Translation to the Presentation Currency from the Functional Currency

IAS 21, The Effect of Changes in Foreign Exchange Rates defines Presentation Currency as the currency in which the financial statements are presented. While the Functional Currency was defined as the currency of the primary economic environment in which the entity operates.

As stated in para.38 of IAS 21, an entity may present its financial statements in any currency. If the presentation currency differs from the entity’s functional currency, it translates its results and financial position into the presentation currency.

If the financial statements of the entity are not in the functional currency of a hyperinflationary economy, then the results and financial position shall be translated into a different presentation currency using the following procedures :

1. assets and liabilities for each statement of financial position presented (ie including comparatives) shall be translated at the closing rate at the date of the statement of financial position;
2. income and expenses for each statement of comprehensive income or separate income statement presented (ie including comparatives) shall be translated at exchange rates at the dates of the transactions; and
3. all resulting exchange differences shall be recognised in other comprehensive income.

The exchange differences as stated above which result from :

• translating income and expenses at the exchange rates at the dates of the transactions and assets and liabilities at the closing rate;
• translating the opening net assets at a closing rate that differs from the previous closing rate

Such exchange differences are not recognised in profit or loss because the changes in exchange rates have little or no direct effect on the present and future cash flows from operations. 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 interest are allocated to, and recognised as part of non-controlling interests in the consolidated statement of financial position (para.41 of IAS 21).

Further, para. 42 of IAS 21 states that the results and financial position of an entity whose functional currency is the currency of a hyperinflationary economy shall be translated into a different presentation currency using the following procedures :

1. all amounts (ie assets, liabilities, equity items, income and expenses, including comparatives) shall be translated at the closing rate at the date of the most recent statement of financial position, except that
2. when amounts are translated into the currency of a non-hyperinflationary economy, comparative amounts shall be those that were presented as current year amounts in the relevant prior year financial statements (ie not adjusted for subsequent changes in the price level or subsequent changes in exchange rates).

When there is a change in an entity’s functional currency, the entity shall apply the translation procedures applicable to the new functional currency prospectively from the date of the change (para.35 of IAS 21) (Hrd).

Recognition of PROVISIONS

IAS 37 regarding Provision, Contingent Liabilities and Contingent Assets defines PROVISIONS as liabilities of uncertain timing or amount.

Provisions can be distinguished from other liabilities such as trade payables and accruals because there is UNCERTAINTY about the timing or amount of the future expenditure required in settlement.

By contrast :

(a)  trade payables are liabilities to pay for goods or services that have been received or supplied  and have been invoiced or formally agreed with the supplier; and

(b)  accruals are liabilities to pay for goods or services that have been received or supplied but have not been paid, invoiced or formally agreed with the supplier, including amounts due to employees (for example, amounts relating to accrued vacation pay). Although it is sometimes necessary to estimate the amount or timing of accruals, the uncertainty is generally much less than for provisions.

Accruals are often reported as part of trade and other payables, whereas provisions are reported separately.

A PROVISION shall be recognised when :

1. an entity has a present obligation (could be either legal obligation or constructive obligation) as a result of a past event;
2. it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation; and
3. a reliable estimate can be made of the amount of the obligation

If these conditions are not met, no provision shall be recognised.

A legal obligation is an obligation that could :

1. be contractual; or
2. arise due to a legislation; or
3. result from other operation of law

A constructive obligation, however, is an obligation that results from an entity’s actions where :

1. by an established pattern of past practice, published policies, or a sufficiently specific current statement, the entity has indicated to other (third) parties that it will accept certain responsibilities; and
2. as a result, the entity has created a valid expectation in the minds of those parties that it will discharge those responsibilities.

In a general sense, all provisions are contingent because they are uncertain in timing or amount. However, within the scope of IAS 37 the term ‘contingent’ is used for liabilities and assets that are not recognised because their existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity (HRD).

Capitalisation of Exchange Differences, permissible or not ?

IAS 21, The Effect of Changes in Foreign Exchange Rates requires recognition of foreign exchange differences as income or expense in the period in which they arise.

Previously, there had been an allowed alternative treatment for certain losses incurred due to effects of exchange rate changes in foreign-denominated obligations associated with asset acquisition. This allowed alternative treatment resulted in capitalization of the loss.

Revised IAS 21 removes the limited option in the previous version of IAS 21 to capitalise exchange differences resulting from a severe devaluation or depreciation of a currency against which there is no means of hedging. Under IAS 21, such exchange differences are now recognised in profit or loss. Consequently, SIC-11, which outlined restricted circumstances in which such exchange differences may be capitalised, has been superseded since capitalisation of such exchange differences is no longer permitted in any circumstances (IAS 21 Paragraph IN10).

Following are further explanation to removed the previously allowed alternative treatment of capitalisation of exchange differences as stated in Basic for Conclusions on IAS 21 :

BC24 - The previous version of IAS 21 allowed a limited choice of accounting for exchange differences that arise ‘from a severe devaluation or depreciation of a currency against which there is no practical means of hedging and that effects liabilities which cannot be settled and which arise directly on the recent acquisition of an asset’. The benchmark treatment was to recognise such exchange differences in profit or loss. The allowed alternative was to recognise them as an asset.

BC25 – The Board noted that the allowed alternative (of recognition as an asset) was not in accordance with the Framework for the Preparation and Presentation of Financial Statements because exchange losses do not meet the definition of an asset. Moreover, recognition of exchange losses as an asset is neither allowed nor required by any liaison standard-setter, so its deletion would improve convergence. Finally, in many cases when the conditions for recognition as an asset are met, the asset would be restated in accordance with IAS 29 Financial Reporting in Hyperinflationary Economies. Thus, to the extent that an exchange loss reflects hyperinflation, this effect is taken into account by IAS 29. For all of these reasons, the Board removed the allowed alternative treatment and the related SIC Interpretation is superseded.

WATCH OUT!

According to IAS 23, Borrowing Costs, an entity shall capitalise borrowing costs that are directly attributable to the acquisition, construction or production of a qualifying asset as part of the cost of that asset. Borrowing costs may include exchange differences arising from foreign currency borrowings to the extent that they are regarded as an adjustment to interest costs.

The above image was taken from : Microsoft Office Website

The Concept of Significant Influence

Based on IAS 24 : Related Party Disclosures, entities are considered to be related parties when one of them either :

1. has the ability to control the other entity
2. can exercise significant influence over the other entity in making financial and operating decisions
3. has joint control over the other
4. is a joint venture in which the other entity is a joint venturer
5. functions as key management personnel of the other entity
6. is a close family member of any individual having the ability to control or influence the entity or is a key management member thereof

Significant Influence

The existence of the ability to exercise significant influence is an important concept in relation to this standard. It is one of the two criteria stipulated in the definition of a related party, which when present would, for the purposes of this standard, make one party related to another. In other words, for the purposes of this standard, if one party is considered to have the ability to exercise significant influence over another, then the two parties are considered to be related.

The existence of the ability to exercise significant influence may be evidenced in one or more of the following ways :

1. By representation on the board of directors of the other entity;
2. By participation in the policy-making process of the other entity;
3. By having material intercompany transactions between two entities;
4. By interchange of managerial personnel between two entities; or
5. By dependence on another entity for technical information

Significant influence may be gained through agreement, by statute, or by means of share ownership. Under the provisions of IAS 24, similar to the presumption of significant influence under IAS 28, an entity is deemed to possess the ability to exercise significant influence if it directly or indirectly through subsidiaries  holds 20% or more of the voting power of another entity (unless it can be clearly demonstrated that despite holding such voting power the investor does not have the ability to exercise significant influence over the investee).

Conversely, if an entity, directly or indirectly through subsidiaries, owns less than 20% of the voting power of another entity, it is presumed that the investor does not possess the ability to exercise significant influence (unless it can be clearly demonstrated that the investor does have such an ability despite holding less than 20% of the voting power).

Further, while explaining the concept of significant influence, IAS 28 also clarifies that “a substantial or majority ownership by another investor does not necessarily preclude an investor from having significant influence” (emphasis added).

Source of this article : WILEY – 2010 Interpretation and Application of International Financial Reporting Standards, by Barry J.Epstein and Eva K.Jermakowicz

Purpose of Related Party Disclosures

IAS 24 : Related Party Disclosures defines a related party as a person or entity that is related to the entity that is preparing its financial statements (reporting entity).

(a) A person or a close member of that person’s family is related to a reporting entity if that person :

1. has control or joint control over the reporting entity;
2. has significant influence over the reporting entity; or
3. is a member of the key management personnel of the reporting entity or of a parent of the reporting entity

(b) An entity is related to a reporting entity if any of the following conditions applies:

1. The entity and the reporting entity are members of the same group (which means that each parent, subsidiary and fellow subsidiary is related to the others)
2. One entity is an associate or joint venture of the other entity (or an associate or joint venture of a member of a group of which the other entity is a member)
3. Both entities are joint ventures of the same third party
4. One entity is a joint venture of a third entity and the other entity is an associate of the third entity
5. The entity is a post-employment benefit plan for the benefit of employees of either the reporting entity or an entity related to the reporting entity. If the reporting entity is itself such a plan, the sponsoring employers are also related to the reporting entity
6. The entity is controlled or jointly controlled by a person identified in (a)
7. A person identified in (a)(1) has significant influence over the entity or is a member of the key management personnel of the entity (or of a parent of the entity).

Related party relationships are a normal feature of commerce and business. For example, entities frequently carry on parts of their activities through subsidiaries, joint ventures and associates. In those circumstances, the entity has the ability to affect the financial and operating policies of the investee through the presence of control, joint control or significant influence.

A related party relationship could have an effect on the profit or loss and financial position of an entity. Related parties may enter into transactions that unrelated parties would not. For example, an entity that sells goods to its parent at cost might not sell on those terms to another customer. Also, transactions between related parties may not be made at the same amounts as between unrelated parties.

The profit or loss and financial position of an entity may be affected by a related party relationship even if related party transactions do not occur. The mere existence of the relationship may be sufficient to affect the transactions of the entity with other parties. For example, a subsidiary may terminate relations with a trading partner on acquisition by the parent of a fellow subsidiary engaged in the same activity as the former trading partner. Alternatively, one party may refrain from acting because of the significant influence of another – for example, a subsidiary may be instructed by its parent not to engage in research and development.

For these reasons, knowledge of an entity’s transactions, outstanding balances, including commitments, and relationships with related parties may affect assessments of its operations by users of financial statements, including assessments of the risks and opportunities facing the entity (Hrd).

The latest update of Financial Instruments, Insurance Contracts, Leases and Revenue Recognition discussions

Following is the report from IASB latest meeting on 12 April to 15 April, 2011 which was dropped into my inbox mail on April 20, 2011.

The IASB met in London from Tuesday 12 April to Friday 15 April. The sessions on Tuesday and Wednesday and on Thursday morning were held jointly with the US-based FASB.

The joint discussions focused on four projects: revenue recognition, leases, insurance contracts, and impairment of financial assets. The IASB-only sessions focused on hedge accounting (which the FASB joined by video) and an update of activities of the IFRS Interpretations Committee.

The boards discussed uncertain consideration in relation to revenue recognition and leases. The revenue recognition sessions also focused on allocating the transaction price, licences and rights to use, fulfilment costs, and sale and repurchase agreements. The leases sessions also focused on the definition of a lease and whether there should be one or two accounting approaches for leases.

The session on insurance focused on the use of a 'top-down approach' to determine a discount rate.

The impairment sessions included consideration of feedback from the outreach activities and comment letters on the joint supplementary document Financial Instruments: Impairment, interest income recognition and the definition of amortised cost and whether to discount a loss estimate.

In the sessions on hedge accounting the IASB began its redeliberations on the exposure draft Hedge Accounting and discussed the objective of hedge accounting and accounting for 'funding swaps', designating risk components of financial instruments that bear interest below a benchmark rate (the 'sub-LIBOR' issue), the eligibility of non-derivative financial instruments as hedging instruments (including the interaction with the fair value option) and macro hedge accounting.

During board week Sir David Tweedie, Chairman of the IASB, and Leslie Seidman, Chairman of the FASB, recorded an interview in which they review the achievements of the convergence programme so far and the time line for completing the remaining elements of the programme. To listen to the interview and read a transcript, please click here : Interview with Sir David Tweedie and Leslie Seidman regarding the timeline for completing the convergence programme

The topics discussed at the joint IASB/FASB board meeting were:

• Financial instruments: impairment
• Insurance contracts
• Leases
• Revenue recognition

The topics discussed at the IASB Board meeting were:

• Financial instruments: hedge accounting
• IFRS Interpretations Committee - update from last meeting

Using the With-and-without Method in Presenting the Compound Instruments in the Financial Statements

Sometimes issued nonderivative financial instruments contain both liability and equity elements. In other words, one component of the instruments meets the definition of a financial liability and another component of the instrument meets the definition of an equity instrument. Such instruments are referred to as compound instruments.

A common form of compound financial instrument is a debt instrument with an embedded conversion option, such as a bond convertible into ordinary shares of the issuer, and without any other embedded derivative features.

Para. 28 of IAS 32 Financial Instruments : Presentation states that the issuer of a non-derivative financial instrument shall evaluate the terms of the financial instrument to determine whether it contains both a liability and an equity component. Such components shall be classified separately as financial liabilities, financial assets or equity instruments, as follows :

1. The issuer’s obligation to make scheduled payments of interest and principal is a financial liability that exists as long as the instrument is not converted. On initial recognition, the fair value of the liability component is the present value of the contractually determined stream of future cash flows discounted at the rate of interest applied at the time by the market to instruments of comparable credit status and providing substantially the same cash flows, on the same terms, but without the conversion option.
2. The equity instrument is an embedded option to convert the liability into equity of the issuer. The fair value of the option comprises its time value and its intrinsic value, if any. This option has value on initial recognition even when it is out of the money.

How to recognize the initial carrying amounts of the liability and equity components of the compound instrument ?

As stated in the : IFRS – Practical Implementation Guide and Workbook, by Abbas Ali Mirza, Magnus Orrell and Graham J.Holt, to determine the initial carrying amounts of the liability and equity components, entities apply the so-called with-and-without method. The fair value of the instrument is determined first including the equity component. The fair value of the instrument as a whole generally equals the proceeds (consideration) received in issuing the instrument. The liability component is then measured separately without the equity component. The equity component is assigned the residual amount after deducting from the fair value of the compound instrument as a whole the amount separately determined for the liability component.

Example :

Entity A issues a bond with a principal amount of $100,000. The holder of the bond has the right to convert the bond into ordinary shares of Entity A. On issuance, Entity A receives proceeds of $100,000. By discounting the principal and interest cash flows of the bond using interest rates for similar bonds without an equity component, Entity A determines that the fair value of a similar bond without any equity component would have been $91,000. Therefore, the initial carrying amount of the liability component is $91,000. The initial carrying amount of the equity component is computed as the difference between the total proceeds (fair value) of $100,000 and the initial carrying amount of the liability component of $91,000. Thus the initial carrying amount of the equity component is $90,000. Entity A makes this journal entry :

Cash	100,000
Financial Liability		91,000
Equity		9,000

Source of this article :

1. IFRS – Practical Implementation Guide and Workbook, by Abbas Ali Mirza, Magnus Orrell and Graham J.Holt (2nd Edition)
2. IAS 32 Financial Instruments : Presentation

A Practical Guide to New IFRSs 2011 (PwC IFRS Publications)

In March 2011, one of the Big 4 accounting firm PricewaterhouseCoopers published its IFRS implementation guidance “A Practical Guide to New IFRSs for 2011”.

Within the 24-page guide book in Q & A format, it provides a high-level outline of the key requirements of new IFRS standards and interpretations that come into effect in 2011. Significant changes to IFRS are due to be published in 2011, but there is a relatively small number of changes that come into effect for 2011 year ends.

One of the significant changes was the IFRS 9, Financial Instruments which was reissued in 2010 to include guidance on financial liabilities and derecognition of financial instruments. This material was relocated from IAS 39, Financial Instruments : Recognition and Measurement, without change, except for financial liabilities that are designated at fair value through profit or loss. The rules on the classification and measurement of financial assets were previously published in the earlier version of IFRS 9. The standard is being added to as the IASB endorses different phases of the project to replace IAS 39. The reissued IFRS 9 applies to 2013 year ends but can be adopted with immediate effect.

Another changes was regarding IFRIC 19, Extinguishing Financial Liabilities with Equity Instruments which comes into effect in 2011.

Two further amendments that have effective dates in 2010 and will impact 2011 year ends. Amendments to IAS 32, Financial Instruments : Presentation, on classification of right issues and amendment to IFRS 1, First-time Adoption of IFRS, on financial instrument disclosures. Amendments that apply from 1 January 2011 include an amendment to IAS 24, Related Party Disclosures, and an amendment to IFRIC 14, IAS 19 – The limit on a defined benefit asset, minimum funding requirements and their interaction.

Download the publication directly from here : A Practical Guide to New IFRSs for 2011

Considering an entity’s Functional Currency

When a reporting entity prepares financial statements, IAS 21, The Effects of Changes in Foreign Exchange Rates, requires each individual entity included in the reporting entity – whether it is a stand-alone entity, an entity with foreign operations (such as a parent) or a foreign operation (such as a subsidiary or branch) – to determine its functional currency and measure its results and financial position in that currency.

The concept of functional currency is key to understanding translation of foreign currency financial statements.

Functional currency is defined as being the currency of the primary economic environment in which an entity operates. This is normally, but not necessarily, the currency in which that entity principally generates and expends cash.

An entity considers the following factors in determining its functional currency :

1. the currency 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
2. the currency of the country whose competitive forces and regulations mainly determine the sales prices of its goods and services
3. the currency that mainly influences labor, material and other costs of providing goods or services (this will often be the currency in which such costs are denominated and settled
4. the currency in which funds from financing activities (ie issuing debt and equity instruments) are generated
5. the currency in which receipts from operating activities are usually retained

The first three items are generally considered to be the most influential in deciding the functional currency.

The entity’s functional currency reflects the underlying transactions, events, and conditions under which the entity conducts its business. Accordingly, once determined, the functional currency is not changed unless there is a change in those underlying transactions, events and conditions.

If the functional currency is the currency of a hyperinflationary economy, the entity’s financial statements are restated in accordance with IAS 29, Financial Reporting in Hyperinflationary Economies.

Where there is a change in the functional currency, it should be applied from the date of change. A change must be linked to a change in the nature of the underlying transactions. For example, a change in the major market may lead to a change in the currency that influences sales prices. The change is accounted for prospectively, not retrospectively (HRD).

The Objective and Scope of IAS 21

OBJECTIVES - The purpose of IAS 21, The Effects of Changes in Foreign Exchange Rates, is to set out how to account for transactions in foreign currencies and foreign operations. The Standard also shows how to translate financial statements into a presentation currency. The presentation currency is the currency in which the financial statements are presented. The key issues are the exchange rate(s) that should be used and where the effects of changes in exchange rates are reported in the financial statements.

SCOPE – As stated in paragraph 3 of IAS 21, the Standard shall be applied :

(a) in accounting for transactions and balances in foreign currencies, except for those derivative transactions and balances that are within the scope of IAS 39, Financial Instruments : Recognition and Measurement and IFRS 9, Financial Instruments;

(b) in translating the results and financial position of foreign operations that are included in the financial statements of the entity by consolidation, proportionate consolidation or the equity method; and

(c) in translating an entity’s results and financial position into a presentation currency.

Further, paragraph 4 of IAS 21 states that IFRS 9 and IAS 39 apply to many foreign currency derivatives and, accordingly, these are excluded from the scope of this Standard. However, those foreign currency derivatives that are not within the scope of IFRS 9 and IAS 39 (e.g., some foreign currency derivatives that are embedded in other contracts) are within the scope of this Standard.

In addition, this Standard applies when an entity translates amounts relating to derivatives from its functional currency to its presentation currency.

This Standard does not apply to hedge accounting for foreign currency items, including the hedging of a net investment in a foreign operation. IAS 39 applies to hedge accounting.

This Standard applies to the presentation of an entity’s financial statements in a foreign currency and sets out requirements for the resulting financial statements to be described as complying with IFRSs. For translations of financial information into a foreign currency that do not meet these requirements, this Standard specifies information to be disclosed.

This Standard does not apply to the presentation in a statement of cash flows of the cash flows arising from transactions in a foreign currency, or to the translation of cash flows of a foreign operation, which are within the scope of IAS 7, Statement of Cash Flows (Hrd).