ACCA Paper P2 (HKG) Corporate Reporting- The Effects of changes in foreign exchange

rate 21 Sept 2012

Gary Leung

www.garyleung.hk

1ACCA P2 Dec 2012

Contents• Introduction

• Definitions

• Functional currency and presentation currency

• Reporting foreign currency transactions in the functional currency

– Exchange rates

– Exchanges difference

• Translation of financial statements

• Foreign subsidiaries and associates

– Translation process

– Consolidation process

• Disposal of Foreign Entity

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Introduction • The objective of HKAS 21 is to prescribe how to

include foreign currency transactions and foreign operations in the financial statements of an entity and how to translate financial statements into a presentation currency.

• The principal issues are which exchange rates to use and how to report the effects of changes in exchange rates in the financial statements.

• An entity may carry on foreign activities in 2 ways:– 1.It may have transactions (purchases, sales, loans) in

foreign currencies, and/or– 2.It may have foreign operations.

• HKAS 21 deals with both overseas transactions in individual companies and foreign entities in consolidated accounts.

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Key definitions• Functional currency is the currency of the primary

economic environment in which the entity operates.• Foreign currency is a currency other than the functional

currency of the entity.• Presentation currency is the currency in which the

financial statements are presented.• Foreign operation a subsidiary, associate, joint venture

or branch of a reporting entity, the activities of which are based or conducted in a country or currency other than those of the reporting entity.

• Spot exchange rate is the exchange rate for immediate delivery.

• Closing rate is the spot exchange rate at the balance sheet date.

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Key definitions• Net investment in a foreign operation is

the amount of the reporting entity’s interest in the net assets of that operation.

• Monetary items : units of currency held and assets and liabilities to be received or paid in a fixed or determinable number of units of currency

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Functional currency and presentation currency

• HKAS 21 permits entities to present their financial statements in any currency. This is because management may not use a single currency when controlling and monitoring the performance and financial position of a group. In addition, in some jurisdictions, entities are required to present their financial statements in the local currency, even when this is not the functional currency. Hence, if the Standard required the financial statements to be prepared in the functional currency, some entities would have to present two sets of financial statements.

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Functional currency and foreign currency

• An entity’s functional currency is:• (a) the currency:

– (i) that mainly influences sales prices for goods and services – this will often be the currency in which sales prices for its goods and services are denominated and settled – and

– (ii) of the country whose competitive forces and regulations mainly determine the sales price of its goods and services.

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

• These factors provide primary evidence and give the clearest indication of the functional currency of an entity.

• Secondary evidence is provided by the following factors:– (a) the currency in which funds from financing activities are generated.– (b) The currency in which receipts from operating activities are usually retained.

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Functional currency and foreign currency

• The following factors are also to be considered in determining the functional currency of a foreign operation and whether that currency is the same as the reporting entity:– Are they carried out as an extension of the reporting entity or does the

foreign operation carry out its activities with a significant degree of autonomy?

– Are transactions between the reporting entity and foreign operation a high percentage of total transactions?

– Do cash flows of the foreign operation directly affect the cash flows of the reporting entity and is cash available for remittance to the reporting entity?

– Is the foreign operation dependent upon the reporting entity to help service debt obligations, both existing and those of the future?

• If the functional currency is not obvious management must use their judgment in identifying the currency that most faithfully represents the economic effects of the underlying transactions.

• Once a functional currency has been identified it should only be changed if there is a change to the economic climate in which it was initially identified.

• If any changes, a entity has to translate all items into the new functional currency prospectively from the date of change. The exchange rate at the date of change will be used for this purpose. ACCA P2 Dec 2012 8

Illustration 1• Scenario A• ABC Ltd is a Hong Kong incorporated company. Most of its sales, purchases, and operating

expenses are transaction in Hong Kong dollars (HK$). • In this case, the functional currency for ABC is HK$.• Scenario B• QF Ltd is a Hong Kong-incorporated company. However, most of its sales and purchases

are done with foreign companies and are denominated in US Dollars (US$).• In this case, the functional currency for QF Ltd is US$.• Scenario C• XYZ Ltd is a Hong Kong-incorporated company. Since it purchase most of its inventories

from USA denominated in US$, it determines its sales prices based on US$ even though the sales prices are quoted in HK$. Also, it pays its top management in HK$, but the amount of the pay is based on the US$ equivalent paid to top management of a similar American company. Further, its bank borrowings are denominated in US$.

• In this case, the functional currency of XYZ Ltd is US$. • Scenario D• T Ltd is a Spanish entity. The currency that mainly influences its selling price for its goods

and services is EUR. The competitive forces and regulations of Spain mainly influence the pricing policy of T Ltd (i.e. EUR). T Ltd mainly pays for its labor in EUR but pays for the imports of raw materials and other materials in GBP which are 80% of its total expenses.

• In this case, the functional currency of T Ltd is EUR.

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Why important ?• Incorrectly determining the functional

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

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Illustration 2• On 1 November 2005, Entity A buys inventory for Euro 140,000.

The exchange rate on this date is GBP 1 = Euro 1.4. Cost in GBP is, therefore, GBP 100,000.

• At 30 November 2005, the payable is settled and the exchange rate is GBP 1 = Euro 1.5. The payment is settled at Euro 140,000 that is now equivalent to GBP 93,333.

• If the functional currency of Entity A was determined as GBP, a gain of GBP 6,666 will be taken to the income statement.

• If the functional currency of Entity A was determined as Euro, the payment – Euro 140,000 – has not changed in value and there is no gain or loss to be reported.

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Reporting foreign currency transactions in functional currency- relevant to individual companies

• Initial Recognition– A foreign currency transaction is a transaction that is denominated or

requires settlement in a foreign currency. It should be recorded, on initial recognition in the functional currency, at the spot rate on the transaction date.

• At subsequent reporting period –subsequent recognition – At each balance sheet date foreign currency monetary items should

be translated using the closing rate. Where this differs from the rate used for initial recognition, an exchange difference will arise.• Examples of monetary items

– Cash and bank balance, trade payable and receivable, Loan receivable and payable

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Reporting foreign currency transactions in functional currency- relevant to individual companies

– Non-monetary items that are measured at cost in a foreign currency should be translated at the rate on the transaction date i.e. non-monetary items are not retranslated.• Examples of non-monetary items

– Non-current assets, Inventories, Goodwill , Intangible assets, Provisions that are settled by delivering a non-monetary asset.

– Non-monetary items that are measured at fair value in a foreign currency should be translated at the rate when the fair value was determined.

• At settlement– Exchange differences arising on settlement of a foreign currency

transaction in the same reporting period shall be recognised in profit or loss for the period.

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Reporting foreign currency transactions in functional currency- relevant to individual companies

• Exchange differences– arising on the settlement of monetary items, or on translating

monetary items at rates different from those at which they were translated on initial recognition, should be recognised in profit or loss in the period in which they arise.

• However, when borrowing costs are capitalized according to the HKAS 23, then any exchange differences are also capitalized and not recognized in the income statements.

• If gain or loss on non- monetary items is recognized directly in equity via OCI (e.g. some gains or losses arising on a revaluation of PPE), then, exchange component of that gain or loss is recognized directly in equity.

• If gain or loss on non- monetary items is recognized directly in Income statement (e.g. FI valued at FVTPL), then, exchange component of that gain or loss is recognized directly in income statement.

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-Transaction during the year-Actual exchange rate at the date of transaction (Historic rate) or average rate if no significant fluctuation

Balance at year end

Transactions settled during

year

Exchange differences will arise at year end

Exchange differences will

arise during year

All exchange (settled or unsettled transactions)

differences go through P&L

Non Monetary

items

Translate at the year end using the closing rate

No exchange difference

arises

Monetary items

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Illustration 3• A Ltd (functional currency is $) has a year end of 31 December

2011. On 25 October 2011 Aston buys goods from a Mexican supplier for Peso 286,000.

• The goods remain in inventory at the year end.• Exchange rates• 25 October 2011 $1:Peso 11.16• 16 November 2011 $1:Peso 10.87• 31 December 2011 $1:Peso 11.02• Required:• Show the accounting entries for the transactions in each of the

following situations:• (a) on 16 November 2011 Aston pays the Mexican supplier in

full;• (b) the supplier remains unpaid at the year end.

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Illustration 3 • (a) Supplier paid• $ $• 25 October 2008 Dr Purchases (W1) 25,627• Cr Trade payables 25,627• 16 November 2008 Dr Trade payables 25,627• Dr Profit or loss – other operating expense 684• Cr Cash (W2) 26,311• The goods will remain in inventory at the year end at $25,627.• WORKINGS• (1) Peso 286,000 ÷ 11.16 = $25,627• (2) Peso 286,000 ÷ 10.87 = $26,311• (b) Year-end trade payable• 25 October 2008 Dr Purchases (W1) 25,627• Cr Trade payables 25,627• 31 December 2008 Dr Profit or loss– • other operating expense 326• Cr Trade payables (W2) 326• The goods will remain in stock at the year end at $25,627.• WORKINGS• (1) Peso 286,000 ÷ 11.16 25,627• (2) Peso 286,000 ÷ 11.02 25,953• 326 17ACCA P2 Dec 2012

Illustration 4• W Ltd (functional currency is USD) has a year end of

31 December 2011. On 29 November 2011 W Ltd received a loan from an Australian bank of AUD 1,520,000.

• The proceeds are used to finance in part the purchase of a new office block.

• The loan remains unsettled at the year-end.• Exchange rates• 29 November 2011 USD 1 = AUD 1.52• 31 December 2011 USD 1 = AUD 1.66• Required:• Show the accounting entries for these transactions.

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Illustration 4 • US $000 US $000• 29 November 2011 Dr Cash 1,000• Cr Loan 1,000• 31 December 2011 Dr Loan 84• Cr Profit or loss 84• WORKINGS• US $000• (1) AUD 1,520,000 ÷ 1.52 1,000• (2) AUD 1,520,000 ÷ 1.66 916• ____• 84• ____

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Net investment in a foreign operation

• An entity may have a monetary item that is receivable from or payable to a foreign operation.

• Such monetary items where settlement is neither planned nor likely to occur in the foreseeable future is in substance part of a “ net investment in the operation” (Note : these items do not include trade receivables and trade payables, including long-term receivables or loan ).

• Exchange differences on such items shall be included in profit or loss in the separate financial statements of the reporting entity or foreign operation.

• In the consolidated financial statements these exchange differences shall be included in other comprehensive income and reclassified through profit or loss on disposal of the Investment.

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Illustration 5

• ABC Ltd, a Hong Kong incorporated company, has a subsidiary, namely SG Ltd which is incorporated in Singapore.

• ABC Ltd extends a loan to SG Ltd, and that the settlement of the loan is neither planned nor likely to occur in the foreseeable future. In this case, the loan is , in substance, an extension of ABC Ltd’s net investment in SG Ltd.

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Translation of financial statements

• Under HKAS 21, there are two scenarios where translation of financial statements is necessary:– Where the presentation currency is not the same as

its functional currency; and– Where, for the purpose of presentation of the

consolidated financial statements, the presentation currency of the subsidiaries and associates are not the same as that of the parent.

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Translation of financial statements

• The financial statements of a foreign operation shall be translated into the presentation currency of the parent entity.

• HKAS 21 requires only the use of closing rate method.

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Reporting foreign currency transactions in functional currency- relevant to consolidated companies (closing rate

method) • When a group contains individual entities with different functional

currencies, the results and financial position of each entity are expressed in a common currency so that consolidated financial statements may be presented.1. Assets and liabilities should be translated at the closing rate.2. Income and expenses should be translated at exchange rates at the dates of

the transactions. For practical reasons, an average rate may be used. This will also apply to any consolidation adjustments to those income and expenses. E.g. additional deprecation on the fair value adjustments, impairment losses ..etc.

3. The group exchange difference is recognized in equity ( and so will appear in the other comprehensive income section of the statement of comprehensive income) and will be apportioned between the parent and the NCI.

4. The exchange difference should be classified through profit or loss when the foreign operation is disposed. The non-controlling share will be included within non-controlling interest in the consolidated statement of financial position.

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Reporting foreign currency transactions in functional currency- relevant to consolidated companies

• 5. Exchange differences are not recognized in profit or loss as changes in exchange rates have little or no direct effect on the present and future cash flows from operations.

• 6. Any goodwill arising on the acquisition of a foreign operation and any fair value adjustments arising on acquisition should be treated as assets and liabilities of the foreign operation. Therefore, they should be expressed in the functional currency of the foreign operation and should be translated at the closing rate.

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Goodwill • Goodwill arising on the acquisition of a foreign entity and any

fair value adjustments to the carrying amounts of assets and liabilities arising on the acquisition of that foreign entity are treated as assets and liabilities of the foreign operation and translated at the closing rate. This would require the recognition of goodwill in the investee’s own accounts. This may mean that the level to which goodwill is allocated for foreign currency purposes is different to that at which it is annually tested at for impairment purposes.

• This treatment of goodwill will give rise to a further exchange difference, which should be reported within other comprehensive income.

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Foreign subsidiaries and Associates • There are several additional issues involved in the

translation of financial statements of foreign subsidiaries and associates for the purpose of preparing consolidated financial statements.– Share capital and Pre-acquisition reserve: should be translated

using the historical exchange rate prevailing at the date when the parent acquired the shareholdings.

– Goodwill arising from the acquisition shall be translated using closing rate.

– Post –acquisition reserve : involves the application of the various exchange rates prevailing in the past years to the past year’s profits. In addition, the translation differences for each of the prior years have to be calculated and added hereto.

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Illustration 6 • ABC Ltd has one subsidiary company in overseas. The summarised

accounts for the year ended 31 May 2011 for the four companies operating in the same business field, are shown below.

• ABC Fast• $’000 FF’000• Tangible non-current assets (net) 17,029 16,640• Trade investments 3,650 0• Share in Fast 1,200 0• Current assets 10,239 9,002• Creditors (5,662) (9,442) • Deferred taxation (4,500) 0 • 21,956 16,200 • Ordinary share capital ($1/FF1) 10,000 8,000• Retained profits 11,956 8,200

21,956 16,200

• Retained profits at 31 May 20109,250 6,550

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Illustration 6

• Further information is provided as follows:• ABC Ltd acquired 5 million ordinary shares of this

company on 1 June 2009 when the profits of the company were FF1,750,000. The shares cost $1,200,000 and the exchange rate FF to the $ on this date was FF12.5=$1. The profits of Fast Ltd had increased to FF6,550,000 on 31 May 2010.

• 1. Rates of exchange FF to the $ were:– Average for the year 31 May 2010 FF11.75 = $1– On 31 May 2010 FF11= $1

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Illustration 6

• During 2010/2011, exchange rates were:• Average for the year 31 May 2011 FF10.3 = $1• On 31 May 2011FF9.7= $1

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Illustration 6• 2. The net assets of the subsidiary are to be

translated for the purpose of the consolidation applying the requirements of HKAS 21. The functional currency of the overseas operation is its own currency, FF.

• 3. Goodwill is capitalised at acquisition, and, for the overseas operation, is to be carried under the requirements of HKAS 21. Since acquisition, goodwill has been impaired, up to 31 May 2011, as follows:– 1/6, per annum, of the total goodwill paid for Fast Ltd

• 4. The NCI is valued using the proportion of net assets method.

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Illustration 6• Required• Prepare a consolidated balance sheet for ABC

Ltd, its subsidiary at 31 May 2011.

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Illustration 6• (i) Translation of net assets of Fast Ltd • FF’000 $000• Tangible non-current assets 16,640 9.7 1,715• Current assets 9,002 9.7 928

• Creditors (9,442) 9.7 (973)• 16,200 1,670• Ordinary share capital 8,000 12.5 640• Profits at acquisition 1,750 12.5 140

Post acq. profits 4800 11.75 409 • Exchange difference 2010 0 Bal. 134• Net assets b/f 1 June 2010 14,550 11 1,323• Profit for the year ended 31 May 2011• (8,200-6,550) 1,650 10.3 160• Exchange difference 2011 0 Bal. 187• 16,200 1,670

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Illustration 6

• Goodwill on acquisition $ $• Fast – Cost 1,200• NCI 292• (8,000 + 1,750)/12.5 X 37.5% • Less (780) 712• (8,000/12.5 +1,750/12.5) Goodwill is to carried

at closing rate.• The carrying value for the Consolidated balance

sheet is (see below) 612

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Illustration 6• Goodwill for Fast must be at the closing rate. Set up your

working schedule as follows:• FF000 Rate $000• At acquisition (712 x 12.5) 8,900 12.5 712• Impairment – y/e 31.5.2010 – 1/6 (1,483) 11.75 (126)

Exchange difference - Bal. 88• At 31.5.2010 7,417 11 674• Impairment – y/e 31.5.2011 – 1/6 (1,483) 10.3 (144)

Exchange difference - Bal. 82• At 31.5.2011 5,834 9.7 612

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Illustration 6• Consolidated Statement of financial position at 31 May 2011•

$’000• Goodwill 612 • Tangible non-current 17,029+1,715 18,744• Non-current asset investments- trade 3,650• Current Assets ( 10,239+928) 11,167• Creditors ( 5662+ 973) (6,635)• Deferred tax (4,500) • 23,038

• Ordinary share capital 10,000• Consolidated reserves – balancing item 12,412• NCI (37.5% X 1,670) 626• 23,038 •

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Illustration 6• (iv) Consolidated profits•

$’000

• Retained profits – ABC Ltd 11,956• Retained profit – Fast Ltd (160+409)X62.5% 356• *Exchange difference reserve 62.5% x 321 200 • *Add: Exchange gains on goodwill(88 + 82) 170• Less: impairment of goodwill (270)• 12,412 • * shown under other comprehensive income.

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Non-controlling Interest• Partial Goodwill method– The non-controlling interest in other comprehensive

income will include their share of exchange differences on translating the subsidiary but will exclude exchange differences arising on retranslating goodwill.

• Full Goodwill method– The non-controlling interest in other comprehensive

income will include their share of exchange differences on translating the subsidiary and will also include exchange differences arising on retranslating goodwill

ACCA P2 Dec 2012 38

Exchange differences at the group accounts stage

• The exchange difference in the group accounts arises on the retranslation of the subsidiary’s – Opening net assets– Profit for the year – Goodwill

• The whole of the group exchange difference will be recognized in the other comprehensive income with the NCI element being reported separately.

• The parent’s share of the exchange difference will be taken to a foreign currency reserve.

• The parent and the NCI share the exchange difference arising on the net assets and profit in their normal proportion, but this will not necessarily apply to gross goodwill as the NCI attributable to gross goodwill is usually in a different proportion.

ACCA P2 Dec 2012 39

Calculation of exchange difference• Total Parent NCI• Opening net assets @ (opening rate) = X• Opening net assets @ (closing rate) = (X)• Difference (P and NCI :based on % of share holdings) X X X• Retained profit• as per the P&L (Average rate) X• as per the NA (Closing rate) (X) • Difference (P and NCI :based on % of share holdings) X X X• Goodwill attributable to the parent

– @ last year’s closing rate X – @ this year closing rate (X) X X

• Goodwill attributable to the NCI– @ last year’s closing rate X – @ this year closing rate (X) X X

• Total X X X

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Disposal of foreign operation• If there is a change (reduction) in the parent’s ownership interest in a

foreign subsidiary that does not result in a loss of control, the change is accounted for an equity transaction. The entity shall reattribute the proportionate share of the cumulative exchange differences recognized in other comprehensive income to the non controlling interests in that foreign operation.

• If, however, the parent loses control of a subsidiary, the parent reclassifies from the equity to profit or loss, as a reclassification adjustment, the parent’s share of the exchange differences previously recognized in other comprehensive income. It can be explained that the disposal of subsidiary has caused the balance on the group exchange difference to become realized and so the balance is recycled to the income statement as part of the gain to the group on disposal.

• When income previously recognized as OCI is reclassified as a gain or loss to profit or loss as a re-classification adjustment, there must bean offsetting loss or gain in OCI, to avoid double-counting of the gain (or loss).

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Illustration 7• A parent company T Ltd is selling all of its holding in a subsidiary for $100 m

when the net assets, the goodwill $20 m, the NCI $10 m and the cumulative gains in the foreign currency exchange reserve $6 m.

• The gain to the group on disposal would be calculated as follows:-• $m • Sales proceeds 100• Less: Net assets (25)• Less: Goodwill (20)• Plus: NCI 10• Plus: fair value of any residual holdings 0• Plus: Exchange gain 6• Gain to the group 71• The company should recognize $71m in profit or loss accounts.• In other comprehensive income, negative income of $6 million should be

recognized, to avoid double counting of the income previously recognized as OCI but now reclassified in profit or loss.

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Do not change in control • If a sale of a portion of an ownership interest in a

controlling investment in a foreign subsidiary does not result in a change in control, a proportionate share of the cumulative amount of the exchange difference recognized in other comprehensive income should be reattributed to the NCI in that foreign operation.

• For example, if a parent entity sells a 30% interest in a foreign subsidiary while maintaining control, only the proportionate share (30%) is reallocated to the NCI from the parent’s accumulated OCI.

ACCA P2 Dec 2012 43