Counterparty credit risk (CVA) is the risk that the counterparty to a financial contract will default prior to the expiration of the contract and will not make all the payments required by the contract. Obviously exchange-traded derivatives are not subject to counterparty risk as the respective exchange guarantees the settlement of cash flows as per the derivative contract. CVA is a measure that adjusts the risk-free value of an instrument to incorporate counterparty credit risk. CVA can be positive or negative depending on which of the two counterparties is most likely to default and the relative balances due or receivable to each other. There were some concerns expressed in certain quarters as to whether the Debit Value Adjustment (DVA) should be considered in determining the fair value. Now based on the recent exposure draft announced jointly by IASB and FASB on 28th January 2011 on Offsetting Financial Assets and Financial Liabilities it is amply clear that the DVA also should be recognized along with CVA.

Different end for reporting periods

• A foreign operation may have a different end of the reporting period for tax reasons, or if legislation in its country requires financial statements to be prepared to a specific date
• Usually the foreign operation will prepare additional statements to the same date as the reporting entity for incorporation in the consolidated financial statements

• IAS 27: Consolidated and Separate Financial Statements, allows the use of a different end of the reporting period if

a)the difference is no greater than three months and
b)adjustments are made for any significant transactions between the different end of the reporting periods

• If a different end of the reporting period being within three months, is used, the assets and liabilities of the foreign operation are translated at

the exchange rate at its end of the reporting period

• Then adjustments are made for any significant movements in exchange rates up to the end of the reporting period of the reporting entity
• For example: if the functional currency of the foreign operation devalues significantly against that of the reporting entity

Goodwill and fair value transactions

Any goodwill arising on the acquisition of a foreign operation and any fair value adjustments to the carrying amounts of assets and liabilities arising on the acquisition of a foreign operation are treated as:
a)assets and liabilities of the foreign operation
and
b)translated at the closing rate

Disposal of foreign operation

• An entity may dispose or partially dispose of its interest in a foreign operation through sale, liquidation, repayment of share capital or abandonment of all, or part of, that entity
• A write-down of the carrying amount of a foreign operation, either because of its own losses or because of an impairment recognised by the investor, does not constitute a partial disposal
• Accordingly, no part of the foreign exchange gain or loss recognised in other comprehensive income is reclassified to profit or loss at the time of a write-down

Deemed as disposals

The following are accounted for as disposals even if the entity retains an interest in the former subsidiary, associate or jointly controlled entity:
a)the loss of control of a subsidiary that includes a foreign operation
b)the loss of significant influence over an associate that includes a foreign operation
c)the loss of joint control over a jointly controlled entity that includes a foreign operation

Disposal of foreign operation

On the disposal of a foreign operation the cumulative translation amount of exchange differences that:
a)have been recognized in other comprehensive income and accumulated in a separate component of equity, and
b)which relate to that foreign operation

are reclassified from equity to profit or loss when the gain or loss on disposal is recognised

Partial disposal

• On the partial disposal of a subsidiary that includes a foreign operation, the entity shall re-attribute the proportionate share of the cumulative amount of the exchange differences recognised in other comprehensive income to the non-controlling interests in that foreign operation
• In any other partial disposal of a foreign operation the entity shall reclassify to profit or loss only the proportionate share of the cumulative amount of the exchange differences recognised in other comprehensive income

Disclosure for exchange differences

• The amount of exchange differences recognized in profit or loss except for those arising on financial instruments measured at ‘fair value through profit or loss’ as per IAS 39
• Net exchange differences recognized in other comprehensive income and classified in a separate component of equity
• A reconciliation of the amount of such exchange differences at the beginning and end of the period

Where in P&L should it be shown

• IAS 21 is silent on where the exchange difference should be presented
• Experts feel that based on other relevant IFRS

–FX differences from trading transactions can be included in the results of operating activities
–FX differences from financing may be included as a component of finance cost/income

You can view the presentation here: IAs 21 - Goodwill etc

Presentation Currency

• The currency in which the financial statements are presented is defined as the presentation currency
• Unlike the functional currency, the presentation currency can be any currency of choice

Exchange differences -Presentation Currency

• Exchange differences are recognised in other comprehensive income
• These exchange differences are not recognised as income or expenses for the period because the changes in exchange rates have little or no direct effect on the present and future cash flows from the entity’s operations

Exchange differences -Presentation Currency

• The cumulative amount of the exchange differences is presented in a separate component of equity until disposal of the foreign operation
• When the exchange differences relate to a foreign operation that is consolidated but not wholly-owned, accumulated exchange differences arising from translation and attributable to non-controlling interests are allocated to, and recognised as part of, non-controlling interests in the consolidated statement of financial position

Intra-group transactions

• The incorporation of the results and financial position of a foreign operation with those of the reporting entity follows normal consolidation procedures, such as the elimination of intra-group balances and intra-group transactions of a subsidiary (see IAS 27 and IAS 31 Interests in Joint Ventures)
• An intra-group monetary item (short-or long-term) cannot be eliminated against the corresponding intra-group asset/liability without showing exchange differences in the consolidated financial statements
• The monetary item signifies a commitment to convert currency, so the entity is exposed to an exchange gain or loss
• In the consolidated financial statements, the exchange differences stay as income or expenses unless they arise on a monetary item forming part of a reporting entity’s net investment in a foreign operation
• Accordingly, in the consolidated financial statements of the reporting entity, such an exchange difference is recognised in profit or loss
• If it arises from the circumstances described in paragraph 32, it is recognised in other comprehensive income and accumulated in a separate component of equity until the disposal of the foreign operation

Elimination of profits

• IAS 21 is silent on the exchange rate to be taken for eliminating the exchange difference on the intra-group profits
• The US counterpart SFAS 52 requires elimination at the actual rate ruling at the transaction date or at a weighted average rate

You can view the presentation here: IAS 21 - Presentation Currency

Exchange differences on monetary items

•Exchange differences arise from:
–the settlement of monetary items at a subsequent date to initial recognition, and
–remeasuring an entity’s monetary items at rates different from those at which they were initially recorded (either during the reporting period or at the previous reporting periods)

•Such exchange differences must be recognised as income or expenses in the period in which they arise

Exchange differences on monetary items

If the transaction is settled in a different accounting period to that of the initial recognition of the transaction, the exchange difference to be recognised in each period is determined by the change in exchange rates during that period

Non-monetary items –P&L

• When a gain or loss on a non-monetary item is recognised in profit or loss, any exchange component of that gain or loss is also recognised in profit or loss
• Example: Property is carried at cost. When there is an impairment, the impairment loss is written off to P&L. If the property is held in foreign currency, then the exchange component of the loss is alsorecognised in profit & loss

Non-monetary items -OCI

• When a gain or loss on a non-monetary item is recognised directly in other comprehensive income, any exchange component of that gain or loss is recognised directly in other comprehensive income
• For example gain or loss on AFS equity securities is recognised in other comprehensive income. The exchange component is also recognised in other comprehensive income

Other comprehensive income

• Other IFRSs require some gains and losses to be recognised in other comprehensive income
• For example, IAS 16 requires some gains and losses arising on a revaluation of property, plant and equipment to be recognised in other comprehensive income
• When such an asset is measured in a foreign currency, the revalued amount to be translated using the rate at the date the value is determined, resulting in an exchange difference that is also recognised in other comprehensive income

Exception to the rule

• There is one exception to this rule given by paragraph 32 of IAS 21
• Exchange differences are recognised directly in other comprehensive income in the consolidated financial statements, if they arise on a monetary item that forms part of a reporting entity’s net investment in a foreign operation denominated in the functional currency of either the parent or the foreign operation
• In the financial statements that include the foreign operation and the reporting entity (eg consolidated financial statements when the foreign operation is a subsidiary), such exchange differences shall be recognised initially in other comprehensive income and reclassified from equity to profit or loss on disposal of the net investment

Exception to the rule -Example

• An example of this may be a long-term loan to the foreign operation without a repayment term, where management confirms that repayment is neither planned nor likely in the future

You can view the presentation here: IAS 21 - Treatment of Exchange difference

Translation of monetary items

• Foreign currency monetary items are translated at the end of the balance sheet date using the closing rate
• Closing rate is the spot rate at the balance sheet date as per IAS 39
• Translating a monetary item at a contracted rate even it is as per the terms of the contract is not permitted
• This becomes a form of hedging and is covered by IAS 39 with strict guidelines for availing the privileges for hedge accounting

FX Translation process

• FX Translation process is different and distinct from the FX Revaluation process
• FX Revaluation is done entry by entry –which means that for every transaction line item appearing in the books of accounts in foreign currency, there will be a corresponding line item appearing in the functional currency based on the day’s closing FX rate

• FX Translation on the other hand is done at the account level
• The balance in the account represented in foreign currency will be valued at the closing rate on the date of valuation and the difference is treated as foreign exchange difference
• This foreign exchange difference is dealt with as per the requirements of IAS 21

The carrying amount of an item

• The carrying amount of an item is determined in conjunction with other relevant Standards
• Example: Property, plant and equipment may be measured in terms of fair value or historical cost in accordance with IAS 16 Property, Plant and Equipment
• Whether the carrying amount is determined on the basis of historical cost or on the basis of fair value, if the amount is determined in a foreign currency it is then translated into the functional currency in accordance with IAS 21 only

Comparison of two amounts

• The carrying amount of some items is determined by comparing two or more amounts
• Example: The carrying amount of inventories is the lower of cost and net realisable value in accordance with IAS 2 Inventories
• Similarly, in accordance with IAS 36 Impairment of Assets, the carrying amount of an asset for which there is an indication of impairment is the lower of its carrying amount before considering possible impairment losses and its recoverable amount

Carrying amount -non-monetary assets

When an asset is non-monetary and is measured in a foreign currency, the carrying amount is determined by comparing:

• a)the cost or carrying amount, as appropriate, translated at the exchange rate at the date when that amount was determined (ie the rate at the date of the transaction for an item measured in terms of historical cost); and
• b)the net realisablevalue or recoverable amount, as appropriate, translated at the exchange rate at the date when that value was determined (eg the closing rate at the end of the reporting period)

Important note:

The effect of this comparison may be that an impairment loss is recognisedin the foreign currency but would not be recognisedin the functional currency, or vice versa

Example for this note

• A foreign currency asset consisting of $ 100,000 is recorded at the date of purchase at INR 3,500,000 @ exchange rate of Rs.35
• On valuation date the exchange rate is Rs.50 to a US$ and the recoverable amount of the asset is $ 80,000
• The carrying value of the foreign currency asset is Rs. 4,000,000 (recoverable amount in FC X exchange rate at the valuation date)
• The impairment loss of $20,000 in foreign currency is not recognized

Several exchange rates

• When several exchange rates are available, the rate used is that at which the future cash flows represented by the transaction or balance could have been settled if those cash flows had occurred at the
  measurement date
• If exchangeability between two currencies is temporarily lacking, the rate used is the first subsequent rate at which exchanges could be made

EXAMPLES OF SUBSEQUENT MEASUREMENT

Foreign Currency Monetary item

Example –1:

• An entity (functional currency Euro) has an outstanding trade payable for A$1,500 which arose from a transaction when the spot exchange rate was Euro1 = A$1.2 and hence was initially recorded at Euro1,250. The closing rate is Euro1 = A$1.5
• At what amount should the payable be recorded at the end of the reporting period?

Foreign Currency Monetary item

•At the end of each reporting period, foreign currency monetary items are translated using the closing rate
•The payable is therefore Euro1,000 (=1,500/1.5) at the end of the reporting period

Non Monetary item –historical cost

Example –2:

•An entity (functional currency Euro) purchased a machine for A$12,000 when the spot exchange rate was Euro1 = A$1.2. The closing rate is Euro1 = A$1.5
•At what amount should the machine be recorded at the end of the reporting period?

Non Monetary item –historical cost

•At the end of each reporting period, non-monetary items that are measured in terms of historical cost in a foreign currency are translated using the exchange rate at the date of the transaction
•The machine is shown as Euro10,000 (=12,000/1.2) at the end of the reporting period

Non Monetary item –Fair value

Example –3:

•An entity (functional currency Euro) owns a building. The entity carries buildings at their revalued amounts. The valuation of the building was done at the end of the reporting period and the fair value was US $150,000. The building was purchased for US $100,000 when the spot rate was Euro1 = US $1.2. The closing rate is Euro1 = US $1.5.
•At what amount should the building be recorded at the end of the reporting period?

Non Monetary item –Fair value

•At the end of each reporting period, non-monetary items that are measured at fair value in a foreign currency are translated using the exchange rates at the date when the value was determined
•The building is shown as Euro100,000 (=150,000/1.5) at the end of the reporting period

You can view the presentation here: IAS 21 - Measurement of Exchange difference

A foreign currency transaction

•A foreign currency transaction is one that is denominated or requires settlement in a foreign currency
•For example an entity may:
–buy or sell goods or services in a foreign currency
–borrow or lend funds when the amounts payable or receivable are in a foreign currency
–acquire or dispose of assets, or incur or settle liabilities, in a foreign currency

•An entity must convert foreign currency items into its functional currency for recording in its books of account
•A foreign currency transaction is entered into directly by an entity
•They often occur on a day-to-day basis
•They involve cash flows, and increase or decrease the net assets of the entity

Initial recognition

•A foreign currency transaction is one denominated or requiring settlement in a foreign currency
•These transactions are 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

Date of transaction & spot rate

• The date of transaction is the date on which the transaction first qualifies for recognition as per IFRS
• Spot rate is the FX rate that is used for immediate spot delivery and for accounting purposes is taken as the official closing rate for the day
• The process of recording every single foreign currency transaction in the functional currency is known as ‘FX-Revaluation’

• For practical reasons, a rate that approximates the actual rate at the date of the transaction is often used, for example, an average rate for a week or a month might be used for all transactions in each foreign currency occurring during that period

• However, if exchange rates fluctuate significantly, the use of the average rate for a period is inappropriate

Where exchange rates are suspended

Where the free market convertibility of any currency is affected resulting in the non-availability of FX rates between the two currencies, the rate on the first subsequent date at which exchanges could be made should be used

Where there are several exchange rates

•When several exchange rates are available, the rate to be used is that:
–at which the future cash flows represented by the transaction or balance could have been settled, if
–those cash flows had occurred at the measurement date

SUBSEQUENT MEASUREMENT

Subsequent reporting periods

•The treatment of foreign currency items at the end of the reporting period depends on whether the item is:
–monetary or non-monetary, and
–carried at historical cost or fair value

To view this presentation please click here: IAS 21 - Foreign Currency Transactions

Monetary Items

•The essential feature of a monetary item is a right to receive (or an obligation to deliver) a fixed or determinable number of units of currency

•Examples:
–pensions and other employee benefits to be paid in cash
–provisions that are to be settled in cash
–cash dividends that are recognised as a liability
–a contract to receive (or deliver) a variable number of the entity’s own equity instruments or a variable amount of assets in which the fair value to be received (or delivered) equals a fixed or determinable number of units of currency is a monetary item

•In this case the entity effectively uses its own equity shares as a ‘currency’ in a contract that can e settled at a value equal to a fixed or a determinable amount
•Such a contract is not an equity instrument, but should be regarded as a monetary financial asset or a liability

Non monetary Items

The essential feature of a non-monetary item is the absence of a right to receive (or an obligation to deliver) a fixed or determinable number of units of currency

•Examples:

–amounts prepaid for goods and services (eg prepaid rent)
–goodwill & inventories
–intangible assets
–property
–plant and equipment
–provisions that are to be settled by the delivery of a non-monetary asset

Not readily apparent

Where it may not be readily apparent whether an item should be regarded as a monetary or a non-monetary item, the management should consider whether the item represents an amount to be received or paid in money

• If so it would be treated as a monetary item
• Or else it would be treated as a non-monetary item

Advances paid or received

• If the advance is refundable in circumstances other than a defalt by the parties to the contract, then it is a case of monetary item as the amount is receivable/payable in units of currency
• However if such an advance payment for goods (other than a default scenario) is to be settled only by the delivery of goods, then such an item is a non-monetary item as it cannot be converted into specified units of a currency

You can view this presentation here: IAS 21 - Monetary & Non-monetary items

What is Foreign operation?

Foreign operation is an entity that is a subsidiary, associate, joint venture or branch of a reporting entity, the activities of which are based or conducted in a country or currency other than those of the reporting entity

ADDITIONAL FACTORS FOR FOREIGN OPERATIONS

Foreign operation –Functional Currency

1.Degree of autonomy

–If its activities are carried out as an extension of the reporting entity without significant autonomy then the currency of the reporting entity would be the functional currency of such
foreign operation

–If the foreign operation accumulates cash and incurs expenses, generates income –all in local currency then the local currency would be the functional currency of such foreign operation

2.Percentage and frequency of transactions with reporting entity

–If the transactions with the reporting entity are a high proportion of its activities then the currency of the reporting entity would be the functional currency of such foreign operation
–Few inter-company transactions would mean the local currency would be the functional currency of such foreign operation

3.Effect of cash flows on the reporting entity

–If the cash flows of the foreign operation directly affect the cash flows of the reporting entity and are available for remittance to it then the currency of the reporting entity would be the
functional currency of such foreign operation –If the cash flows are mainly in local currency and do not impact the reporting entity’s cash flows the local currency would be the functional
currency of such foreign operation

4.Financing & debt servicing

–If the cash flows of the foreign operation are sufficient to service debt obligations without assistance from the reporting entity then the currency of the reporting entity would be the
functional currency of such foreign operation

–If the financing and servicing of debt is out of local currency surpluses then the local currency would be the functional currency of such foreign operation

Where indicators are mixed

• Management uses its judgement to determine the functional currency that most faithfully represents the economic effects of the underlying transactions, events and conditions
• Priority is given to the primary indicators before considering the additional indicators which are designed to provide additional supporting evidence to determine an entity’s functional currency

Different Functional Currencies in same country

• There could be two or more foreign operations in the same country but with different functional currencies
• One entity may be a sales outfit and the other an operating unit each justifying different functional currencies
• Management should determine the appropriate functional currency for each unit by applying the factors given in IAS 21

Accounting records not maintained in Functional Currency

• Where the books and records are not maintained in the functional currency, the management should remeasure the same into the functional currency while preparing its financial statements
• The same rules for translating the foreign currency transactions should be deployed by the management as would have occurred had all the items been recorded in the functional currency in the first place

Change of Functional Currency

• An entity’s functional currency reflects the underlying transactions, events and conditions that are relevant to it
• Accordingly, once determined, the functional currency is not changed unless there is a change in those underlying transactions, events and conditions
• Change if warranted should be accounted for prospectively from the date of change

You can view the presentation here  IAS 21 - Foreign Operations

Functional Currency

The functional currency of an entity is the currency of the primary economic environment in which that entity operates
The primary economic environment in which an entity operates is normally the one in which it primarily generates and expends cash

How to determine Functional Currency

The functional currency is determined separately for individual entities
An entity includes a foreign operation i.e., subsidiary, branch, JV or associate
There is no such thing as a “group functional currency”
IAS 21 gives the factors, primary and additional, that to determine the functional currency of an entity

Apply factors in IAS 21

An entity’s functional currency is a matter of fact
The functional currency is determined by applying the factors in IAS 21
It cannot be chosen freely by an entity
Once determined, it is not changed unless there is a change in those underlying circumstances

Importance of identifying functional Currency

Identifying the functional currency of the entity is a very important requirement of IAS 21
This helps identify if the entity is engaging in foreign currency transactions as all currencies other
than functional currency is treated as foreign currency transactions
This has a direct impact on the treatment of the foreign exchange gains/losses arising from the various transactions

Primary Factors

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

the currency that mainly influences labour, material and other costs of providing goods or services
–(this will often be the currency in which such costs are denominated and settled)

Additional Factors

a.the currency in which funds from financing activities (i.e.,issuing debt and equity instruments) are generated
b.the currency in which receipts from operating activities are usually retained. This is the currency in which the excess of receipts over the payments is maintained and usually this would be the local currency

Importance of Functional Currency

Incorrectly determining the functional currency can have a major impact on the financial statements.
If it is determined incorrectly, transactions in the correct functional currency will be recorded as if they were foreign currency transactions
Exchange differences will be recognised on transactions for which no foreign exchange difference should have arisen

Importance of Functional Currency

Similarly, transactions that should have led to recognition of foreign exchange differences, will not be provided for
This may have a significant impact on both the statement of comprehensive income and the statement of financial position

An Example

An entity is located in Paris, France and trades primarily in crude oil where all its sales and purchases are denominated in US Dollars.
As per IAS 21 it is determined that the functional currency of this entity is USD
The entity’s capital is funded in Pound Sterling by its English parent based at London
Also it has significant transactions in Euros
How should the Sterling & Euros transactions be recorded?

Answer

Since as per IAS 21 it is determined that the functional currency of this entity is USD, all transactions other than USD are treated as foreign currency transactions
Sterling & Euro currency transactions should be treated as foreign currency transactions and dealt with according to IAS 21
It does not matter that the entity is located in Paris and that it is funded through Sterling

You can view this presentation by clicking on the following link

Globalization of markets

1.Globalization has resulted in expansion of international trade
2.Increasingly entities buy and sell goods and services from overseas parties/customers
3.Also they extend their international reach through overseas branches in the form of subsidiaries or associates

Application of IAS 21

Thus an entity may carry on foreign activities in two ways

1.It may have transactions in foreign currencies
2.It may have foreign operations

In addition, an entity may present its financial statements in a foreign currency

Need for this standard

1.International transactions are often expressed and denominated in foreign currencies
2.Such transactions should be converted into the functional currency of the entity
3.The question remains at what rates should such transactions be converted into the functional currency –historical or closing rate
4.How should the difference in foreign exchange rate be treated

1.Also the foreign operation of the entity in the form of a branch or a subsidiary may maintain the books in such foreign currency
2.These transactions cannot be summed up with the transactions of the parent entity without
converting the same into the functional currency of the entity
3.How and when should such conversion be made and at what rate

1.The financial statements may also be required to be presented in another currency other than the functional currency of the entity to the investors or prospective investors of the entity
2.While presenting the financial statements in another currency what exchange rates should be used –historical or closing or average
3.How should the exchange difference be accounted for

Objectives

The objectives of this Standard are

1.To prescribe how to include foreign currency transactions and foreign operations in the financial statements of an entity and
2.To specify which exchange rates to use and how to report the effects of such changes in exchange rates in the financial statements
3.How to translate financial statements into a presentation currency

Scope of IAS 21

1.Accounting for transactions and balances in foreign currencies
2.Translating the results and financial position of foreign operations, included in the financial
statements of the entity by consolidation, proportionate consolidation or the equity method
3.Translating an entity’s results and financial position into a presentation currency

Benefits of IAS 21

Reduces the risk of foreign activities being incorrectly accounted for and the functional currency being determined incorrectly
This could have a major impact on the financial statements
Improves efficiency when dealing with foreign activities

Outside the scope of IAS 21

Derivative transactions in foreign currencies and balances that are within the scope of IAS 39
Foreign currency derivatives embedded in various contracts requiring separate accounting under IAS
39 are scoped out of IAS 21
Hedge accounting including the hedging of a net investment in a foreign
Presentation of cash flows arising from transactions in a foreign currency, or with the translation of cash flows of a foreign operation

Within the scope of IAS 21

Foreign currency derivatives embedded in various contracts that do not require separate accounting under IAS 39 are within the scope of IAS 21
Translation of foreign currency derivatives from a functional currency to a presentation currency is within the scope of IAS 21

You can view this presentation by clicking on the following link