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In December 2016, the IFRIC issued an interpretation that addresses the exchange rate to use in transactions that involve advance consideration paid or received in a foreign currency. This interpretation is effective 1 January 2018.
Many entities do business with overseas suppliers or customers, or have overseas operations. This gives rise to two main accounting issues:
- Some transactions (for example, those with overseas suppliers or customers) may be denominated in foreign currencies. These transactions are expressed in the entity's own currency ('functional currency') for financial reporting purposes.
- A parent entity may have foreign operations such as overseas subsidiaries, branches or associates. The functional currency of these foreign operations may be different to the parent entity’s functional currency and therefore the accounting records may be maintained in different currencies. Because it is not possible to combine transactions measured in different currencies, the foreign operation's results and financial position are translated into a single currency, namely that in which the group's consolidated financial statements are reported ('presentation currency').
The methods required for each of the above circumstances are summarised below.
Expressing foreign currency transactions in the entity's functional currency
A foreign currency transaction is expressed in an entity's functional currency using the exchange rate at the transaction date. Foreign currency balances representing cash or amounts to be received or paid in cash ('monetary items') are retranslated at the end of the reporting period using the exchange rate on that date. Exchange differences on such monetary items are recognised as income or expense for the period. Non-monetary balances that are not re-measured at fair value and are denominated in a foreign currency are expressed in the functional currency using the exchange rate at the transaction date. Where a non-monetary item is re-measured at fair value in the financial statements, the exchange rate at the date when fair value was determined is used.
Translating functional currency financial statements into a presentation currency
Assets and liabilities are translated from the functional currency to the presentation currency at the closing rate at the end of the reporting period. The income statement is translated at exchange rates at the dates of the transactions or at the average rate if that approximates the actual rates. All resulting exchange differences are recognised in other comprehensive income.
The financial statements of a foreign operation that has the currency of a hyper-inflationary economy as its functional currency are first restated in accordance with IAS 29, 'Financial reporting in hyper-inflationary economies'. All components are then translated to the presentation currency at the closing rate at the end of the reporting period.
Conventional financial reporting is distorted by inflation. This is especially the case with hyper-inflation where the measuring unit (the currency unit) is not stable. Adjustments to stabilise the unit of measurement – to measure items in units of constant purchasing power – make the financial statements more relevant and reliable. IAS 29 requires financial statements prepared in the currency of a hyper-inflationary economy to be stated in terms of the value of money at the end of the reporting period. This requirement needs an understanding of complex economic concepts, a knowledge of the entity’s financial and operating patterns and a detailed series of procedures.
Prices change over time as the result of political, economic and social factors. Two phenomena should be distinguished: (1) changes in supply and demand and technological changes may cause prices of individual items to increase or decrease independently of each other (‘specific price changes’); (2) other factors in the economy may result in changes in the general level of prices and therefore in the general purchasing power of money (‘general price changes’). The purchasing power of money declines as the level of prices of goods and services rises. The purchasing power of money in an inflationary environment and the price level are interdependent.
Financial statements unadjusted for inflation in most countries are prepared on the basis of historical cost without regard either to changes in the general level of prices or to changes in specific prices of assets held. However there are exceptions where the entity is required to, or chooses to, measure certain assets or liabilities at fair value. Examples are property, plant and equipment, which may be revalued to fair value under IAS 16 and biological assets, which are generally required to be measured at fair value by IAS 41. This produces a meaningful result provided that there are no dramatic changes in the purchasing power of money.
Significant changes in the purchasing power of money, particularly in a hyper-inflationary economy, mean that financial statements unadjusted for inflation are not useful and are likely to be misleading. Amounts are not comparable between periods or even within a period and the gain or loss in general purchasing power that arises in the reporting period is not recorded. Financial statements unadjusted for inflation do not properly reflect the company’s position at the end of the reporting period, the results of its operations or its cash flows. In a hyper-inflationary economy, financial statements, whether they are based on a historical cost approach or a current cost approach, are useful only if they are expressed in terms of the measuring unit current at the end of the reporting period.
Inflation-adjusted financial statements are an extension to, not a departure from, historical cost accounting. IAS 29 aims to overcome the limitations of historical cost financial reporting in hyper-inflationary environments, but it does not reflect specific price changes in assets and liabilities.