Foreign currency transactions

As stated in IAS 21.8 (edited, emphasis added): [a] foreign currency is a currency other than the functional currency of the entity.

Consequently, the guidance provided by IAS 21 depends on how the functional, not local, currency is defined.

It also implies, a local currency could be a foreign currency if an entity's functional currency is not its local currency.

For example, ABC is a contractor domiciled in Switzerland.

Most of its construction projects are in neighboring countries. Consequently, not only does it get paid mostly EUR, the euro zone’s competitive forces and regulations mainly determine the amount of EUR it collects. Likewise, since most of its projects occur in euro zone countries, most of its labour, material and other costs are incurred in EUR. In addition, as the projects are managed at the project level, its euro zone operations are conducted with a high degree of autonomy.

As a result, as outlined in IAS 21.9 to 14, ABC designates the EUR as its functional currency, making its local currency (the Swiss Franc) a foreign currency for IFRS purposes.

While subsidiaries are invariably set up (registered as separate legal entities) on a national level, it is not uncommon for a company domiciled in one eurozone country to do business in several eurozone countries making the EUR a regional, rather than national, currency.

While this does not make much difference from a (consolidated) US GAAP perspective if the jurisdiction is a country or region, from a national GAAP / tax perspective how a business is structured can alter (sometimes dramatically) the results.

As stated in ASC 830-20 (edited, emphasis added): [a foreign currency is] a currency other than the functional currency of the entity being referred to (for example, the dollar could be a foreign currency for a foreign entity)...

Consequently, the guidance provided by ASC 830 depends on how the functional, not local, currency is defined.

It also implies, a local currency could be a foreign currency if an entity's functional currency is not its local currency.

For example, ABC, a contractor, moved its headquarters to the US when it listed on a US exchange.

As it was established in Europe, most of its projects continue to be in euro zone countries. So, not only does it get paid mostly EUR, the euro zone’s competitive forces and regulations mainly determine the amount of EUR it collects. Likewise, most of its labour, material and other costs are incurred in EUR. In addition, as it finances its projects at the local level, practically all of its liabilities are in EUR.

Fortunately, most normal US companies do not find themselves in this predicament.

So, for a normal US company, the local, accounting, reporting and functional currencies are the USD with any currency not the USD being a foreign currency.

After the listing, more than 50% of its shares were held by US investors.

As its headquarters was in the US and the majority of its executive officers and directors were US citizens or residents, it did not qualify for the SEC's foreign private issuer exemption (link: SEC) so could not use IFRS.

Most US based companies have no foreign operations (many do not even sell to non-US customers or buy from non-US suppliers). Those that do invariably set up a subsidiary (or several) in each jurisdiction.

So, while keeping track of local, accounting, reporting and functional currencies may require some judgment at the subsidiary level, it is a non-issue at the parent level.

As outlined in ASC 830-10-55-5, ABC would designate the EUR as its functional currency making the USD (its local currency) a foreign currency from a GAAP perspective.

Hopefully, it would decide to its keep books EUR so it would not need to remeasure them as outlined in ASC 830-10-45-17.

But, regardless of how it keeps its books, as outlined in ASC 830-30-45-3, it would still need to translate its EUR results into USD so it could report them to the stock market (and SEC).

The RC only becomes important when drafting financial reports.

Either because it sells in that currency or because its sales prices are derived from that currency.

For example, XYZ issues invoices in EUR but incurs expenses in GBP. It passes the currency risk to its customers by first calculating the invoiced amount in GBP, then remeasuring to EUR using a month end exchange rate.

In this situation, while the receipts are nominally in EUR, they are factually denominated in GBP.

Many subsidiaries are financed (directly or indirectly) by their parent organization. In this situation, only liabilities to third parties (not the parent or different subsidiaries) should be considered.

Factors to consider according to IAS 21:

• Paragraph 9.a.i - sales prices
• Paragraph 9.a.ii - competitive forces
• Paragraph 9.b – cash expenses (labour, material, etc.)
• Paragraph 10.a - financing
• Paragraph 10.b - sales receipts
• Paragraph 11.a - autonomy of the business unit
• Paragraph 11.b - proportion of FC transactions
• Paragraph 11.c - effect of FC on overall cash flows
• Paragraph 11.d - if FC cash flows can service FC debt

Factors to consider according to ASC 830-10-55-5:

1. affect of a subsidiary's cash flows on the parent's cash flows
2. a subsidiary's sales

Are the subsidiary's sales prices determined by local conditions (local competition or local government regulation) or by international conditions?

In other words, does the subsidiary price its sales in its LC or an FC (i.e. the parent's LC)?

3. how active is the FC market
4. a subsidiary's cash expenses (labor, materials, etc.)
5. a subsidiary's financing
6. the volume of transactions between a subsidiary and parent

IAS 21.12 (edited, emphasis added) states: When the above indicators are mixed and the functional currency is not obvious, management uses its judgement to determine the functional currency that most faithfully represents the economic effects of the underlying transactions, events and conditions...

ASC 830-10-55-4 (edited, emphasis added) states: ... In those instances in which the indicators are mixed and the functional currency is not obvious, management's judgment will be required to determine the functional currency that most faithfully portrays the economic results of the entity's operations and thereby best achieves the objectives of foreign currency translation...

While IAS 21.22 includes a practical expedient allowing rates approximating spot rates (i.e. weekly or monthly averages) to be used, in situations outlined here, such rates would not be appropriate because translating the FC at an average rate would lead to an unnecessary discrepancy between the recognized amounts and the amounts appearing on bank or broker/dealer statements.

Note: while ASC 830-10-55-10 and 11 also discusses the use of averages, this guidance applies to foreign currency translations rather than transactions.

Specifically, as outlined in IFRS 9.B5.7.3, an investment in equity instruments is not a monetary item even though monetary item are "... assets and liabilities to be received or paid in a fixed or determinable number of units of currency" and equity securities will only yield units of currency (dividends, cash received from the sale of the security or residual cash received from the liquidation of the company) that are (especially if the securities are market traded) determinable.

While guidance seems odd to some, it is actually helpful when remeasuring FC equity securities to fair value as, unlike monetary items, when non-monetary items are remeasured, the associated gain or loss does not need to be bifurcated into the gain / loss related to the change in market value and the gain / loss related to the change in exchange rates.

While ASC 830-10-45-18 addresses the remeasurement of the books of record into the FunC, it provides a useful list of common non-monetary balance sheet items and related revenue, expense, gain, and loss accounts:

1. Equity securities without readily determinable fair values...
2. Inventories carried at cost
3. Prepaid expenses such as insurance, advertising, and rent
4. Property, plant, and equipment
5. Accumulated depreciation on property, plant, and equipment
6. Patents, trademarks, licenses, and formulas
7. Goodwill
8. Other intangible assets
9. Deferred charges and credits, except policy acquisition costs for life insurance companies
10. Deferred income
11. Common stock
12. Preferred stock carried at issuance price
13. Revenues and expenses related to nonmonetary items, for example:
1. Cost of goods sold
2. Depreciation of property, plant, and equipment
3. Amortization of intangible items such as patents, licenses, and so forth
4. Amortization of deferred charges or credits except policy acquisition costs for life insurance entities.

While not mentioned by ASC 830-10-45-18, monetary items include:

• Cash
• Cash equivalents
• Securities (traded)
• Receivables: accounts, notes, loans
• Refundable deposits, holdbacks
• Accounts payable
• Loans, notes, bonds, leases and other financial liabilities
• Contingent liabilities requiring cash settlement

As this guidance addresses changing prices, it is less useful than ASC 830-10-45-18.

Nevertheless, ASC 255-10-20 does define monetary assets as money or a claim to receive money / liabilities obligations to pay money, that is fixed or determinable without reference to future prices of goods or services.

ASC 255-50-51 & 52 then discuses nonmonetary assets and liabilities specifying they include goods held for resale or assets held to provide services, claims to cash based on future prices of goods or services, goodwill, equity and similar residual interest, obligations to furnish goods or services denominated in quantity not price, and obligations to pay for goods or services based on their future prices.

While using reference rates brings benefits, it also involves a cost: reference rates are not the rates outlined in IAS 21.8 or ASC 830-20-35-1 and 2.

Whether these benefits (ease of use, verifiability and consistency with a national GAAP) outweigh the costs (misapplying the letter of the guidance), is something each company (together with its independent auditor) must decide for itself.

Note: if an entity uses a spot rate for IFRS | US GAAP purposes in a jurisdiction where national GAAP requires a reference rate, it can either reconcile its financial reports or use parallel accounts.

If that national GAAP is also used for tax purposes, it will also need to contend with the resulting tax implications.

IAS 20.20 states: A foreign currency transaction is a transaction that is denominated or requires settlement in a foreign currency, including transactions arising when an entity:

1. buys or sells goods or services whose price is denominated in a foreign currency;
2. borrows or lends funds when the amounts payable or receivable are denominated in a foreign currency; or
3. otherwise acquires or disposes of assets, or incurs or settles liabilities, denominated in a foreign currency.

ASC 830 glossary defines: Transactions whose terms are denominated in a currency other than the entity's functional currency. Foreign currency transactions arise when a reporting entity does any of the following:

1. Buys or sells on credit goods or services whose prices are denominated in foreign currency
2. Borrows or lends funds and the amounts payable or receivable are denominated in foreign currency
3. Is a party to an unperformed forward exchange contract
4. For other reasons, acquires or disposes of assets, or incurs or settles liabilities denominated in foreign currency.

IAS 21.29: When monetary items arise from a foreign currency transaction and there is a change in the exchange rate between the transaction date and the date of settlement, an exchange difference results. When the transaction is settled within the same accounting period as that in which it occurred, all the exchange difference is recognised in that period. However, when the transaction is settled in a subsequent accounting period, the exchange difference recognised in each period up to the date of settlement is determined by the change in exchange rates during each period

ASC 830-20-35-1: A change in exchange rates between the functional currency and the currency in which a transaction is denominated increases or decreases the expected amount of functional currency cash flows upon settlement of the transaction. That increase or decrease in expected functional currency cash flows is a foreign currency transaction gain or loss that generally shall be included in determining net income for the period in which the exchange rate changes.

IAS 21.29: When monetary items arise from a foreign currency transaction and there is a change in the exchange rate between the transaction date and the date of settlement, an exchange difference results. When the transaction is settled within the same accounting period as that in which it occurred, all the exchange difference is recognised in that period. However, when the transaction is settled in a subsequent accounting period, the exchange difference recognised in each period up to the date of settlement is determined by the change in exchange rates during each period

ASC 830-20-35-1: A change in exchange rates between the functional currency and the currency in which a transaction is denominated increases or decreases the expected amount of functional currency cash flows upon settlement of the transaction. That increase or decrease in expected functional currency cash flows is a foreign currency transaction gain or loss that generally shall be included in determining net income for the period in which the exchange rate changes.

IAS 21.9 defines: Monetary items are units of currency [a.k.a. cash] held and assets and liabilities to be received or paid in a fixed or determinable number of units of currency.

Note: unlike US GAAP, IFRS does not consider equity instruments to be monetary items.

While this factlet has no bearing on the illustration at hand, it is interesting nonetheless.

IAS 21.8 defines the closing rate as the spot rate and the spot rate as the rate for immediate delivery.

When applied to subsequent measurement, it is the rate for immediate delivery on the balance sheet date.

ASC 830-20-35-2 refers to items denominated in a foreign currency specifying that the rate to be used is the rate at which the related receivables or payables could be settled.

The ASC master glossary defines monetary items using cash, receivables and payables as examples.

Thus, while the ASC does not (like IAS 21) explicitly state: monetary items are remeasured / non-monetary items are not remeasured, it is implied.

Note: since ASC 830-20 does refer to monetary / non-monetary items, it does not discuss how to distinguish the two. Fortunately, both ASC 830-10-45-18 and ASC 255 do provide some additional guidance.

Also note: while US GAAP considers equity instruments (other than those listed above) to be monetary items, IFRS considers them non-momentary items.

While ASC 830-20-35-1 and 2 do not explicitly state that a closing rate should be used, this is how the "the ratio between a unit of one currency and the amount of another currency for which that unit can be exchanged at a particular time" is commonly determined.