 PAS 21

the effects of changes in foreign exchange rates

Two ways of conducting foreign activities

1. Foreign currency transactions – e.g., import or export transactions that are to be settled
in a foreign currency. These transactions need to be translated to Philippine pesos
before they can be recorded in the books of accounts.

2. Foreign operations – e.g., a branch in another country. The overseas branch will
normally maintain its accounting records and prepare its financial statements in a
foreign currency. Those financial statements need to be translated to Philippine pesos
before they can be combined with the home office’s financial statements.

Two main accounting issues

Exchange rates are constantly changing. Therefore, the principal issues in the accounting for
foreign activities are determining:

a. Which exchange rate(s) to use; and

b. How to report the effects of changes in exchange rates in the financial statements.

Functional currency

PAS 21 requires an entity to determine and disclose its functional currency, which is “the
currency of the primary economic environment in which the entity operates”. (PAS 21.8)

This functional currency is the currency in which the entity’s cash inflows and outflows are
normally denominated into and is not necessarily the currency of the country where the entity
is based.

An entity considers the following factors (in descending order) when determining its functional
currency:

a. The currency that mainly influences the entity’s sale prices and costs of goods or
services

b. The currency in which cash flows from financing activities and operating activities are
usually generated and retained
Additional factors are considered in determining the functional currency of a foreign operation,
such as whether the foreign operation is essentially an extension of the entity (and therefore
the foreign operation’s functional currency is the same as that of the entity).

Once determined, the functional currency is not changed unless there is a change in underlying
transactions, events and conditions. In such cases, a change in functional currency is accounted
for by translating the financial statements into the new functional currency prospectively from
the date of change.

All currencies other than the entity’s functional currency are considered foreign currencies.

Foreign currency transactions

A foreign currency transaction is “a transaction that is denominated or requires settlement in a

foreign currency”. (PAS 21. 20)

Examples: purchase or sale of goods, services or other assets at a price that is denominated in a
foreign currency, and borrowing, lending or settling receivables or payables at amounts that are
denominated in a foreign currency.

Initial Recognition

A foreign currency transaction is initially recognized by translating the foreign currency amount
into the functional currency using the spot exchange rate at the date of the transaction.

• Spot exchange rate is “the exchange rate for immediate delivery”. (PAS 21.8)… or
simply, the current exchange rate on a given date.

• Date of a transaction is “the date on which the transaction first qualifies for recognition
in accordance with PFRSs”. (PAS 21.22)

For example, goods acquired for $100 are initially recognized by translating the $100 into pesos
using the spot exchange rate on the date of acquisition.

For practical reasons, an average rate (e.g., for a week or a month) may be used for all
transactions occurring during that period. However, if exchange rates fluctuate significantly, the
use of the average rate for a period is inappropriate.

Subsequent Measurement

At each reporting date, the following items are translated as follows:

• Closing rate – the spot exchange rate at the reporting date.

Monetary items vs. Non-monetary items

 Monetary items are currencies held and assets and liabilities to be received or paid in a
fixed or determinable amount of money.

 Non-monetary items are those which do not give rise to receipt or payment of a fixed or
determinable amount of money.

Examples:

Exchange Differences

Exchange differences is “the difference resulting from translating a given number of units of one
currency into another currency at different exchange rates”. (PAS 21.8)

Exchange differences arising from settling or translating:

a. Monetary items are recognized in profit or loss in the period in which they arise.

b. Nonmonetary items – if the gain or loss is recognized in other comprehensive income

(OCI), the exchange component of the gain or loss is also recognized in OCI. Conversely,
if the gain or loss is recognized in profit or loss, the exchange component is also
recognized in profit or loss.

Illustration: Foreign currency transactions – Purchase

On December 1, 20x1, Entity A purchases inventories for €10,000, to be settled on January 3,

20x2. The following are the exchange rates:

December 1, 20x1 ₱58:€1

December 31, 20x1 ₱60:€1

January 3, 20x2 ₱61:€1

 Initial recognition:

Entity A records the inventories and the related accounts payable at P580,000 (€10,000 x P58
spot exchange rate at acquisition date.

Subsequent measurement – December 31, 20x1:

a. Inventories are non-monetary items. Therefore, they are not retranslated after initial
recognition. They will be carried in the statement of financial position at P580,000. If
they are sold, the amount charged to cost of sales is also P580,000.
 If the inventories are measured at net realizable value determined in terms of euros (€),
the NRV is translated using the exchange rate at the date when the NRV was determined.

b. Accounts payable is a monetary item. This is translated at the closing rate.

Accounts payable, 12/1/x1 (€10,000 x P58) 580,000

Accounts payable, 12/31/x1 (€10,000 x P60) 600,000

Increase in payable – Foreign exchange loss (20,000)

Entity A recognizes a FOREX loss because the payable has increased; thereby, requiring more
pesos to settle.

 Subsequent measurement – January 3, 20x2

On settlement date, Entity A again recognizes an exchange difference on the accounts payable.

Accounts payable, 12/31/x1 (€10,000 x P60) 600,000

Settlement amount, 1/3/x2 (€10,000 x P61) 610,000

FOREX loss (10,000)

The FOREX losses computed above are recognized in profit or loss in the period in which they
arise. Thus, the P20,000 FOREX loss on December 31, 20x1 is included in the 20x1 profit or loss
while the P10,000 FOREX loss on January 3, 20x2 is included in the 20x2 profit or loss. The total
FOREX loss recognized on the transaction is P30,000.

Translation of Financial Statements

An entity is required to present its financial statements using its functional currency (i.e.,
Philippine pesos). However, whenever needed, the entity may translate its financial statements
into any presentation currency (e.g., Japanese yen, US dollars, etc.), as follows:

For expediency reasons, an average rate for the period may be used, except when exchange
rates fluctuate significantly.

Illustration:

Entity A has just started its operations on January 1, 20x1. On this date, Entity A equity
consisted of ₱2M share capital, which were issued also on this date. Entity A’s functional
currency is the Philippine peso (₱). However, it wishes to present its 20x1 financial statements
into Japanese yen (¥). The following information was gathered on December 31, 20x1, after a
year of operations.
Total assets ₱ 10M

Total liabilities ₱ 5M

Share capital 2M

Retained earnings 3M

Total liabilities and equity ₱ 10M

Income ₱ 7M

Expenses (4M)

Profit ₱ 3M

Relevant exchange rates:

January 1, 20x1 (historical rate for the share capital) ₱1: ¥2

Average rate ₱1: ¥3

December 31, 20x1 (closing rate) ₱1: ¥4

Translation:

in pesos rates in yens

Total assets ₱ 10M ¥4 (CR) ¥ 40M

Total liabilities ₱ 5M ¥4 (CR) ¥ 20M

Share capital 2M ¥2 (HR) 4M

Retained earnings 3M (see below) 9M

Exchange differences - (squeeze) 7M

Total liabilities and equity ₱ 10M ¥ 40M

Income ₱ 7M ¥3 (AR) ¥ 21M

Expenses (4M) ¥3 (AR) (12M)

Profit ₱ 3M ¥3 (AR) ¥ 9M

Retained earnings is translated as follows:

 in pesos rate in yens

Retained earnings, beginning 0 (not applicable) 0

Profit 3M 3 9M

Retained earnings, end 3M 9M

 After translating all the amounts, the exchange difference is simply “squeezed” as the
balancing figure between ‘total assets’ and ‘total liabilities and equity’. This is computed
as follows: (¥40M total assets - ¥20M total liabilities - ¥4M share capital - ¥9M retained
earnings) = ¥7M exchange difference gain (credit).

The exchange difference can also be reconciled as follows:

1) Translation of opening net assets

Equity, Jan. 1 – at opening rate (₱2M x ¥2) ¥4M

Equity, Jan. 1 – at closing rate (₱2M x ¥4) 8M

Increase in opening net assets – gain ¥4M

Cumulative translation gain, Jan. 1 0

2) Translation of changes in net assets during the period:

Profit or loss:

Profit – at average rate (₱3M x ¥3) ¥9M

Profit – at closing rate (₱3M x ¥4) 12M

Increase in profit – gain ¥3M

Exchange difference – gain ¥7M

Foreign Operation

A foreign operation is a subsidiary, associate, joint venture or branch that is based in a foreign
country and is using a foreign currency.

The financial statements of a foreign operation need to be translated before they can be
incorporated into the reporting entity’s financial statements. The translation procedures
discussed above apply to the translation of a foreign operation’s financial statements.
When a foreign operation is disposed of, the cum