Advanced Accounting — Effects of Changes in Exchange Rates: Foreign Currency Transactions and Translation

Exporters and importers are paid in dollars but keep their books in won, and groups with foreign subsidiaries combine statements in several currencies into one in won. K-IFRS 1021 The Effects of Changes in Foreign Exchange Rates (IAS 21) distinguishes two things: recording foreign currency transactions in the functional currency, and translating functional-currency financial statements into the presentation currency.

1. Functional currency and presentation currency

The functional currency is the currency of the primary economic environment in which the entity operates. It is judged by the currency that mainly influences sales prices and costs and the currency in which operating funds are raised and held. The presentation currency is the currency in which the financial statements are presented and may be chosen by the entity. For a Korean head office, both are usually the won. A US subsidiary has the dollar as its functional currency and is translated into won for consolidation.

2. Translating foreign currency transactions

Principles for translating foreign currency items
Item	Examples	Translation at the reporting date	Treatment of differences
Monetary items	Foreign currency cash, receivables, payables, borrowings	Closing rate	Exchange differences in profit or loss
Non-monetary items at historical cost	Inventory and equipment bought in foreign currency, prepayments and advances received	Rate at the transaction date (not retranslated)	None
Non-monetary items at fair value	Shares denominated in foreign currency (FVPL, FVOCI)	Rate at the date fair value was determined	Same place as the fair value change (profit or loss or OCI)

Monetary items are those for which a fixed or determinable number of units of currency is received or paid. A prepayment is a right to receive goods later and so is non-monetary.

A. Worked example

Company EE (functional currency won) bought raw materials of USD 10,000 on credit from the United States on 1 November 20X1. The exchange rate was ₩1,300 on 1 November, ₩1,350 on 31 December and ₩1,320 on 31 January 20X2, the settlement date.

Treatment of a foreign currency payable (unit: ₩10,000)
Date	Rate	Payable	Profit or loss
1 Nov 20X1 purchase	1,300	1,300	Raw materials of 1,300 recognized
31 Dec 20X1 year-end	1,350	1,350	Translation loss 50
31 Jan 20X2 settlement	1,320	0 (cash of 1,320 paid)	Exchange gain 30

Raw materials are non-monetary and stay at ₩13 million at the 1 November rate; they do not change when the rate rises at year-end. A translation loss of ₩500,000 arises in 20X1 and an exchange gain of ₩300,000 in 20X2, a net loss of ₩200,000 over the two years — exactly the extra amount actually paid on settlement.

3. Translating foreign operations

The financial statements of a foreign subsidiary whose functional currency is not the won are translated into won as follows.

Assets and liabilities: the closing rate at the reporting date
Income and expenses: rates at the transaction dates (the average rate if rates do not fluctuate significantly)
Equity (paid-in capital, retained earnings at acquisition): historical rates
The resulting difference: translation differences on foreign operations, in OCI

Translation difference on a foreign operation

\text{Translation difference} = \text{Closing net assets} \times \text{Closing rate} - (\text{Opening net assets} \times \text{Opening rate} + \text{Profit} \times \text{Average rate})

Any dividends or capital contributions, with their transaction-date rates, are also included in the brackets.

If a US subsidiary has opening net assets of USD 10,000 (opening rate ₩1,200), profit of USD 2,000 (average rate ₩1,250) and closing net assets of USD 12,000 (closing rate ₩1,300), the translation difference is $1{,}560 - (1{,}200 + 250) = 110$ (₩10,000), i.e. ₩1.1 million. This is the effect of the won weakening, which increased the won value of the dollar net assets.

When a foreign operation is disposed of, the cumulative translation difference is reclassified to profit or loss. Goodwill and fair value adjustments arising on the acquisition of a foreign operation are treated as its assets and translated at the closing rate.

4. How the functional currency judgement changes the numbers

If a foreign subsidiary is merely an extension of the head office and its functional currency is the won, its foreign currency transactions are treated as if recorded directly in won. Exchange differences on monetary items then go to profit or loss rather than OCI. The functional currency judgement can change earnings volatility dramatically. The functional currency is changed only when the underlying economic environment changes, and the change is applied prospectively from that date.

Check your understanding

Company FF (functional currency won) received an advance of USD 5,000 under an export contract on 1 December 20X1 (rate ₩1,320), and on 15 December exported goods to another customer, recognizing a receivable of USD 8,000 (rate ₩1,310). The closing rate on 31 December is ₩1,340. What translation gain or loss is recognized at year-end?

The advance is an obligation to deliver goods later and so is non-monetary; it stays at ₩6.6 million at the transaction-date rate and is not retranslated. The receivable is monetary, so a translation gain of $8{,}000 \times (1{,}340 - 1{,}310)$ , i.e. ₩240,000, is recognized. The year-end translation result is a gain of ₩240,000.

References

Korea Accounting Standards Board, K-IFRS 1021 The Effects of Changes in Foreign Exchange Rates
IASB, IAS 21 The Effects of Changes in Foreign Exchange Rates
Joe Hoyle, Thomas Schaefer and Timothy Doupnik, Advanced Accounting, ch. 10