of domestic currency in terms of units of foreign currency.SGD1/USD 0.769

SGD1/MYR2.44

SGD1/AUD0.771

3. 2 Types of Exchange Rate Exposures introducedForeign exchange rate exposure can be broadly categorised into 2 types, operating and accounting exposure.

Operating Exposure

Operating exposure affects the competitive position of a firm and the value of the firm. Changes in foreign exchange rates can affect the demand and supply functions for a firms goods and services, thereby, affecting its operating cash flows or items on its financial statement.

Example: If a Singaporean company imports Japanese goods, it has exposure to Japanese Yen. If the Yen appreciates, imported Japanese goods will be more costly.

Accounting Exposure

Accounting exposure impacts the statement of Comprehensive Income and Retained Profits or financial position of a firm. Accounting exposure can be divided into:

(i) Transaction exposure: arises directly as a consequence of firms foreign currency transactions. For instance,(a)buys or sells goods or services whose price is denominated in a foreign currency;

(b)borrows or lends funds when the amounts payable or receivable are denominated in a foreign currency; or

(c)otherwise acquires or disposes of assets, or incurs or settles liabilities, denominated in a foreign currency.

Since a foreign currency transaction is denominated in a foreign currency, it may be exposed to risks arising from fluctuations in foreign exchange rates. Typically, these transactions occur at one date and are settled on another later date. Foreign exchange movements between the 2 dates will result in a transaction gain or loss.If a foreign transaction may be receivable or payable in domestic currency (Singapore dollar), in which case, it would be a domestic currency transaction with no exposure to exchange fluctuations, even though it is a foreign transaction.

(ii) Translation exposure: arises from translation of foreign currency financial statements from local currency to the groups reporting currency for purposes of consolidation. For example, a Singapore company with Malaysian subsidiary needs to translate the subsidiary accounts, denominated in MYR to SGD before consolidation.(This will be covered later in the lecture)4.Accounting for Foreign Currency TransactionsTransactions denominated in Foreign CurrencyThe following time line represents a typical foreign exchange transaction.

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(a) Initial Recognition - FRS 21, Para 21 & 22Foreign currency transaction should be recorded using the actual exchange rate at the date of transaction. Monetary vs Non-monetary item:

Monetary items are units of currency held and assets and liabilities to be received or paid in a fixed or determinable number of units of currency. Example: cash, accounts receivable, accounts payable

Non-monetary items do not have the right to be received or paid in a fixed or determinable number of units of currency. Examples include, prepayments, intangibles and fixed assets

(b) Reporting at subsequent Balance Sheet dates - FRS 21, Para 23At each balance sheet date:(a)Foreign currency monetary items shall be translated using the closing rate

This is because monetary items are carried at contractual amounts that are eventually settled or received in a specific currency.

For example, a loan of US$100,000 is equivalent to S$130,000 as at 15 December 2011. Assuming that on 31 December 2011, the exchange rate is US$1 to S$1.2, the loan in domestic currency should be remeasured to S$120,000. (b)Foreign currency non-monetary items that are measured in terms of historical cost in a foreign currency shall be translated using the exchange rate at the date of the transaction

For example, the Singapore company bought fixed asset of US$10,000 on 1 December 2011 when exchange rate was US$1 to S$1.2. As at 31 December 2011, even if exchange rates have changed, the fixed asset is still carried at historical cost.(c)Foreign currency non-monetary items that are measured at fair value in a foreign currency shall be translated using the exchange rates at the date when the fair value was determined

For example if Singapore company bought tradable securities denominated in US$ on 1 December 2011 of US$10,000 when exchange rate was US$1 to S$1.2, and the fair value as at 31 December 2011 was US$10,500 and exchange rate was US$1 to S$1.25, the amount reflected on the balance sheet is S$13,125 (10,500*1.25)Recognition of exchange differences - exchange gains or losses

Exchange differences can be recognised using 2 different methods, one transaction perspective and two transaction perspective.

One transaction perspective

The trading transaction and the settlement transaction are viewed as a single transaction and the exchange difference will be adjusted to the trading transaction.

Two transactions perspective

The trading transaction and the settlement transaction are viewed as a two separate transaction and the exchange difference will be adjusted separately as an exchange gain or loss.

FRS 21 requires the adoption of the two transactions perspective.

The Exchange differences arising on the settlement of monetary items or on translating monetary items at rates different from those at which they were translated on initial recognition during the period or in previous financial statements shall be recognised in profit or loss in the period in which they arise, FRS 21, para 28Example:

1: Exchange rates2: Reporting at subsequent Balance Sheet dates

Unrealised exchange differences on monetary items

3: Realised exchange differences on monetary itemsExample 1

A Ltd (a company incorporated in Singapore, year end 31 December) sold goods invoiced at RM100,000 to B Bhd (a company incorporated in Malaysia) on 10 November 20x1 when the exchange rate RM1 = S$0.80. What is the journal entry to record on the transaction date?

In the books of A Ltd (Singapore Co.)10/11/x1

DrAccounts Receivable

80,000

Cr

Sales

80,000

(To record sales on 10/11/20x1)

Example 2

Assume that at 31 December 20x1, B Bhd still has not paid A Ltd and the exchange rate prevailing at 31 December 20x1 is RM1 = S0.75. What is the journal entry to record at the financial year end?

31/12/x1

DrUnrealised exchange loss (P/L)5,000

Cr

Accounts Receivable

5,000

(To record unrealised exchange differences)

Example 3

Assume that the B Bhd paid A Ltd on 20 Jan 20x2 when RM1 = S$0.70

20/1/x2

DrCash

70,000

DrRealised exchange loss (P/L)

5,000

Cr

Accounts Receivable

75,000

(To record cash received from B Bhd)

With reference to Example 3 above, the sales and the eventual receipt are viewed as two separate transactions and exchange differences are recorded separately according to the two transactions perspective as exchange gains and losses.

If one transaction perspective was applied, the sale and eventual receipt will be viewed as a single transaction and exchange differences will be adjusted to sales. (For your reference) 5. Translation of Foreign Currency Financial Statements

5.1 What is Foreign Currency Translation?Translation process involves converting the measuring unit of the final accounts of the foreign operations (for examples, subsidiary company, associated companies, joint ventures and branches) from foreign currencies to the reporting currency of the holding company or head office.

There are 2 issues involved, as to:

(a) Which exchange rate to be used to translate the various items in the final accounts of the foreign operations;

(b) Treatment of the exchange differences (translation gain or loss) arises from the translation.

Presentation Currency:The currency in which the financial statements are presented is called the presentation currency.

Functional Currency:

Functional currency is the currency of the primary economic environment in which the entity operates. This is the economic environment is the environment in operates that primarily generates and expends cash.The following primary factors are to be considered to determine the functional currency:

-The currency that sales prices are denominated and settled

-The currency of the country whose competitive forces and regulations mainly determine the sales price of goods and services and

-The currency in which labour and costs are denominated and settled.

Secondary factors to consider include:

-The currency in which funds from financing activities are generated

-The currency in which receipts from operating activities are usually retained.

Generally company needs to exercise judgement in determining the functional currency.

Firms need to designate a currency as its functional currency. It should be the currency that firm receives most of its cash receipts and expends most of its cash outlays.

For example for Neptune Orient Lines, the national shipping company of Singapore, most of its revenue is billed in US$ and most of its costs are fuel prices, also paid in US$. Therefore, even though it is a Singapore-domiciled company, its functional currency is US$.

5.2 Translation to the presentation currency (FRS 21 Para 39 & 42)Non- hyperinflationary economy

The results and financial position of an entity whose functional currency is not the currency of a non-hyperinflationary economy shall be translated into a different presentation currency using the following procedures:

(a)assets and liabilities for each balance sheet presented (i.e. including comparatives) shall be translated at the closing rate at the date of that financial position;

(b)income and expenses for each income statement (i.e. including comparatives) shall be translated at exchange rates at the dates of the transactions (usually average rate is used); and

(c)all resulting exchange differences shall be recognised as a separate component of equity. (called the foreign currency translation reserve)Hyperinflationary economy

The results and financial position of an entity whose functional currency is the currency of a hyperinflationary economy shall be translated into a different presentation currency using the following procedures:

(a) all amounts (ie assets, liabilities, equity items, income and expenses, including comparatives) shall be translated at the closing rate at the date of the most recent statement of financial position, except that (b) when amounts are translated into the currency of a 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). (exception includes dividends.) (Share capital and pre-acq reserves to be translated at acquisition date rates.)

5.3 Closing rate method (Tested)The method whereby the financial statements are translated from the functional currency into the presentation currency is known as the Closing Rate Method. 5.4 Temporal method (For your reference)When the financial statements of the entity are prepared in a currency other than its functional currency, a remeasurement will be used to remeasure/translate the foreign currency to the functional currency. Such process is also termed as the Temporal Method. 5.5 Exchange differences

The treatment of exchange differences are recognised as a separate component of equity under the closing rate method.(a) Exchange differences are not recognised in profit or loss because the changes in exchange rates have little or no direct effect on the present and future cash flows from operations.(b) On disposal of the foreign operations, the cumulative amount of the exchange differences deferred in the separate component of equity is recognised in profit and loss. (not tested)5.6 Share capital and pre-acquisition reserves

It should be noted that no matter which translation method is used, the share capital and pre-acquisition reserves of the foreign operations should be translated at the exchange rate in effect on the date of acquisition.

Example 4 & 5: (Closing rate method)i) Solution (A), assume hyperinflationary economyii) Solution (B), assume non-hyperinflationary economy5.7 Disclosure requirementsRefer to FRS 21, par 51-57"The End"

Settlement date

Financial year end. Outstanding amount

Foreign currency transaction recorded at actual (historical) exchange rate (eg Accounts receivable)

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