A business entity may have to deal with the issue of the changes in the exchange rates. In other words, a business entity may have certain undertakings that involve foreign exchange. These undertakings could either be business transactions in foreign currencies or operations outside the country of its domicile.
Now, business transactions in foreign currencies or foreign operation must be included in the financial statements of the business entity. The fundamental issues with accounting for such foreign currency transactions or foreign operations are:
the exchange rate at which these should be recorded and
the manner in which the differences on account of changes in the exchange rates must be identified[/vc_column_text]
Scope of AS 11
As mentioned above, Accounting Standard 11, Effects of Changes in Foreign Exchange Rates, applies to:
- accounting of the foreign currency transactions of a business entity and
- translating the financial statements of foreign operations of a business entity
Apart from accounting of the above transactions or operations, following points also be considered to understand the purview of AS 11:
- AS 11 applies to exchange differences on forward exchange contracts. The forward contracts include the ones entered into by the entity to cover the foreign currency risk. These, however, do not include the forward contracts which are undertaken for future foreign currency transactions. Such transactions are in regards to which firm commitments are made by the entity or are just potential forecast transactions.
- It does not state the currency in which a business entity presents its financial statements. But, typically, a business entity prepares the financial statements in the currency of the country of its domicile. In case, for any reason, it presents its financial statements in a different currency, it must reveal the underlying reason for using such a currency. Also, AS 11 demands the business entity to disclose the reasons for changing its reporting currency.
- AS 11 does not include restatement of financial statements from reporting currency into any other currency for the ease of users who are familiar with such a currency.
- It does not deal with presenting the cash flows occurring as a result of foreign currency transactions. And translation of cash flows of foreign operations in the cash flow statement.
- Finally, it does not cater to the exchange differences occurring on account of foreign currency borrowings. It is to the degree to which such borrowings are treated as an adjustment to interest cost.
Foreign Currency Transactions
I. Initial Recognition
A transaction in foreign currency is nothing but a transaction that is either expressed or requires settlement in a foreign currency. Accordingly, foreign currency transactions include transactions like:
- buying or selling of goods or services where prices are expressed in a foreign currency
- borrowing or lending funds where the amounts receivable or payable are expressed in a foreign currency
- the ones where the business entity is one of the parties to an unperformed foreign exchange contract
- purchasing or disposing off assets, incurring or settling liabilities that are expressed in a foreign currency
Furthermore, on initial recognition, a foreign currency transaction must be recorded in the reporting currency. Reporting currency is the currency that is used by the business entity to report its business transactions in the financial statements.
Accordingly, the foreign currency transactions are recorded by applying the foreign exchange rate between the reporting currency and foreign currency to the foreign currency amount. This exchange rate is the prevailing rate at the date of transaction.
Also, a single rate, which is a close approximation of the actual exchange rate, may be used to record all the foreign currency transactions. Such a rate could be the average rate of a week or month.
However, in cases where there is frequent fluctuations in the exchange rate, using a single average rate for that period may not be valid.
II. Reporting at Subsequent Balance Sheet Dates
Following points must be kept in mind while reporting the foreign currency transactions on the balance sheet date:
- the foreign currency monetary items must be recorded at the closing rate on the balance sheet date. Foreign currency monetary items include cash, receivables, payables, etc. However, there can be cases when the closing rate may not demonstrate precisely (i) the amount in reporting currency that is expected to be received from or (ii) required to pay a foreign currency monetary item on the balance sheet date. In these situations, such a foreign currency monetary item must be reported in the reporting currency. It must be reported at an amount that is expected to be received from or required to pay such an item on the balance sheet date.
- non monetary items that are carried at historical cost expressed in foreign currency must be reported at an exchange rate that prevails at the date of such a transaction. Non – monetary items include fixed assets, inventories, investments in equity shares etc.
- foreign currency non – monetary items that are carried at the fair value must be reported by using an exchange rate that prevailed at the time of determining such items.
Recognition of Exchange Differences
As per this accounting standard, exchange differences can arise as a result of:
- settlement of monetary items or
- reporting the entity’s monetary items at exchange rates different from the rates at which they were initially recorded. Such items were recorded either during that period or in the previous financial statements.
Accordingly, such exchange differences must be accounted as either expenses or income in the period in which they arise.
However, there are exchange differences that arise on a monetary item that fundamentally form part of the entity’s net investment in a non – integral foreign operation. Such differences must go into in a ‘foreign currency translation reserve’ in the financial statements.
These exchange differences must go into foreign currency translation reserve until such net investments are disposed off. Further, at the time of their disposal, these must be accounted as an income or expense.
Foreign Operations Financial Statements
There are various methods to translate the financial statements of the foreign operation into reporting currency. These methods depend upon the manner in which a foreign operation is financed and operates in respect of the reporting entity.
For this purpose, the foreign operations can be classified into ‘Integral Foreign Operations’ and ‘Non – Integral Foreign Operations.’
Integral Foreign Operations
Integral foreign operations, as the name suggests, are the ones that carry out their business activities as if such operations were an extension of the operations of the reporting entity.
Therefore, changes in the exchange rate of the reporting currency and currency of the country of foreign operation directly impact the ‘cash flow from operations’ of the reporting entity.
Accordingly, the exchange rate changes impact individual monetary items of the foreign operation and not the net investment in that foreign operation by the reporting entity.
Non-Integral Foreign Operations
On the other hand, non – integral foreign operations incur expenses, earn income, accumulate cash and other monetary items, avail borrowing all considerably in the local currency.
They may enter into foreign currency transactions, including the currency of the reporting entity. Furthermore, when there are changes in the exchange rate between the reporting and the local currency, there is small or no change in the present and future cash flow from operation of either the reporting entity or non – integral foreign operation.
In other words, exchange rate changes impact the net investment of the reporting entity in the non – integral foreign operation. And not the individual monetary and non – monetary items held by the non – integral foreign operation.
Exchange Differences Tax Effects
Gains or losses with respect to the foreign currency transactions and exchange differences on account of translation of financial statements of foreign operations may have certain tax effects.
Such tax effects are accounted as per the guidelines given in AS 22 – Accounting for taxes on income.
Forward Exchange Contracts
- A business entity may enter into a forward contract or any other financial instrument. Such a contract is a forward exchange contract entered into by an entity to determine the amount of reporting currency needed or available at the date of settlement of a transaction. Furthermore, entity does not enter into such a forward exchange contract for speculative or trading purposes.
- The premium or discount arising at the beginning of the forward exchange contract must be amortized as an expense or income (as the case may be) over the life of the contract. Further, the exchange differences on these contracts must be recognized in the profit and loss in the period in which such exchange rate changes take place.
- Additionally, there may be any gain or loss arising on account of cancellation or renewal of such forward exchange contracts. Such gains or losses must be accounted as an income or expense for the given period.