Concepts, Rules, and Examples | WILEY IAS 2003: Interpretation and Application of International Accounting Standards

Classification of Foreign Operations

Under IAS 21, the way in which the foreign operations are financed and operate (i.e., in relation to the reporting entity) determines the method that would be used to translate their financial statements. Thus, the classification accorded to a foreign operation will determine the methodology to be used in translating their financial statements. According to IAS 21, a foreign operation may be classified as either (1) a foreign operation that is integral to the operations of the reporting entity or (2) a foreign operation that is not integral to the operations of the reporting entity (referred to as a foreign entity).

The following factors, if present, indicate that a foreign operation is a foreign entity (i.e., that the foreign operation is not integral to the operations of the reporting entity):

Its activities are carried out with significant autonomy.
Transactions with the reporting entity are not a high proportion of the foreign enterprise's operations.
Its activities are financed principally from its own resources or through local borrowings in lieu of the reporting entity's funds.
Cost of labor, material, and other components of the foreign operation's products or services are paid or settled primarily in the local currency rather than the currency of the reporting entity.
Its sales are principally made in currencies other than the reporting currency.
Cash flows of the reporting enterprise are insulated from the day-to-day activities of the foreign operation rather than being affected directly by the activities of the foreign operation.

The classification of a foreign operation is to be based on the facts of each case, and sometimes this determination could be quite subjective and unclear. Thus, a degree of caution is to be exercised in judgments relating to classification of borderline cases, since on such a classification will depend the method that will ultimately be used to translate the foreign operation's financial statements into the reporting currency.

Translation of Foreign Operations That Are Integral to the Operations of the Reporting Enterprise

The financial statements of foreign operations that are integral to the operations of the reporting enterprise should be translated based on the premise that these are, in substance, the transactions of the reporting enterprise itself. The requirements for translating the financial statements of such a foreign operation are the following:

Foreign currency monetary items should be reported using the closing rate.
Foreign currency nonmonetary items when carried at historical costs should be reported using the exchange rate at the date of the transaction.
Foreign currency nonmonetary items when carried at fair values (e.g., revalued property, plant, and equipment under the allowed alternative treatment prescribed by IAS 16) should be reported using exchange rates that existed when the fair values were determined.
Generally, all income and expense items should be translated using exchange rates at the dates of the transactions. In practice, a rate that approximates the actual rate at the date of the transaction is used. For instance, an average rate based on month-end exchange rates might be used for translation of the annual expense and income figures on the financial statement of the foreign operation into the reporting currency. However, as specifically provided by the standard, depreciation expense should be translated using the exchange rate at the date of purchase of the asset, unless the asset is carried at fair value (i.e., revalued under the allowed alternative treatment prescribed by IAS 16), in which case the rate that existed on the date of such valuation is to be used.
Generally, exchange differences arising from reporting an entity's monetary items at rates different from those in which they were initially reported in previous financial statements should be recognized as income or expense in the period in which they arise. Note, however, that an exception is made, in the case of exchange differences relating to monetary items which are, in substance, part of the enterprise's net investment in a foreign entity. In such a case they should be classified as a separate component of equity in the reporting enterprise's financial statements until disposal of the net investment at which time they should be recognized as income or expense (of the same period the gain or loss on disposal is recognized). Similarly, exchange differences which arise from a foreign liability accounted as a hedge of an enterprise's net investment in a foreign entity should be classified as a separate component of equity on the balance sheet until the disposal of the net investment (at which time they should be recognized as income or expense in the same period as the gain or loss on disposal is recognized).

IAS 21 elaborates upon the translation methodology for plant assets and inventories as follows:

The translation of the cost and depreciation of property, plant, and equipment is to be done based on rates in effect at the date(s) of acquisition, and if revalued (i.e., carried at fair value), then at the exchange rate(s) at the date(s) of such revaluation.
Inventories should be translated at the rates in effect at the dates of acquisition; however, if carried at a lower realizable value (or recoverable amount), then the exchange rate prevailing on the date when such lower realizable value (or recoverable amount) was determined (the rate in which case will be the closing rate, since determination of lower of cost or net realizable value is usually undertaken at the balance sheet date).

Sometimes an adjustment may be required to reduce the carrying amount of an asset in the financial statements of the reporting entity even though such an adjustment was not necessary in the separate, foreign currency based financial statements of the foreign operation. This stipulation of IAS 21 can best be illustrated by the following case study.

Example

Inventory of merchandise owned by a foreign operation (which is integral to the operations of the reporting enterprise) is being carried by the foreign operation at 3,750,000 SR (Saudi riyals) on its balance sheet. Suppose that the exchange rate fluctuated from 3.75 SR = 1 US dollar at September 15, 2002, when the merchandise was bought, to 4.25 SR = 1 US dollar at December 31, 2002 (i.e., the balance sheet date). The translation of this item into the reporting currency will necessitate an adjustment to reduce the carrying amount of the inventory to its net realizable value if this value when translated into the reporting currency is lower than the carrying amount translated at the rate prevailing on the date of purchase of the merchandise.

Although the net realizable value, which in terms of Saudi riyals is 4,000,000 (SR), is higher than the carrying amount in Saudi riyals (i.e., 3,750,000 SR) when translated into the reporting currency (i.e., US dollars) at the balance sheet date, the net realizable value is lower than the carrying amount (translated into the reporting currency at the exchange rate prevailing on the date of acquisition of the merchandise). Thus, on the financial statements of the foreign operation the inventory would not have to he adjusted. However, when the net realizable value is translated at the closing rate (which is 4.25 SR = 1 US dollar) into the reporting currency, it will require the following adjustment:

Carrying amount translated at the exchange rate on September 15, 2002 (i.e.. the date of acquisition) = SR 3,750,000 @ 3.75 SR to 1 US dollar= $1,000,000.
Net realizable value translated at the closing rate = SR 4,000,000 @ 4.25 SR to 1 US dollar = $941,176.
Adjustment needed = $1,000,000 - $941,176 = $58,824.

Conversely, IAS 21 further stipulates that an adjustment that already exists on the financial statements of the foreign operation may need to be reversed in the financial statements of the reporting enterprise. To illustrate this point, the facts of the example above are repeated, with some variation, below.

Example

All other factual details remaining the same as the preceding example; it is now assumed that the inventory, which is carried on the books of the foreign operation at Saudi riyals (SR) 3,750,000, instead has a net realizable value of SR 3,250,000 at year-end. Also assume that the exchange rate fluctuated from SR 3.75 = I US dollar at the date of acquisition of the merchandise to SR 3.00 = 1 US dollar on the balance sheet date.

Since in terms of Saudi riyals, the net realizable value on the balance sheet date was lower than the carrying value of the inventory, an adjustment must have been made on the balance sheet of the foreign operation (in Saudi riyals) to reduce the carrying amount to the lower of cost or net realizable value. In other words, a contra asset account (i.e., a lower of cost or market reserve) representing the difference between the carrying amount (SR 3,750,000) and the net realizable value (SR 3,250,000) must have been created on the books of the foreign operation.

On translating the financial statements of the foreign operation into the reporting currency, however, it is noted that due to the fluctuation of the exchange rates the net realizable value when converted to the reporting currency [SR 3,250,000 (@ 3.00 SR = 1 US dollar) = $1,083,333] is no longer lower than the translated carrying value which is to be converted at the exchange rate prevailing on the date of acquisition of the merchandise [SR 3,750,000 (@ SR 3.75 = I US dollar) = $1,000,000].

Thus, a reversal of the adjustment (for lower of cost or market) is required on the financial statements of the reporting enterprise, upon translation of the financial statements of the foreign operation.

Translation Methods Commonly Used in Translating Financial Statements of Foreign Operations

The methodology for translating foreign currency denominated financial statements has evolved over time, as differing theories have gained popularity and as the limitations of particular methods have become realized. No single method accomplishes all objectives perfectly, and understanding translated financial statements continues to present challenges for both preparers and users.

The challenges arise, in part, because four rather different methods have been, or continue to be, used to translate assets and liabilities of entities' foreign operations. The primary distinction among the methods is the classification scheme employed to distinguish assets and liabilities that would be translated at either the current (i.e., latest balance sheet date) or historical (i.e., date of asset acquisition or liability incurral) rate. Under IAS 21, the current rate method is used to translate the financial statements of a foreign entity.

Prior practices (some of which are continuing under certain national GAAP standards) included the use of the temporal, the monetary/nonmonetary, and the current/noncurrent methods. The temporal method translates cash, receivables, payables, and assets and liabilities carried at either present or future values at the current rate, with all remaining assets and liabilities carried at historical costs translated at the applicable historical rates. In essence, under this method, the accounting principles used to measure the assets and liabilities in the foreign statements are retained, but there will be foreign exchange gains or losses that arise due to the translation methodology which are not a result of economic events that affect the foreign entity's operations. This was the mandated method in the United States under prior GAAP (current US GAAP, SFAS 52, requires that the current rate method to be used in most, but not all, situations).

Results similar to those obtained under the temporal method are generally obtained from the use of the monetary/nonmonetary method. This translation technique (which is required under US GAAP when the books and records are not maintained in the functional currency) translates all nonmonetary assets and liabilities at their relevant historical rates. While the monetary/nonmonetary distinction will often roughly coincide with the current/noncurrent one, this will not generally be true (e.g., for noncurrent investments in monetary assets).

The third method encountered is the current/noncurrent method, which employs balance sheet classification as the sole criterion for choice of translation rate. Current assets and liabilities are translated at the current rate and noncurrent assets and liabilities at the applicable historical rates. Major weaknesses under this approach relate to the treatments accorded to inventory and long-term debt. Inventory, a current asset, must be translated at its current cost, a major departure from traditional GAAP. The translation of foreign-denominated long-term debt under this approach, at historical rates in effect when the debt was incurred, could also be misleading to users. For instance, from the perspective of a US reporting entity, if the dollar were to weaken, it will require the use of more dollars to repay the foreign-denominated obligation, but this fact would not be apparent from the reporting entity's financial statements. Additional complications arise because some balance sheets are not classified, and there may also be variations between current and noncurrent classifications in classified balance sheets.

The final approach, the current rate method, is the approach mandated by IAS for translation of financial statements of a foreign entity. The distinguishing feature of this method is that all assets and liabilities, both monetary and nonmonetary, are translated at the closing (balance sheet date) rate, which obviously simplifies the process and also more closely corresponds to the viewpoint of users, who tend to relate to currency rates then in existence rather than those of prior years.

The theoretical basis for the current rate method is the "net investment concept," wherein 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 environment (economics, legal, and political) where the entity operates. This approach works best, of course, when foreign-denominated debt is used to purchase 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 recognized in the parent company's balance sheet, as described below.

Under US GAAP, if the foreign entity's local currency is the functional currency, (which is the normal situation), the current rate method is prescribed for translating the foreign entity's financial statements. On the other hand, if the US dollar is the functional currency of the foreign operation, a different technique, called the remeasurement method, must be employed when translating the foreign entity's financial statements. This distinction is not made under IAS, however.

Translation of Financial Statements of a Foreign Operation That Is Not Integral to the Operations of the Reporting Enterprise (i.e., Foreign Entity)

The following rules should be used in translating the financial statements of a foreign entity:

All assets and liabilities, whether monetary or nonmonetary, should be translated at the closing rate.
Income and expense items 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.
All resulting exchange differences should be classified as a separate component of equity of the reporting enterprise until disposal of the net investment in a foreign entity.

Guidance under IAS 21 in Special Situations

Minority interests.

When a foreign entity is consolidated but is not wholly owned by the reporting enterprise, there will be minority interest reported in the consolidated balance sheet. IAS 21 requires that the accumulated exchange differences resulting from translation and attributable to the minority interest be allocated to and reported as minority interest instead of as a separate component of equity.

Goodwill arising on acquisition of a foreign entity.

Any goodwill (which in the authors' opinion includes negative goodwill) arising on the acquisition of a foreign entity should be treated as either

An asset (or a liability in case of negative goodwill) of the foreign entity and translated at the closing rate, or
An asset (or a liability in case of negative goodwill) of the reporting entity which is either already expressed in the reporting currency or is converted to the reporting currency, such as nonmonetary items that are carried at historical costs and translated at the exchange rate on the date of the transaction in accordance with IAS 21.

Fair value adjustments to carrying amount of assets and liabilities arising on acquisition of a foreign entity.

IAS 21 prescribes the same treatment for this as well as for goodwill arising on acquisition of a foreign entity (discussed above).

Exchange differences on elimination of intragroup balances.

While incorporating the financial statements of a foreign entity into those of the reporting enterprise, normal consolidation procedures such as elimination of intragroup balances and transactions are undertaken as required by IAS 27 and IAS 31. However, IAS 21 requires that exchange differences arising from intragroup monetary items should not be eliminated against corresponding amounts arising on other intragroup balances. This is because monetary items represent commitments to convert one currency into another and expose the reporting enterprise to a gain or loss through currency fluctuations. Thus, on consolidation, such exchange differences would continue to be recognized either as income or expense, or if they arise from exceptional circumstances described in IAS 21, they should be classified as equity until the disposal of the net investment.

Different reporting dates.

When reporting dates for the financial statements of a foreign entity and those of the reporting enterprise differ, the foreign entity normally switches and prepares financial statements with reporting dates coinciding with those of the reporting enterprise. However, sometimes this may not be practicable to do. In such circumstances IAS 27 allows the use of financial statements drawn up to different dates, provided that the difference is no more than three months. In such a case, the assets and liabilities of the foreign entity should be translated at the exchange rates prevailing on the balance sheet date of the foreign entity. Adjustments should be made for any significant movements in exchange rates between the balance sheet date of the foreign entity and that of the reporting entity in accordance with the provisions of IAS 27 and IAS 28 relating to this matter.

Disposal of a foreign entity.

Any cumulative exchange differences are to be carried as a separate component of equity until the disposal of the foreign entity in terms of the specific stipulation in IAS 21. The standard prescribes the treatment of the cumulative exchange differences account on the disposal of the foreign entity. This balance, which has been deferred, should be recognized as income or expense in the same period in which the gain or loss on disposal is recognized.

Disposal has been defined to include a sale, liquidation, repayment of share capital, or abandonment of all or part of the entity. Normally, payment of dividends would not constitute a repayment of capital. However, in rare circumstances, it does; for instance, when an enterprise pays dividends out of capital instead of divisible profits, as defined in the companies' acts of certain countries where this expression is used, such as the United Kingdom, this would constitute repayment of capital. In such circumstances, obviously, dividends paid would constitute a disposal for the purposes of this standard.

IAS 21 further stipulates that in the case of a partial disposal of an interest in a foreign entity, only a proportionate share of the related accumulated exchange differences is recognized as a gain or a loss. A write-down of the carrying amount of the foreign entity does not constitute a partial disposal, and thus the deferred exchange differences carried forward as part of equity would not be affected by such a write-down.

Change in classification of a foreign operation.

Since whether or not a foreign operation is categorized as a foreign entity depends on the way the foreign operation operates in relation to the reporting enterprise or is financed, a subsequent change in these circumstances could sometimes lead to a change of classification. In such circumstances the translation procedures applicable to the revised classification should be applied from the date of change in the classification.

Comprehensive example of the practical application of the current rate method

Assume that a US company has a 100%-owned subsidiary in Germany that began operations in 2002. The subsidiary's operations consist of leasing space in an office building. This building, which cost 500 deutsche marks (DM), was financed primarily by German banks. All revenues and cash expenses are received and paid in deutsche marks. The subsidiary also maintains its books and records in DM.

As a result, management of the US company has decided that the financial statements of the German subsidiary be translated for incorporation into its financials as if it were a foreign operation that was not integral to the operations of the reporting entity, in other words, as if it were a foreign entity. The subsidiary's balance sheet at December 31, 2002, and its combined statement of income and retained earnings for the year ended December 31, 2002, are presented below in DM.

German Company Balance Sheet at December 31, 2002
*Assets*		*Liabilities and stockholders' equity*
Cash	DM	50	Accounts payable	DM	30
Note receivable		20	Unearned rent		10
Land		100	Mortgage payable		400
Building		500	Common stock		40
Accumulated depreciation		(10)	Additional paid-in capital		160
			Retained earnings		20
Total assets	DM	660	Total liabilities and stockholders' equity	DM	660

German Company Combined Statement of Income and Retained Earnings for the Year Ended December 31, 2002
Revenues	DM	200
Operating expenses (including depreciation expense of DM 10)		170
Net income	DM	30
Add retained earnings, January 1, 2002		--
Deduct dividends		(10)
Retained earnings, December 31, 2002	DM	20

Various exchange rates for 2002 are as follows:

1 DM	=	$0.40 at the beginning of 2002 (when the common stock was issued and the land and building were financed through the mortgage)
1 DM	=	$0.43 weighted-average for 2002
1 DM	=	$0.42 at the date the dividends were declared and the unearned rent was received
1 DM	=	$0.45 at the end of 2002

Since the German subsidiary is a foreign entity (as per IAS 21), 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 Balance Sheet Translation at December 31, 2002
*Assets*	DM		Exchange rates	US dollars
Cash	DM	50	0.45	$ 22.50
Accounts receivable		20	0.45	9.00
Land		100	0.45	45.00
Building (net)		490	0.45	220.50
Total assets	DM	660		$297.00
*Liabilities and stockholders' equity*
Accounts payable	DM	30	0.45	$ 13.50
Unearned rent		10	0.45	4.50
Mortgage payable		400	0.45	180.00
Common stock		40	0.40	16.00
Additional paid-in capital		160	0.40	64.00
Retained earnings		20	(see income statement)	8.70
Cumulative exchange difference (translation adjustments)		--	--	10.30
Total liabilities and stockholders' equity	DM	660		$297.00

German Company Combined Income and Retained Earnings Statement Translation for the Year Ended December 31, 2002
	DM		Exchange rates	US dollars
Revenues	DM	200	0.43	$86.00
Expenses (including DM 10 depreciation expense)		170	0.43	73.10
Net income	DM	30		$12.90
Add retained earnings, January 1		--	--	--
Deduct dividends		(10)	0.42	(4.20)
Retained earnings, December 31	DM	20		$ 8.70

German Company Statement of Cash Flows for the Year Ended December 31, 2002
	DM		Exchange rates	US dollars
*Operating activities*
Net income	DM	30	0.43	$ 12.90
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation		10	0.43	4.30
Increase in accounts receivable		(20)	0.43	(8.60)
Increase in accounts payable		30	0.43	12.90
Increase in unearned rent		10	0.42	4.20
Net cash provided by operating activities	DM	60		$ 25.70
*Investing activities*
Purchase of land		(100)	0.40	(40.00)
Purchase of building		(500)	0.40	(200.00)
Net cash used by investing activities		(600)		(240.00)
*Financing activities*
Common stock issue		200	0.40	80.00
Mortgage payable		400	0.40	160.00
Dividends paid		(10)	0.42	(4.20)
Net cash provided by financing		590		235.80
Effect on exchange rate changes on cash		N/A		1.00
Increase in cash and equivalents	DM	50		$ 22.50
Cash at beginning of year		--		---
Cash at end of year	DM	50	0.45	$ 22.50

The following points should be noted concerning the current rate method:

All assets and liabilities are translated using the current exchange rate at the balance sheet date (1 DM = $0.45). All revenues and expenses should be translated at the rates in effect when these items are recognized during the period. Due to practical considerations, however, weighted-average rates can be used to translate revenues and expenses (1 DM = $0.43).
Stockholders' equity accounts are translated by using historical exchange rates. Common stock was issued at the beginning of 2002 when the exchange rate was 1 DM = $0.40. 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 DM = $0.42).
Cumulative exchange differences (translation adjustments) result from translating all assets and liabilities at the current rate, while stockholders' 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 a separate component in the stockholders' equity section of the US company's consolidated balance sheet. 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.

The cumulative exchange differences (translation adjustments) credit of $10.30 is calculated as follows:

Net assets at the beginning of 2002 (after common stock was issued and the land and building were acquired through mortgage financing)	200 DM (0.45 - 0.40)	=	$10.00 credit
Net income	30 DM (0.45 - 0.43)	=	.60 credit
Dividends	10 DM (0.45 - 0.42)	=	.30 debit
Exchange difference (translation adjustment)			$10.30 credit

Since the translation adjustments balance that appears as a separate component of stockholders' 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 $10.30 at the end of 2002. The analysis of this change was presented previously. In addition, assume that the following occurred during 2003:

German Company Balance Sheet December 31
*Assets*	2003		2002		Increase/(decrease)
Cash	DM	100	DM	50	DM	50
Accounts receivable		--		20		(20)
Land		150		100		50
Building (net)		480		490		(10)
Total assets	DM	730	DM	660	DM	70
*Liabilities* and *stockholders' equity*
Accounts payable	DM	50	DM	30	DM	20
Unearned rent		--		10		(10)
Mortgage payable		450		400		50
Common stock		40		40		--
Additional paid-in capital		160		160		--
Retained earnings		30		20		10
Total liabilities and stockholders' equity	DM	730	DM	660	DM	70

German Company Combined Statement of Income and Retained Earnings for the Year Ended December 31, 2003
Revenues	DM	220
Operating expenses (including depreciation expense of DM 10)		170
Net income	DM	50
Add: Retained earnings, Jan. 1, 2003		20
Deduct dividends		(40)
Retained earnings, Dec. 31, 2003	DM	30

Exchange rates were:

1 DM = $0.45 at the beginning of 2003
1 DM = $0.48 weighted-average for 2003
1 DM = $0.50 at the end of 2003
1 DM = $0.49 when dividends were paid in 2003 and land bought by incurring mortgage

The translation process for 2003 is illustrated below.

German Company Balance Sheet Translation at December 31, 2003
*Assets*	DM		Exchange rates	US dollars
Cash	DM	100	0.50	$ 50.00
Land		150	0.50	75.00
Building		480	0.50	240.00
Total asets	DM	730		$365.00
*Liabilities and stockholders' equity*
Accounts payable	DM	50	0.50	$ 25.00
Mortgage payable		450	0.50	225.00
Common stock		40	0.40	16.00
Addl. paid-in capital		160	0.40	64.00
Retained earnings		30	(see income statement)	13.10
Cumulative exchange difference (translation adjustments)		--		21.90
Total liabilities and stockholders' equity	DM	730		$365.00

German Company Combined Income and Retained Earnings Statement Translation for the Year Ended December 31, 2003
	DM		Exchange rates	US dollars
Revenues	DM	220	0.48	$105.60
Operating expenses (including depreciation of DM 10)		170	0.48	81.60
Net income	DM	50	0.48	$ 24.00
Add: Retained earnings 1/1/03		20	--	8.70
Less: Dividends		(40)	0.49	(19.60)
Retained earnings 12/31/03	DM	30		$ 13.10

German Company Statement of Cash Flows for the Year Ended December 31, 2003
	DM		Exchange rates	US dollars
Operating activities
Net income	DM	50	.48	$24.00
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation		10	.48	4.80
Decrease in accounts receivable		20	.48	9.60
Increase in accounts payable		20	.48	9.60
Decrease in unearned rent		(10)	.48	(4.80)
Net cash provided by operating activities	DM	90		$43.20
Investing activities
Purchase of land		(50)	.49	(24.50)
Net cash used by investing activities		(50)		(24.50)
Financing activities
Mortgage payable		50	.49	24.50
Dividends		(40)	.49	(19.60)
Net cash provided by financing activities		10		4.90
Effect of exchange rate changes on cash		NA		3.90
Increase in cash and equivalents	DM	50		$27.50
Cash at beginning of year		50		22.50
Cash at end of year	DM	100	.50	$50.00

Using the analysis that was presented before, the total exchange differences (translation adjustment) attributable to 2003 would be computed as follows:

Net assets at January 1, 2003	200 DM (0.50 - 0.45)	=	$ 11.00 credit
Net income for 2003	50 DM (0.50 - 0.48)	=	1.00 credit
Dividends for 2003	40 DM (0.50 - 0.49)	=	.40 debit
Total			$11.60 credit

The balance in the cumulative exchange differences (translation adjustment) account at the end of 2003 would be $21.90 ($10.30 from 2002 and $11.60 from 2003).

Use of the equity method by the US company in accounting for the subsidiary would result in the following journal entries based on the information presented above:

	2002		2003
Original investment
Investment in German subsidiary	80 ^[a]		--
Cash		80		--
Earnings pickup
Investment in German subsidiary	12.90		24 ^[b]
Equity in subsidiary income		12.90		24
	2002		2003
Dividends received
Cash	4.20		19.60
Investment in German subsidiary		4.20		19.60
Exchange difference (translation adjustments)
Investment in German subsidiary	10.30		11.60
Translation adjustments		10.30		11.60
^[a][$0.40 x common stock of 40 DM plus additional paid-in capital of 160 DM] ^[b][$0.48 x net income of 50 DM]

Note that the stockholders' equity of the US company should be the same whether or not the German subsidiary is consolidated (IAS 28). Since the subsidiary does not report the translation adjustments on its financial statements, care should be exercised so that it is not forgotten in application of the equity method.

If the US company disposes of its investment in the German subsidiary, the translation adjustments balance becomes part of the gain or loss that results from the transaction and must be eliminated. For example, assume that on January 2, 2004, the US company sells its entire investment for 300 DM. The exchange rate at this date is I DM = $0.50. The balance in the investment account at December 31, 2003, is $115 as a result of the entries made previously.

	Investment in German Subsidiary
1/1/02	80.00
	12.90	4.20
	10.30
1/1/03	99.00
	24.00
	11.60	19.60
12/31/03	115.00

The following entries would be made to reflect the sale of the investment:

Cash (300 DM x $0.50)	150
Investment in German subsidiary		115
Gain from sale of subsidiary		35
Translation adjustments	21.90
Gain from sale of subsidiary		21.90

If the US company had sold a portion of its investment in the German subsidiary, only a proportionate share of the translation adjustments balance (cumulative amount of exchange differences) would have become part of the gain or loss from the transaction. To illustrate, if 80% of the German subsidiary was sold for 250 DM on January 2, 2004, the following journal entries would be made:

Cash	125
Investment in German subsidiary (0.8 x $115)		92
Gain from sale of subsidiary		33
Cumulative exchange difference (translation adjustments) (0.8 x $21.90)	17.52
Gain from sale of subsidiary		17.52

For an illustration of the remeasurement method under US GAAP, refer to the Appendix of this chapter.

Translation of Foreign Currency Transactions

According to IAS 21, a foreign currency transaction is a transaction that is "denominated in or requires settlement in a foreign currency." Denominated means that the amount to be received or paid is fixed in terms of the number of units of a particular foreign currency, regardless of changes in the exchange rate.

From the viewpoint of a US company, for instance, a foreign currency transaction results when it imports or exports goods or services to a foreign entity or makes a loan involving a foreign entity and agrees to settle the transaction in currency other than the US dollar (the reporting currency of the US company). In these situations, the US company has "crossed currencies" and directly assumes the risk of fluctuating exchange rates of the foreign currency in which the transaction is denominated. This risk may lead to recognition of foreign exchange differences in the income statement of the US company. Note that exchange differences can result only when the foreign currency transactions are denominated in a foreign currency.

When a US company imports or exports goods or services and the transaction is to be settled in US dollars, the US company will incur neither gain nor loss because it bears no risk due to exchange rate fluctuations. The following example illustrates the terminology and procedures applicable to the translation of foreign currency transactions.

Assume that a US company, an exporter, sells merchandise to a customer in Germany on December 1, 2002, for 10,000 DM. Receipt is due on January 31, 2003, and the US company prepares financial statements on December 31, 2002. At the transaction date (December 1, 2002), the spot rate for immediate exchange of foreign currencies indicates that 1 DM is equivalent to $0.50.

To find the US dollar equivalent of this transaction, the foreign currency amount, 10,000 DM, is multiplied by $0.50 to get $5,000. At December 1, 2002, the foreign currency transaction should be recorded by the US company in the following manner: Accounts receivable—Germany 5,000; sales 5,000. The accounts receivable and sales are measured in US dollars at the transaction date using the spot rate at the time of the transaction. While the accounts receivable is measured and reported in US dollars, the receivable is denominated or fixed in DM.

This characteristic may result in foreign exchange differences if the spot rate for DM changes between the transaction date and the date of settlement (January 31, 2003). If financial statements are prepared between the transaction date and the settlement date, all receivables and liabilities that are denominated in a foreign currency (the US dollar) must be restated to reflect the spot rates in existence at the balance sheet date.

Assume that on December 31, 2002, the spot rate for DM is 1 DM = $0.52. This means that the 10,000 DM are now worth $5,200 and that the accounts receivable denominated in DM should be increased by $200. The following journal entry would be recorded as of December 31, 2002:

Accounts receivable—Germany	200
Foreign currency exchange difference		200

Note that the sales account, which was credited on the transaction date for $5,000, is not affected by changes in the spot rate. This treatment exemplifies the two-transaction viewpoint (which is a US GAAP expression). In other words, making the sale is the result of an operating decision, while bearing the risk of fluctuating spot rates is the result of a financing decision. Therefore, the amount determined as sales revenue at the transaction date should not be altered because of a financing decision to wait until January 31, 2003, for payment of the account.

The risk of a foreign exchange transaction loss can be avoided either by demanding immediate payment on December 1 or by entering into a forward exchange contract to hedge the exposed asset (accounts receivable). The fact that the US company in the example did not act in either of these two ways is reflected by requiring the recognition of foreign currency exchange differences (transaction gains or losses) in its income statement (reported as financial or nonoperating items) in the period during which the exchange rates changed.

This treatment has been criticized, however, because both the unrealized gain and/or loss are recognized in the financial statements, a practice that is at variance with traditional GAAP. Furthermore, earnings will fluctuate because of changes in exchange rates and not because of changes in the economic activities of the enterprise.

On the settlement date (January 31, 2003), assume that the spot rate is 1 DM = $0.51. The receipt of 10,000 DM and their conversion into US dollars would be journalized in the following manner:

Foreign currency	5,100
Foreign currency transaction loss	100
Accounts receivable—Germany		5,200
Cash	5,100
Foreign currency		5,100

The net effect of this foreign currency transaction was to receive $5,100 from a sale that was measured originally at $5,000. This realized net foreign currency transaction gain of $100 is reported on two income statements: a $200 gain in 2002 and a $100 loss in 2003. The reporting of the gain in two income statements causes a temporary difference between pretax accounting and taxable income. This results because the transaction gain of $100 is not taxable until 2003, the year the transaction was completed or settled. Accordingly, inter-period tax allocation is required for foreign currency transaction gains or losses.

Benchmark vs. Allowed Alternative Treatments of Exchange Differences

The benchmark treatment for exchange differences requires recognition as income or expense in the period in which they arise. Under current IAS (which will possibly change due to the IASB's Improvements Project, however), there is an allowed alternative treatment for certain exchange differences. This results in capitalization of the loss incurred due to effect of exchange rate changes on foreign-denominated obligations associated with asset acquisitions, as described in the following paragraphs.

Capitalization of certain losses resulting from severe currency devaluation or depreciation.

The benchmark treatment for the accounting to be applied to exchange differences that arise from settlement of a monetary item denominated in a foreign currency (e.g., an invoice for the purchase of machinery) is to report these items in current period earnings. However, for narrowly defined circumstances, IAS 21 provides an alternative treatment which may be selected by the reporting entity. Under this optional, alternative method, if the exchange gain or loss resulted from a severe devaluation or depreciation, and certain conditions are met, this difference may be added or deducted from the carrying amount of the asset acquired (e.g., the machinery). In order to qualify for such alternative accounting, the following conditions must be met:

The exchange difference had to arise in the context of a severe devaluation or depreciation of the currency; this cannot simply be the continuation of ongoing devaluation, but rather must be sudden, unexpected, and significant.
The reporting entity cannot be reporting in the currency of a hyperinflationary economy, as defined by IAS 29.
There must have been no practical means of hedging the risk of devaluation or depreciation. The standard does not imply that there was a complete impossibility of doing so, but only that it would have been impractical under the circumstances. As interpreted further by SIC 11, this means that the foreign-denominated liability could not have been settled (e.g., via a forward transaction) and that it was impracticable to hedge prior to the occurrence of the devaluation event. This threshold would be met if the foreign currency were not available in the market, and that it was impracticable to utilize derivatives.
The acquisition of the assets must have been "recent," which while not defined by IAS 21, was later interpreted by SIC 11 as being within twelve months prior to the severe devaluation or depreciation.

A final caveat is that, if such a loss is experienced and the allowed alternative method under IAS 21 is invoked to add the loss to the carrying value of an acquired asset, this may have to be limited so that the carrying value of the asset does not exceed the lower of the replacement cost and the amount recoverable from the sale or use of the asset.

If the alternative method is used, it must be continued in use for other similar situations (i.e., exchange differences arising in the context of the above described conditions), adding losses to other assets acquired as appropriate. This will be illustrated by means of the following example:

Example of capitalization of exchange differences

Sandoval Company International enters into a binding contract to import a machine from country A on January 1, 2003. The terms of the contract specify that payments must commence within twelve months of the date of the purchase contract. The reporting currency of Sandoval company undergoes a severe devaluation, there is no practical means of hedging the exchange risk, and the foreign currency necessary for the settlement of the liability is not available. The foreign currency liability is to be settled as follows:

June 30, 2003	25% of the purchase price
September 30, 2003	25% of the purchase price
December 31, 2003	25% of the purchase price
March 31, 2003	25% of the purchase price

The exchange losses incurred on the payments made on June 30, September 30, and December 31, 2002, can clearly be capitalized based on the interpretation of the term "recent acquisition" in SIC 11 since these dates fall within twelve months of the date of acquisition. The final installment payment, March 31, 2003 (which is beyond the period of twelve months from the date of acquisition) also qualifies for capitalization with the cost of the asset, according to SIC 11, since the "recent" limitation relates to the event of devaluation in relation to the asset acquisition and does not limit the accounting for subsequent disbursements on that acquisition.

Thus, if other conditions for capitalization continue to be met, such as the lack of availability of foreign currency necessary for settlement of the liability, and the impracticality of hedging the exchange risk, such exchange losses should continue to be capitalized once the alternative method is elected (provided the adjusted carrying amount does not exceed the recoverable amount of the asset).

While the foregoing option is presently available, if the proposed (as of mid-2002) changes are enacted, IAS 21 will no longer allow this, and SIC 11 will be withdrawn. See the discussion of the Improvements Project proposals later in this chapter.

Disclosure Requirements

A number of disclosure requirements have been prescribed by IAS 21. Primarily, disclosure is required of the amounts of exchange differences included in net income or loss for the period, exchange differences that are included in the carrying amount of an asset, and those that are classified as equity along with a reconciliation of the beginning and ending balance in the cumulative exchange difference account carried as part of the equity.

When there is a change in classification of a foreign operation, disclosure is required as to the nature of the change, reason for the change, and the impact of the change on the current and each of the prior years presented. When the reporting currency is different from the currency of the country of domicile, the reason for this should be disclosed, and in case of any subsequent change in the reporting currency, the reason thereof should also be disclosed. An enterprise should also disclose the method selected to translate goodwill and fair value adjustments arising on the acquisition of a foreign entity. Disclosure is encouraged of an enterprise's foreign currency risk management policy.

The following additional disclosures are required by SIC 19:

When the measurement currency is different from the currency of the country in which the enterprise is domiciled, the reason for using a different currency;
The reason for any change in measurement currency or presentation currency; and
When financial statements are presented in a currency other than the enterprise's measurement currency, the reason for using a different presentation currency, and a description of the method used in the translation process.

Yet further disclosure requirements have been imposed by SIC 30:

When financial statements are presented in a currency other than the measurement currency, an enterprise should state the fact that the measurement currency reflects the economic substance of underlying events and circumstances;
When financial statements are presented in a currency other than the measurement currency, and the measurement currency is the currency of a hyperinflationary economy, an enterprise should disclose the closing exchange rates between measurement currency and presentation currency existing at the date of each balance sheet presented;
When additional information not required by IAS is displayed in financial statements and in a currency other than presentation currency, as a matter of convenience to certain users, an enterprise should:
- Clearly identify such information as supplementary information;
- Disclose the measurement currency used to prepare the financial statements and the method of translation used to determine the supplementary information displayed;
- Disclose the fact that the measurement currency reflects the economic substance of the underlying events and circumstances of the enterprise and the supplementary information is displayed in another currency for convenience purposes only; and
- Disclose the currency in which supplementary information is displayed.

Proposed Changes to IAS 21

The IASB's Improvements Project has proposed that certain changes be made to IAS 21. These changes are deemed likely to be enacted and quite possibly will be effective before year-end 2003. These are summarized in the following paragraphs.

Foreign currency derivatives that are properly addressed by IAS 39 would be removed from the scope of IAS 21. Also, hedging guidance would be moved to IAS 39.
The current concept of reporting currency set forth in IAS 21 would be replaced with two other concepts: functional currency (defined as the currency in which the entity measures the items in its financial statements) and presentation currency (which is the currency in which the entity presents its financial statements). In the amended IAS 21, the term functional currency is used in place of measurement currency, which was used in SIC 19, since functional currency is the more commonly used term, although having essentially the same meaning as measurement currency.
Each entity—be it a stand-alone entity, a parent of a group, or an operation within a group (such as a subsidiary, associate or branch)—will be required to determine its functional currency and measure its results and financial position in that currency. The proposed definition of functional currency is "the currency of the primary economic environment in which the entity operates." Some of the guidance in SIC 19 on how to determine a measurement currency will be incorporated into IAS 21. Greater emphasis will be given to the currency of the economy that determines the pricing of transactions than to the currency in which transactions are denominated. Consequently,
- An entity (whether a stand-alone entity or an operation within a group) would not have a free choice of functional currency.
- An entity could not avoid restatement under IAS 29, for example, by adopting a stable currency (such as the functional currency of its parent) as its functional currency.
The provisions in IAS 21 on distinguishing between foreign operations that are integral to the operations of the reporting entity and foreign entities will be revised, to become part of the indicators of what is an entity's functional currency. As a consequence,
- There will be no distinction between integral foreign operations and foreign entities. Instead, an entity that was previously classified as an integral foreign operation will have the same functional currency as the reporting entity.
- There will be only one translation method needed for foreign operations, the method described in IAS 21 as applying to foreign entities.
- The language in IAS 21—which deals with the distinction between an integral foreign operation and a foreign entity and which specifies the translation method to be used for the former—will be deleted.
The allowed alternative treatment in IAS 21, permitting the capitalization of exchange differences arising in severe devaluation circumstances would be eliminated, making all such gains or losses recognizable in current earnings.
Under amended IAS 21, goodwill and fair value adjustments to assets and liabilities that arise on the acquisition of a foreign entity will be required to be treated as part of the assets and liabilities of the acquired entity and translated at the closing rate.
A reporting entity (whether a group or a stand-alone entity) will be permitted to present its financial statements in the currency (or currencies) of its choice.
An entity (whether a stand-alone entity, a parent of a group, or an operation within a group) will be required to translate its results and financial position from its functional currency into the presentation currency (or currencies) using the same method as IAS 21 requires for translating a foreign operation for inclusion in the reporting entity's financial statements.
Comparative amounts will have to be translated as follows:
- For an entity whose functional currency is not the currency of a hyperinflationary economy
  - Assets and liabilities in the comparative balance sheet will be translated at the closing rate at the date of that balance sheet (i.e., the prior year's comparatives are translated at the prior year's closing rate).
  - Income and expense items in the comparative income statement will be translated at exchange rates at the dates of the transactions (i.e., the prior year's comparatives will be translated at the prior year's actual or average rate).
- For an entity whose functional currency is the currency of a hyperinflationary economy, and for which the comparative amounts are being translated into the currency of a hyperinflationary economy, all amounts (both balance sheet and income statement items) would be translated at the closing rate of the most recent balance sheet presented (i.e., the prior year's comparatives, as adjusted for subsequent changes in the price level, are translated at the current year's closing rate).
- For an entity whose functional currency is the currency of a hyperinflationary economy, and for which the comparative amounts are being translated into the currency of a nonhyperinflationary economy, all amounts are those presented in the prior year financial statements (i.e., these are not adjusted for either subsequent changes in the price level or subsequent changes in exchange rates). This translation method would apply both when translating the financial statements of a foreign operation for inclusion in the financial statements of a foreign operation for inclusion in the financial statements of the reporting entity, and when translating the financial statements of an entity into a different presentation currency.
- SIC 11 is to be withdrawn since the allowed alternative for accounting for exchange differences under conditions of severe devaluation would be deleted, and SIC 19 is to be withdrawn, with its provisions folded into revised IAS 21.

Hedging a Net Investment in a Foreign Entity Or Specific Transactions

Hedging a Net investment.

While IAS 21 did not address hedge accounting for foreign currency items other than classification of exchange differences arising on a foreign currency liability accounted for as a hedge of a net investment in a foreign entity, the recent issuance of IAS 39 has established accounting requirements which largely parallel those for cash flow hedges. (Cash flow hedging is discussed in Chapter 10.) Specifically, IAS 39 states that the portion of the gain or loss on the hedging instrument that is determined to be an effective hedge is to be recognized directly in equity via the statement of changes in equity, whereas the ineffective portion of the hedge is to be either recognized immediately in results of operations if the hedging instrument is a derivative instrument, or else reported directly in equity if the instrument is not a derivative.

The gain or loss associated with an effective hedge is reported similar to foreign currency translation gain or loss, as an additional equity account. In fact, if the hedge is fully effective (which is rarely achieved in practice, however) the hedging gain or loss will be equal in amount and opposite in sign to the translation loss or gain.

In the examples set forth earlier in this chapter (see page 824), which illustrated the accounting for a foreign (German) operation of a US company, the cumulative translation gain as of year-end 2002 was reported as $10.30. If the US entity had been able to enter into a hedging transaction that was perfectly effective (which would most likely have involved a series of currency forward contracts), the net loss position as of that date would have been $10.30. If this were reported in stockholders' equity, as required under IAS 39, it would have served to exactly offset the cumulative translation gain at that point in time.

It should be noted that under the translation methodology prescribed by IAS 21 the ability to precisely hedge the net (accounting) investment in the German subsidiary would have been very remote, since the cumulative translation gain or loss is determined 'by both the changes in exchange rates since the common stock issuances of the subsidiary (which occurred at discrete points in time and thus could conceivably have been hedged), as well as the changes in the various periodic increments or decrements to retained earnings (which having occurred throughout the years of past operations, would involve a complex array of exchange rates, making hedging very difficult to achieve). As a practical matter, hedging the net investment in a foreign subsidiary would serve a very limited economic purpose at best. Such hedging is more often done to avoid the potentially embarrassing impact of changing exchange rates on the reported results of operations and financial position of the parent company, which may be important to management, but rarely connotes real economic performance over a longer time horizon.

Notwithstanding the foregoing comments, it is possible for a foreign currency transaction to act as an economic hedge against a parent's net investment in a foreign entity if

The transaction is designated as a hedge.
It is effective as a hedge.

To illustrate, assume that a US parent has a wholly owned British subsidiary which has net assets of 2 million. The US parent can borrow 2 million to hedge its net investment in the British subsidiary. Assume further that the British pound is the functional currency and that the 2 million liability is denominated in pounds. Fluctuations in the exchange rate for pounds will have no net effect on the parent company's consolidated balance sheet because increases (decreases) in the translation adjustments balance due to the translation of the net investment will be offset by decreases (increases) in this balance due to the adjustment of the liability denominated in pounds.

Hedging transactions.

It may be more important for managers to hedge specific foreign currency denominated transactions, such as merchandise sales or purchases which involve exposure for the time horizon over which the foreign currency denominated receivable or payable remains outstanding. For example, consider the illustration set forth earlier in this chapter (see page 755), which discussed the sale of merchandise by a US entity to a German customer, denominated in deutschmarks, with the receivable being due some time after the sale. During the period the receivable remains pending, the creditor is at risk for currency exchange rate changes that might occur, leading to exchange rate gains or losses, depending on the direction the rates move. The following discussion sets forth the possible approach that could have been taken (and the accounting therefore) to reduce or eliminate this risk.

In the example, the US company could have entered into a forward exchange contract on December 1, 2002, to sell 10,000 DM for a negotiated amount to a foreign exchange broker for future delivery on January 31, 2003. Such a forward contract would be a hedge against the exposed asset position created by having an account receivable denominated in DM. The negotiated rate referred to above is called a futures or forward rate. This instrument would qualify as a derivative under IAS 39.

In most cases, this futures rate is not identical to the spot rate at the date of the forward contract. The difference between the futures rate and the spot rate at the date of the forward contract is referred to as a discount or premium. Any discount or premium must be amortized over the term of the forward contract, generally on a straight-line basis. The amortization of discount or premium is reflected in a separate revenue or expense account, not as an addition or subtraction to the foreign currency transaction gain or loss amount. It is important to observe that under this treatment, no net foreign currency transaction gains or losses result if assets and liabilities denominated in foreign currency are completely hedged at the transaction date.

To illustrate a hedge of an exposed asset, consider the following additional information for the German transaction.

On December 1, 2002, the US company entered into a forward exchange contract to sell 10,000 DM on January 31, 2003, at $0.505 per DM. The spot rate on December 1 is $0.50 per DM. The journal entries that reflect the sale of goods and the forward exchange contract appear as follows:

Sale transaction entries			Forward exchange contract entries (futures rate 1 DM = $0.505)

12/1/02 (spot rate 1 DM = $0.50)			Due from exchange broker	5,050
Accounts receivable—Germany	5,000		Due to exchange broker		5,000
Sales		5,000	Premium on forward contract		50
12/31/02 (spot rate 1 DM = $0.52)			Foreign currency transaction loss	200
Accounts receivable—Germany	200		Due to exchange broker		200
Foreign currency transaction			Premium on forward contract	25
gain		200	Financial revenue ($25 = $50/2 months)		25
1/31/03 (spot rate 1 DM = $0.51)
Foreign currency	5,100		Due to exchange broker	5,200
Foreign currency transaction loss	100		Foreign currency		5,100
Accounts receivable—Germany		5,200	Foreign currency transaction gain		100
			Cash	5,050
			Due from exchange broker		5,050
			Premium on forward contract	25
			Financial revenue		25

The following points should be noted from the entries above:

The net foreign currency transaction gain or loss is zero. The account "Due from exchange broker" is fixed in terms of US dollars, and this amount is not affected by changes in spot rates between the transaction and settlement dates. The account "Due to exchange broker" is fixed or denominated in DM. The US company owes the exchange broker 10,000 DM, and these must be delivered on January 31, 2003. Because this liability is denominated in DM, its amount is determined by spot rates. Since spot rates change, this liability changes in amount equal to the changes in accounts receivable because both of the amounts are based on the same spot rates. These changes are reflected as foreign currency transaction gains and losses which net out to zero.
The premium on forward contract is fixed in terms of US dollars. This amount is amortized to a financial revenue account over the life of the forward contract on a straightline basis.
The net effect of this transaction is that $5,050 was received on January 31, 2003, for a sale originally recorded at $5,000. The $50 difference was taken into income via amortization.

Interpretations on Currency Transactions As Derivatives

The IASC's IAS 39 Implementation Guidance Committee (IGC) has addressed a few issues that pertain to translation of financial statements and foreign currency transactions. It has considered whether a currency swap that requires an exchange of different currencies of equal fair values at inception is a derivative, and has ruled that indeed it is. The IGC finds that the definition of a derivative instrument includes such currency swaps because the initial exchange of currencies of equal fair values does not result in an initial net investment in the contract, but instead, is an exchange of one form of cash for another form of cash of equal value. Such a contract has underlying variables (the foreign exchange rates) and will be settled at a future date. Thus, the criteria for being defined as a derivative financial instrument are all met.

The IGC offers an illustration similar to the following to demonstrate how such a swap works. Assume that Axis Corp. and Basic GmbH enter into a five-year fixed-for-fixed currency swap on euros and US dollars. The current spot exchange rate is 1 euro per dollar. The five-year interest rate in the United States is presently 8%, while the five-year interest rate in euro countries is 6%. At the initiation of the swap, Axis pays 20 million euros to Basic, which in return pays $20 million to Axis. During the life of the swap, Axis and Basic make periodic interest payments to each other gross (i.e., without netting). Basic pays 6% per year on the 20 million euros it has received (1.2 million euros per year), while Axis pays 8% per year on the 20 million dollars it has received ($1.6 million per year). At the termination of the swap, the two parties again exchange the original principal amounts.

The IGC has also noted that certain foreign currency denominated transactions can involve embedded derivative instruments. It illustrates this concept with an example of a supply contract that provides for payment in a currency other than (1) the currency of the primary economic environment of either party to the contract and (2) the currency in which the product is routinely priced in international commerce. This arrangement contains an implicit embedded derivative that should be separated under IAS 39.

In the IGC's example, a Norwegian company agrees to sell oil to a company in France. The oil contract is denominated in Swiss francs, although oil contracts are routinely denominated in US dollars in international commerce. Importantly, neither company carries out any significant activities in Swiss francs. In this case, the Norwegian company regards the supply contract as a host contract with an embedded foreign currency forward to purchase Swiss francs. The French company regards the supply contract as a host contract with an embedded foreign currency forward to sell Swiss francs. Each company includes fair value changes on the currency forward in net profit or loss unless the reporting enterprise designates it as a cash flow hedging instrument, if doing so would be appropriate under the circumstances.

Interpretations on Reporting Currency

SIC 19, Reporting Currency—Measurement and Presentation of Financial Statements under IAS 21 and IAS 29, effective in 2001, addressed the importance of selecting a reporting currency which provides useful information about the reporting entity, reflecting the substance of underlying economic events and other circumstances relevant to that entity. In other words, a reporting currency cannot be selected because it provides an opportunity for the reporting entity to conceal or obfuscate important economic effects that would otherwise be communicated to users of the financial statements. SIC 19 provides that all currencies other than that used for primary financial reporting purposes are to be treated as foreign currencies in the measurement of items in its financial statements, and in performing translation of the financial statements. Furthermore, a reporting entity does not have an arbitrary choice to avoid restatement under the provisions of IAS 29 (see Chapter 25) of financial statements which are measured in the currency of an economy which meets the threshold test for hyperinflation under that standard.

SIC 19 provides an example of a Russian entity which reports in Russian rubles and also applies IAS 29 during a period in which the Russian economy is suffering from hyperinflation. The entity is not, however, precluded from also reporting in a foreign currency, such as German marks, for the convenience of users of the financial statements.

SIC 30, Reporting Currency—Translation from Measurement Currency to Presentation Currency, which interprets IAS 21 and IAS 29, addresses the issue of how an enterprise should translate its financial statements from a currency used for measuring items in its financial statements (measurement currency) into another currency for presentation purposes (presentation currency). SIC 30 builds upon the foundation established by SIC 19, by explaining the mechanism of translation of financial statements from a "measurement currency" to a "reporting currency." Thus, the guidance offered by SIC 30 should be applied in conjunction with that of SIC 19. It should be noted that SIC 19 requires that the translation method used should not lead to reporting in a manner that is inconsistent with the measurement of items in the financial statements.

SIC 30 elaborates on the mechanism of restatement of financial statements from "measurement currency" to "presentation currency" and explains how the requirements of SIC 19 should be applied as follows:

Assets and liabilities for all balance sheets presented (including comparatives) should be translated at the closing rate at the date of each balance sheet presented, except when an enterprise's measurement currency is the currency of a hyperinflationary economy, in which case assets and liabilities for all balance sheets presented (including comparatives) should be translated at the closing rate existing at the date of the most recent balance sheet presented; and
Income and expense items for all periods presented (including comparatives) should be translated at the exchange rates existing at the dates of the transactions or at a rate that approximates the actual exchange rates, except when an enterprise's measurement currency is the currency of a hyperinflationary economy, in which case income and expense items for all periods presented (including comparatives) should be translated at the closing rate existing at the end of the most recent period presented.
Equity items, other than the net profit or loss for the period, that are included in the balance of accumulated profit or loss should be translated at the closing rate existing at the date of each balance sheet presented, except when an entity's measurement currency is the currency of a hyperinflationary economy, in which case equity items for all balance sheets presented (including comparatives) should be translated at closing rate existing at date of the most recent balance sheet; and
All resulting exchange differences should be reported directly in equity.

SIC 30 also addresses convenience translations. These are presentations of additional information not required by IAS, displayed in a currency other than the currency used in presenting financial statements, as a convenience to certain users. SIC 30 requires that in such circumstance an enterprise should

Clearly identify the information as supplementary information to distinguish it from the information required by IAS; and
Disclose the method of translation used as a basis for presenting the information.