IAS 21 - does it need amending?

The International Accounting Standards Board (IASB) recently initiated a research project, which examined the previous research conducted by the Korean Accounting Standards Board (KASB). This research considered whether any work on IAS 21, The Effects of Changes in Foreign Exchange Rates, was appropriate. This article looks at some of the issues raised by the project in the context of IAS 21.

The foreign exchange market is affected by many factors, and in countries with a floating exchange rate, their foreign exchange rates are inevitably exposed to volatility due to the effects of the different factors influencing the market. For example, the ongoing problem of Greece repaying its enormous debts has significantly affected the value of the euro. 

As the barriers to international flows of capital are further relaxed, the volatility of the foreign exchange market is likely to continue. This volatility affects entities that engage in foreign currency transactions and there has been a resultant call in some quarters to amend IAS 21.

IFRS 7, Financial Instrum­ents: Discl­osure requires disclosure of market risk, which is the risk that the fair value or cashflows of a financial instrument will fluctuate due to changes in market prices. Market risk reflects, in part, currency risk. In IFRS 7, the definition of foreign currency risk relates only to financial instruments. IFRS 7 and IAS 21 have a different conceptual basis. IFRS 7 is based upon the distinction between financial/non-financial elements, whereas IAS 21 utilises the monetary/non-monetary distinction. 

The financial/non-financial distinction determines whether an item is subject to foreign currency risk under IFRS 7, whereas translation in IAS 21 uses monetary/non-monetary distinction, thereby possibly causing potential conceptual confusion. Foreign currency risk is little mentioned in IAS 21 and on applying the definition in IFRS 7 to IAS 21, non-financial instruments could be interpreted as carrying no foreign currency risk. Under IAS 21, certain monetary items include executory contracts, which do not meet the definition of a financial instrument. These items would be translated at the closing rate, but as such items are not financial instruments, they could be deemed not to carry foreign currency risk under IFRS 7.

Foreign currency translation should be conceptually consistent with the conceptual framework. IAS 21 was issued in 1983 with the objective of prescribing how to include foreign currency transactions and foreign operations in the financial statements of an entity and how to translate financial statements into a presentation currency. 

There is little conceptual clarification of the translation requirements in IAS 21. The require­ments of IAS 21 can be divided into two main areas: the reporting of foreign currency transactions in the functional currency; and the translation to the presentation currency. Exchange differences arising from monetary items are reported in profit or loss in the period, with one exception which is that exchange differences arising on monetary items that form part of the reporting entity’s net investment in a foreign operation are recognised initially in other comprehensive income, and in profit or loss on disposal of the net investment. 

However, it would be useful to re-examine whether it is more appropriate to recognise a gain or loss on a monetary item in other comprehensive income instead of profit or loss in the period and to define the objective of translation. Due to the apparent lack of principles in IAS 21, difficulty could arise in determining the nature of the information to be provided on translation.

There is an argument that the current accounting standards might not reflect the true economic substance of long-term monetary assets and liabilities denominated in foreign currency because foreign exchange rates at the end of the reporting period are used to translate amounts that are to be repaid in the future. IAS 21 states that foreign currency monetary amounts should be reported using the closing rate with gains or losses recognised in profit or loss in the period in which they arise, even when the rate is abnormally high or low. 

There are cases where an exchange rate change is likely to be reversed, and thus it may not be appropriate to recognise foreign exchange gains or losses of all monetary items as realised gains or losses. Thus there is an argument that consideration should be given as to whether foreign exchange gains or losses should be recognised in profit or loss or in other comprehensive income (OCI) based on the distinction between current items and non-current items. 

Any potential fluctuation in profit or loss account would be reduced by recognising in OCI those foreign exchange gains or losses of non-current items with a high possibility of reversal. Furthermore, the question would arise as to whether these items recognised in OCI could be reclassified.

However, the IASB is currently determining via its conceptual framework project the purpose and nature of OCI, as there is no obvious principle that drives gains and losses out of profit or loss and into OCI, and there is no shared view among the IASB’s constituents about what should be in profit or loss and what should be in OCI.

IAS 21 does provide some guidance on non-monetary items by stating that when a gain or loss on a non-monetary item is recognised in OCI, any exchange component of that gain or loss shall be recognised in OCI. 

Conversely, when a gain or loss on a non-monetary item is recognised in profit or loss, any exchange component of that gain or loss shall be recognised in profit or loss. 

Long-term liabilities

In the case of long-term liabilities, although any translation gains must be recognised in profit or loss, and treated as part of reported profit, in some jurisdictions, these gains are treated as unrealised for the purpose of computing distributable profit. 

The reasoning is that there is a greater likelihood in the case of long-term liabilities that the favourable fluctuation in the exchange rate will reverse before repayment of the liability falls due.

As stated already, IAS 21 requires all foreign currency monetary amounts to be reported using the closing rate; non-monetary items carried at historical cost are reported using the exchange rate at the date of the transaction and non-monetary items carried at fair value are reported at the rate that existed when the fair values were determined. As monetary items are translated at the closing rate, although the items are not stated at fair value, the use of the closing rate does provide some fair value information. However, this principle is not applied to non-monetary items as, unless an item is measured at fair value, the recognition of a change in the exchange rate appears not to provide useful information.

A foreign operation is defined in IAS 21 as a subsidiary, associate, joint venture, or branch whose activities are based in a country or currency other than that of the reporting entity. Thus the definition of a foreign operation is quite restrictive. It is possible to conduct operations in other ways; for example, using a foreign broker. Therefore, the definition of a foreign operation needs to be based upon the substance of the relationship and not the legal form.

Although the exchange rate at the transaction date is required to be used for foreign currency transactions at initial recognition, an average exchange rate may also be used. The date of a transaction is the date on which the transaction first qualifies for recognition in accordance with International Financial Reporting Standards. For practical reasons, a rate that approximates to the actual rate at the date of the transaction is often used. For example, an average rate for a week or a month might be used for all transactions in each foreign currency occurring during that period. However, if exchange rates fluctuate significantly, the use of the average rate for a period is inappropriate.

Average exchange rate

A question arises as to which exchange rate to use and therefore it would be useful to have more specific guidance on the use of the average exchange rate. IAS 21 allows a certain amount of flexibility in calculating the average rate. The determination of the average rate depends upon factors such as the frequency and value of transactions, the period over which the rate will apply and the nature of the entity’s systems. There are a large number of methods that can be used to calculate the average rate, but no guidance is given in IAS 21 as to how such a rate is determined.

The IASB has completed its initial assessments on this project and decided that narrow scope amendments were unnecessary. In May 2015, it had no plans to undertake any additional work and is to remove this project from the research programme, subject to feedback in the next agenda consultation.

Written by a member of the P2 examining team