The foreign exchange market can be affected by many factors. In countries with a floating exchange rate, their foreign exchange rates are exposed to volatility due to the effects of the different factors. Read on to find out more…
Accounting standards are a set of written statements and principles that define accounting practices. They are issued by authorised institutions of the accounting profession across the world.
The IAS-21 standard outlines how to account for foreign currency transactions and operations in financial statements and also how to translate financial statements into a presentation currency.
Let’s look at the IAS-21 standard, what it means and how it applies to your company.
Basic Steps of Foreign Currency Translation
As a company, you must determine a functional currency based on the primary economic environment in which you operate and generally record foreign currency transactions using the spot conversion rate to that functional currency on the date of the transaction.
There are a number of steps to be followed when translating foreign currency amounts into your functional currency. These are:
- The reporting entity determines its functional currency
- The reporting entity then translates all foreign currency items into the functional currency.
- The reporting entity must then report the effects of the translation – this includes the reporting of foreign currency transactions in the functional currency and reporting the tax effects of exchange differences.
Foreign currency transactions
A foreign currency transaction should be recorded at the exchange rate on the date of transaction; averages are permitted if they are a reasonable approximation.
At the subsequent balance sheet dates:
- Foreign currency amounts should be recorded at the closing rate
- Non-monetary items carried at historical cost should use the rate at the date of the transaction
- Non-monetary items carried at fair value should use the rate that existed when the fair values were determined
Exchange differences due to translation must be recorded in the profit and loss for the period, although exceptions exist around investment in foreign operations. In order to reduce the impact on the profit and loss account, many companies use hedging as a way to minimise foreign exchange risk.
Two common contracts used are forward contracts and options.
- A forward contract will lock in an exchange rate today at which the currency transaction will occur at a future date.
- An option sets an exchange rate at which the company may choose to exchange currencies. If the current exchange rate is more favourable, then the company will not exercise this option.
The main difference between these methods is who derives the benefit of a favourable movement in the exchange rate.
With a forward contract, the other party derives the benefit, while with an option, the company retains the benefit by choosing not to exercise the option if the exchange rate moves in its favour.
We hope this article gives you an overview of IAS-21 and its relevance to your company.