FRS 102: Foreign currency

Foreign currency issues are dealt with in FRS 102 at Section 30 Foreign Currency Translation. The Scope section of Section 30 recognises that an entity can conduct foreign activities in three ways:

• Undertaking transactions in foreign currencies;
• Possess foreign operations; or
• Present its financial statements in a foreign currency.

For the purposes of Section 30, a ‘foreign operation’ is an entity that is 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.

Functional currency

Reporting entities are required to identify their ‘functional currency’. Paragraph 30.2 says that an entity’s functional currency is the currency of the primary economic environment in which the entity operates. For example, the functional currency of a company based in the UK will be pound sterling. For clarity, paragraph 30.3 outlines some important factors when considering the functional currency of an entity, it says:

‘The primary economic environment in which an entity operates is normally the one in which it primarily generates and expends cash. Therefore, the following are the most important factors an entity considers in determining its functional currency:

• 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
  • of the country whose competitive forces and regulations mainly determine the sales prices of its goods and services; and
• 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).’

In addition, the currency in which funds from financing activities are generated will also have a bearing on an entity’s functional currency as well as the currency in which receipts from operating activities (the day-to-day, revenue-producing activities of the entity) are usually retained. A change in functional currency can only take place if there is a change to the underlying transactions, events and conditions which are pertinent to the entity. This could arise, for example, where there is a change of currency (for example if the UK decided to adopt the Euro).

In a group situation, it is not uncommon for a foreign subsidiary to be a member of a group and paragraph 30.5 outlines various additional factors that are to be considered in determining the functional currency of a foreign operation which will then lead to the conclusion as to whether the functional currency is the same as that of the parent:

1. Whether the activities of the foreign operation are carried out as an extension of the reporting entity, rather than being carried out with a significant degree of autonomy.
2. Whether transactions with the reporting entity are a high or a low proportion of the foreign operation’s activities.
3. Whether cash flows from the activities of the foreign operation directly affect the cash flows of the reporting entity and are readily available for remittance to it.
4. Whether cash flows from the activities of the foreign operation are sufficient to service existing and normally expected debt obligations without funds being made available by the reporting entity.

Accounting for individual foreign currency transactions

A company may enter into a foreign exchange transaction with an overseas supplier whereby the transaction will be denominated in a foreign currency and will be settled in a foreign currency. Examples include:

• Purchase or sale of goods or services whose price is denominated in a foreign currency;
• Borrowing or lending of funds when the amounts payable or receivable are denominated in a foreign currency; and
• Acquisition or disposal of assets, or incurring or settling of liabilities, denominated in a foreign currency.

On initial recognition, the transaction is accounted for using the rate of exchange prevailing on the date of the transaction. This applies whether or not the transaction is covered by a forward foreign currency contract (which is different than the choice offered in SSAP 20 at paragraph 46 where an entity can record the transaction at the rate of exchange on the date of the transaction or the rate specified in the contract).

Example – purchase of goods from an overseas supplier

A company based in the UK buys a batch of chemicals from its supplier based in Austria. The cost of the chemicals is €180,000 and the spot rate on the date of the transaction is £1 = €1.45. The company does not have credit facilities with this supplier.

The invoice will be translated into sterling at the exchange rate prevailing at the date of the transaction, i.e. £124,138 (€180,000 ÷ 1.45) and this is the amount that will be recorded in the supplier’s purchase ledger.

It may be the case that payment is made in accordance with agreed credit terms and, using the example above, if it is assumed that the company has a four-week credit period and settles the invoice on time, but the exchange rate has moved to £1 = €1.65 there will be an exchange difference of £15,047 ((€180,000 ÷ 1.65) – £124,138). This has arisen because the exchange rate has moved from the date the transaction was entered into to the date the transaction was settled and the £15,047 would be recognised as a gain on exchange in profit or loss.

Note: if the payment was made AFTER the year-end, the gain would be recorded in the subsequent year’s financial statements. No exchange rate differences are accrued or prepaid which relate to settlement of foreign currency transactions after the reporting date.

Net investment in a foreign operation

Reporting entities could have a monetary item that is receivable from, or payable to, a foreign operation. If the settlement of such amounts is not planned or likely to occur in the foreseeable future, such transactions will form part of an entity’s net investment in that foreign operation. Please note, such monetary items may include long-term debtors or loans but they DO NOT include trade debtors or trade creditors.

Any exchange differences that arise on a monetary item which forms part of a reporting entity’s net investment in a foreign operation is recorded in profit or loss in the individual financial statements of the reporting entity or the individual financial statements of the foreign operation (as appropriate). However, if consolidated financial statements are prepared where the foreign operation is a subsidiary, such exchange differences are recognised in other comprehensive income and accumulated within equity and are NOT recognised in profit or loss when the parent disposes of the net investment.

Presentation currency

The term ‘presentation currency’ is the currency in which the financial statements are presented. FRS 102 does acknowledge in paragraph 30.17 that an entity may present its financial statement in any currency (or currencies).

Example – presentation currency

TopCo Limited is the parent of a number of subsidiaries which operate throughout Germany, Spain and France, however the majority of the group’s turnover and profits are generated in the United Kingdom.

As most of the group’s turnover and profits are generated in the United Kingdom, TopCo Ltd chooses to present its consolidated financial statements in Great British Pounds.

The above example is not conclusive in the UK and it might well be that a UK group has a large number of overseas subsidiaries that trade in different currencies. If, say, 80% of a group’s profit is generated by European subsidiaries whose functional currency is the Euro, (despite the fact that the group has other functional currencies such as US Dollars and Canadian Dollars), it may adopt the Euro as its presentation currency for the purpose of consolidated financial statements.

In situations where an entity’s presentation currency differs from the entity’s functional currency, the entity must translate its items of income and expense and financial position into the presentation currency. This is achieved as follows:

• Assets and liabilities for each statement of financial position presented (i.e. including comparatives) shall be translated at the closing rate* at the date of that statement of financial position;
• Income and expenses for each statement of comprehensive income (i.e. including comparatives) shall be translated at the exchange rates at the dates of the transactions; and
• All resulting exchange differences shall be recognised in other comprehensive income.

*The closing rate is defined as the spot rate of exchange as at the end of the reporting period.

Paragraph 30.19 does recognise that for practical reasons, an entity may use average rates of exchange, particularly to translate income and expense items. Care must be taken where average rates of exchange are employed because the paragraph does also recognise that where exchange rates have fluctuated significantly, the use of an average rate of exchange for a period will be inappropriate.

Example – foreign subsidiary which is not wholly-owned

TopCo Limited owns 80% of ForeignCo Inc and has accumulated exchange differences which have been recognised in other comprehensive income.

In the consolidated financial statements, exchange differences that relate to a foreign operation which is not wholly-owned and which are attributable to the non-controlling interests (minority interests) are allocated to, and recognised as part of, non-controlling interests within the consolidated balance sheet.

Consolidated goodwill

If a group acquires a foreign subsidiary, any goodwill which arises on the acquisition of the subsidiary is treated as an asset of the foreign operation. Any fair value adjustments to the carrying amount of assets and liabilities arising on the acquisition of a foreign operation are treated as assets and liabilities of the foreign operation. Assets and liabilities for each statement of financial position presented (which must also include the comparatives) should be translated from the functional currency to the presentation currency at the closing exchange rate at the reporting date.

A key difference to note in comparison to SSAP 20 Foreign Currency Translation is that SSAP 20 regards consolidated goodwill as an asset of the parent company and not the subsidiary.

Disclosure requirements

The following are required to be disclosed for foreign currency transactions:

1. The amount of exchange differences recognised in profit or loss during the period, except for those arising on financial instruments measured at fair value through profit or loss in accordance with Sections 11 Basic Financial Instruments and Section 12 Other Financial Instruments Issues.
2. The amount of exchange differences arising during the period and classified in equity at the end of the reporting period.

In addition, reporting entities must also disclose:

• The currency in which the financial statements are presented. When the presentation currency is different from the functional currency, an entity shall state that fact and shall disclose the functional currency and the reason for using a different presentation currency.
• When there is a change in the functional currency of either the reporting entity or a significant foreign operation, the entity shall disclose that fact and the reason for the change in functional currency.

Category: Accounting and standards, Audit