Current accounting treatment
SSAP 20 (applicable to entities not required or opting to apply FRS 23) requires foreign currency transactions to be translated in the entity’s local currency using the spot exchange rate, or an average rate for a period that is a close approximation. Foreign currency monetary items are retranslated at balance sheet date exchange rate.
Non-monetary items are carried at historic exchange rate. An entity’s local currency is the currency of the primary economic environment in which the entity operates and generates cash flows. Exchange gains and losses are recognised in profit or loss. SSAP 20 permits transactions covered by a forward contract to be translated at the contract rate.
Accounting treatment under FRS 102
FRS 102 requires entities to initially translate foreign currency transactions in an entity’s functional currency using the spot exchange rate, although an average rate for a week or month may be used if the exchange rate does not fluctuate significantly. Foreign currency monetary items are subsequently translated in the functional currency at the exchange rate applicable at the end of the reporting period. Non-monetary items are carried at the historic rate and non-monetary items measured at fair value are translated at the rate of the date when the fair value is re-measured.
An entity’s functional currency is the currency of the primary economic environment in which the entity operates, normally the one in which it primarily generates and expends cash. Exchange differences on monetary items are recognised in profit or loss. Exchange gains or losses on non-monetary items measured at fair value are recognised as part of the change in fair value posted in other comprehensive income or profit or loss.
FRS 102 does not include provisions about using a contracted exchange rate to match a trading transaction. Therefore balances covered by a forward contract will be retranslated at the year-end rate. In turn under FRS 102 a foreign exchange forward contract will be recognised in the balance sheet as a financial instrument at fair value through profit or loss.
However, FRS 102 allows designating a foreign exchange forward contract as a hedging instrument in a designated relationship to hedge the foreign exchange risk of a trading transaction. In such a case the change in the fair value of the forward contract will be recognised in other comprehensive income to the extent that it effectively offsets the retranslation gain or loss on the expected cash flows from the trading transaction.
The option of adopting hedge accounting is, however, onerous in terms of documentation, complexity of the rules and disclosures and it is unlikely to be attractive for many entities. FRS 102 allows an entity to present its financial statements in any currency, a ‘presentation currency’. To do so all the items expressed in its functional currency should be translated in the presentation currency of choice.
Assets and liabilities should be translated at the closing rate at the end of the reporting period while income and expenses shall be translated at the exchange rates at the day of transactions. Exchange differences resulting from the translation of financial statements in functional currency to presentation currency are recognised in other comprehensive income.
The transition section of the standard is silent on the treatment of foreign currency translations and accordingly the general transitional procedures in FRS 102 will apply on first-time adoption, ie assets and liabilities will be recognised, reclassified and measured as at the transition date in accordance with FRS 102.
Financial impact of the changes
While the translation into a presentation currency different from an entity’s functional currency follows a set of separate rules whose effect on the financial statements are difficult to gauge, the use of a presentation currency may be important to a number of entities which, for example, need to provide comparable financial information to overseas shareholders or, as it is often the case for UK subsidiaries of a foreign group that may have Sterling as functional currency while their group prepares accounts in US Dollars or Euros, need to present their financial statements in the functional currency of their parent to facilitate consolidation procedures and comparability of results and financial position.
In particular switching to financial statements presented in a currency other than Sterling may need to be agreed with lenders and would need to be verified against any restrictive covenants. Additionally choosing a foreign presentation currency may result in alterations to results reported into an entity’s functional currency generated by the variations in exchange rates between the two currencies.
Such variations may affect not only debt covenants but also remuneration and share based schemes that may have been originally stipulated by reference to local currency and that would need to be revisited to take into account any foreign exchange distortion. For entities using forward foreign exchange contracts to match their commercial transactions, the changes in FRS 102 result in a more exacting financial reporting treatment. Such entities would have, under SSAP 20, reduced their exposure to volatility in the profit and loss account by using the exchange rates specified in the forward contracts.
Under FRS 102, in order to achieve an element of matching foreign exchange gains and losses on their commercial transactions, entities may choose to apply hedge accounting to such arrangements in accordance with Section 12 of the standard. However, it is likely that entities may decide not to adopt hedge accounting because the administrative burden of maintaining the relevant documentation and the intrinsic complexities of hedge accounting may outweigh the benefits of the accounting treatment permitted.
Entities not opting to apply hedge accounting will, however, need to recognise forward foreign exchange contracts at fair value when they are taken out and will recognise fair value gains and losses in profit or loss on an on-going basis at each reporting date rather than just at the time of settlement. On the other hand, transactions and monetary items covered by forward contracts will be translated at the exchange rate of the transaction date and of the year end respectively with exchange differences recognised in profit or loss. Effectively this treatment will produce two sets of entries in profit or loss, while under SSAP 20 there would have been none.
Taxation impact of the changes
Profits and losses arising to the company from its derivative and related contracts include exchange gains and losses. The exception to this is a gain or loss on a derivative that consists wholly or mainly of currency.
Where a company prepares its accounts in accordance with UK GAAP (excluding FRS23 and 26) and uses a forward currency contract to match its exchange exposure, the exchange movements arising in respect of the forward currency contract that are eligible for matching are determined by reference to the spot rate prevailing at the end of the accounting period. It is no longer possible for profits and losses on forward currency contracts to be left out of account.