CHAPTER SIX

ACCOUNTING FOR FOREIGN CURRENCY TRANSACTIONS

AND TRANSLATION OF FOREIGN CURRENCY FINANCIAL
STATEMENTS (IAS 21)

PREPARED BY: MELESE Z.(MSc)

 CHAPTER OBJECTIVES AND CONTENT

Definition of terms
Exchange Rates and Meaning of Translation
Types of currency-related exposures
Determination of functional currency
Accounting for foreign currency transactions
Recognition and reporting of exchange differences
Translation of foreign operations
•Rationale/Objectives of translation
•Translation methods & criteria for applications
Disclosure requirements
 Definition of terms
 Foreign currency transactions -economic activities denominated in a
currency other than the entity’s recording currency.

• These include:

1. Purchases or sales of goods or services (imports or exports), the

prices of which are stated in a foreign currency

2. Loans payable or receivable in a foreign currency

3. Purchase or sale of foreign currency forward exchange contracts

4. Purchase or sale of foreign currency units

 Cont…
• Foreign currency transactions of an Ethiopian company
denominated in other currencies must be restated to their Br
equivalents before they can be recorded in the Ethiopian
company’s books and included in its financial statements.

Translation: The process of restating foreign currency

transactions to their Br equivalent values.
 CONT……
 Foreign Currency Exchange Rates-the ratio of exchange of two
currencies.
• Exchange Difference is resulting from translating a given number of units
of one currency in to another currency.
Two Methods of Reporting Exchange Rates
1. Direct Exchange Rate (DER): is the number of local currency units (LCUs) needed to acquire
one foreign currency unit (FCU).
– From the viewpoint of a Ethiopian entity:
DER = Br – equivalent value
1 FCU
Example: On January 1, 2020, an Ethiopian based company can purchase one Dollar for Br 30.
Br 30 = Br 30/$
DER =
1$
 Cont…
2. Indirect Exchange Rate (IER): is the reciprocal of the direct exchange rate.
It is the number of Foreign currency units (FCUs) needed to acquire one
Local currency unit (LCU).
– From the viewpoint of a Ethiopian entity:
1 FCU
IER = Br – equivalent value

Example: On January 1, 2020, an Ethiopian based company can purchase one

Dollar for Br 30.
$1
Br 30 = $ 0.034/ Br
IER =
 ANALYSIS OF EXCHANGE RATE
DER Increase/IER Decreases
 Weakening of Local currency
 Taking More Local currency to acquire one Foreign Currency.
 One LCU acquiring Fewer FCUs.
 Export Increase and Import Decrease.
DER Decreases/IER Increase
 Strengthening of Local currency
 Taking Less Local currency to acquire one Foreign Currency.
 One LCU acquiring Higher FCUs.
 Export Decrease and Import Increase
 REASON OF EXCHANGE RATE FLUCTUATION
• Determination of exchange rates
– Exchange rates change because of a number of economic factors
affecting the supply and demand for a nation’s currency.
– Factors causing fluctuations are a nation’s
• Level of inflation
• Balance of payments
• Changes in a country’s interest rate
• Investment levels
• Stability and process of governance
 TYPES OF EXCHANGE RATES
1. Spot rate: is the exchange rate for immediate delivery of currencies
2. Current (Closing) Rate: is Spot rate on the entity’s balance sheet date.
3. Forward Rate: Expectations about the relative value of currencies are
built into the forward rate.
• Spread: The difference between the forward rate and the spot rate on a
given date.
• The spread gives information about the perceived strengths or
weaknesses of currencies.
 TYPES OF CURRENCIES FOR REPORTING PURPOSE

1. Functional currency: is the currency of the primary economic

environment in which the entity operates.
2. Presentation Currency: is the currency in which the financial statements
are presented.
3. Foreign Currency: is a currency other than the functional currency of the
entity.
4. Local Currency: is the currency of the country in which the entity
operates.
 DETERMINATION OF FUNCTIONAL CURRENCY

 Factors to be consider during determining Functional Currency:-

1. Sales prices for goods and services are denominated and settled.

2. The currency of competitive forces and regulations.

3. the currency that mainly influences labor, material and other costs.

 Factors that provide evidence of an entity’s functional currency:

1. the currency in which funds from financing activities (i.e. issuing debt and equity
instruments) are generated.

2. currency in which receipts from operating activities are usually retained.

3. High volume of intercompany transactions

 Cont…
Note:
 When the above indicators are mixed and the functional currency is not
obvious, management uses its judgment to determine the functional currency
that most faithfully represents the economic effects of the underlying
transactions, events and conditions

 Once determined, the functional currency is not changed unless there is a

change in those underlying transactions, events and conditions.
 Monetary and Non-Monetary Items

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

Eg. Accounts receivable, investments in bonds , accounts payable, bond

liabilities, pensions and other employee benefits to be paid in cash,
provisions that are to be settled in cash, and cash dividends that are
recognized as a liability.
 Cont…..
Conversely, the essential feature of a non-monetary item is the absence
of a right to receive (or an obligation to deliver) a fixed or determinable
number of units of currency.

Eg. are amounts prepaid for goods and services (e.g., prepaid rent);
goodwill; intangible assets; inventories; property, plant, and equipment;
deferred income taxes; and provisions that are to be settled by the delivery
of a non-monetary asset.
FOREIGN CURRENCY IMPORT AND EXPORT TRANSACTIONS
1. Transaction date: Record the purchase or sale transaction at the Local
Currency Units using the spot direct exchange rate on this date.
2. Balance sheet date: Adjust the payable or receivable to its Local
Currency Units, end-of-period value using the current direct exchange rate.
• Recognize any exchange gain or loss for the change in rates between the
transaction and balance sheet dates.
3. Settlement date: Adjust the foreign currency payable or receivable for
any changes in the exchange rate between the balance sheet date (or
transaction date) and the settlement date, recording any exchange gain or
loss as required.
• Record the settlement of the foreign currency payable or receivable

Note- Individual transactions must be translated into the functional currency

at the historical rate.
 CONT…..D

According to IAS 21, a foreign currency transaction must be recorded, on

initial recognition, in the functional currency by applying to the foreign
currency amount the spot exchange rate between the functional currency
and the foreign currency at the date of the transaction.
 CONT…D
At the end of each reporting period,

(a) Foreign currency monetary items must be translated using the closing
rate,

(b) Non-monetary items that are measured in terms of historical cost in a

foreign currency must be translated using the historical rate, and

(c) Non-monetary items that are measured at fair value in a foreign

currency must be translated using the spot exchange rates at the date
when the fair value was determined.
 CONT…D

Any exchange adjustments arising on the settlement of monetary items or

on the translation of them at rates different from those at which they
were translated on initial recognition or in previous financial statements
must be recognized in profit or loss in the period in which they arise,
with one exception.

When a gain or loss on a non-monetary item is recognized in other

comprehensive income, any exchange adjustment pertaining to that item
must also be recognized in other comprehensive income. For example, IAS
16 requires some gains and losses arising on a revaluation of property,
plant, and equipment to be recognized in other comprehensive income.
 EXAMPLE 1

On October 1, 2010, ABC Company, an Ethiopian Company, acquired goods from

Martin, an American company, for $2,000,000.00. ABC prepared Financial
Statement at year end on December 31, 2010. Settlement of the payables was
made on April 1, 2011.
Spot rates
October ….........…..1$ = Br 30
December 31......…1$ = Br 34
April 1…………………..1$ = Br 32
 Solution
ABC
October 1 Purchase/Inventory……..Br 60,000,000.00
Account Payable………Br 60,000,000.00
($2,000,000 * Br 30/$ = Br 60,000,000)

December 31 Loss on Foreign Exchange Transaction …….Br 8,000,000.00

Account Payable………………………………….Br 8,000,000
($2,000,000 * Br 34/$ = Br 68,000,000)

April 1 Account Payable……….Br 4,000,000.00

Gain on Foreign Exchange Transaction…..Br 4,000,000.00
Account Payable………..Br 64,000,000.00
Cash……………………………………………Br 64,000,000.00
($2,000,000 * Br 32/$ = Br 64,000,000.00)
 EXAMPLE 2
Suppose ethio telecom buys a large consignment of goods from a
supplier in Egypt. The order is placed on 1 April and the agreed price is
124,250 Egypt Dollar. At the time of delivery the rate of foreign
exchange was Birr 1.00 to 3.50 Egypt Dollar.
Required
Show the initial recognition
What will the entries be if the exchange rate is 3.55 when payment is
made on may 1?.
 Solution
Initial recognition- ethio telecom will recognize the purchase using its functional currency (Birr) by
applying the spot exchange rate when the purchase was made (Birr 1.00 to 3.50 Egypt Dollar)

Inventory account (124,250 ÷ 3.5)....................Br 35,500

Payables account.........................................Br 35,500

When ethio telecom comes to pay the supplier, it needs to obtain some foreign currency. By this time,
however, if the rate of exchange has altered to 3.55 to 1, the cost of raising €124,250 would be (÷ 3.55)
35,000. The company would need to spend only 35,000 to settle a debt for inventories 'costing' 35,500.
Since it would be administratively difficult to alter the value of the inventories in the company's books of
account, it is more appropriate to record a profit on conversion of 500.

Account Payable..................................Br 500

Gain on Foreign Exchange Transaction...................Br 500

Account Payable.............................Br 35,000

Cash...........................Br 35,000
AN IMPORT EXAMPLE
On June 1, Year 1, Glory Importers Inc. purchased merchandise from a
supplier in Australia at a cost of 10,000 Australian dollars (A$), with
payment in full to be made in 60 days. The exchange rate on the date of
purchase was A$1 = Br.52and A$1 = Br52.5 on June 30, Year 1, the
company’s year-end. Maritime paid its supplier on July 30, Year 1, when the
exchange rate was A$1 = Br.52.9. The following journal entries, recorded in
Ethiopian Birr, illustrate the company’s purchase of merchandise, year-
end adjustments, and subsequent payment.
AN EXPORT EXAMPLE

We will now consider an example of the export of goods by Ethiopian

Company. On November 15, Year 1, LMD Malt Producers Ltd. shipped a carload
of malt to a brewery in the United States, with full payment to be received on
January 31, Year 2. The selling price of the malt was US$26,000. LMD Malt has
a December 31 year-end. The following exchange rates existed on the dates
significant for accounting purposes:

Transaction date Nov. 15, Year 1

Exchange rate US$1 = Br.54
Year-end Dec. 31, Year 1
Exchange rate US$1 = Br.54.62
Settlement date Jan. 31, Year 2
Exchange rate US$1 = Br.54.1
 Translation of foreign Currency Financial
Statements
Foreign-currency-denominated financial statements must be translated to the
presentation currency of the reporting entity.

There are two methods used under IAS 21 to translate the financial statements
of a foreign operation.

The two methods as the functional currency translation (FCT) method and the
presentation currency translation (PCT) method.
 Cont……
The FCT method was used to translate and account for foreign
transactions. The same method will be used to translate the financial
statements of a foreign operation from its recording currency to its
functional currency.

Foreign operation as an entity that is a subsidiary, associate, joint arrangement 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.

The PCT method will be used to translate the financial statements of a

foreign operation from its functional currency to a different
presentation currency.
Procedures to translate functional currency to presentation
currency (PCT) in
(a) Assets and liabilities shall be translated using the closing rate

(b) Income and expenses shall be translated using exchange rates at

the dates of the transactions; and

(c) All resulting exchange differences shall be recognized in other

comprehensive income in the name of Foreign currency
translation adjustments
For depreciation and Cost of goods sold, historical rate for FCT method is
the rate when the asset was acquired, whereas All revenues and
expenses are translated using the exchange rate in effect on the dates on
which such items are recognized in income during the period for PCT.

Dividends are translated at the historical rate on the date of declaration.

Under the PCT method, the net assets position of the foreign entity is at
risk from currency fluctuations, while under the FCT method it is
typically the net monetary position that is at risk.
ADVANCED FINANCIAL ACCOUNTING
II(ACFN 402)

COURSE INSTRACTOR –MELESE Z.(MSc.)