Learning Outcomes
After reading this article, you will be able to explain key principles of translating foreign operations under IAS 21. You will understand the concepts of functional and presentation currency, the mechanics of translating subsidiary financial statements for consolidation purposes, and how to recognise and present exchange differences in group accounts for ACCA Financial Reporting (FR).
ACCA Financial Reporting (FR) Syllabus
For ACCA Financial Reporting (FR), you are required to understand the accounting for foreign operations within groups. This article will help you prepare for questions on:
- The definition and determination of functional and presentation currency
- The translation of a foreign subsidiary’s financial statements into the group’s presentation currency
- The treatment and disclosure of exchange differences in consolidated financial statements
- The basic consolidation adjustments relating to foreign operations
Test Your Knowledge
Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.
- Define the terms "functional currency" and "presentation currency" in the context of IAS 21.
- When translating a foreign subsidiary's financial statements, which rate should be used for assets and liabilities? a) Historic rate b) Average rate for the year c) Closing rate d) Forward rate
- True or false? Exchange differences arising from translating foreign subsidiaries are reported in the group statement of profit or loss.
- Briefly describe the basic steps required to translate a foreign subsidiary’s financial statements for group consolidation.
Introduction
Many groups have subsidiaries operating in countries with different currencies. For group reporting, these foreign operations must be translated into the parent’s presentation currency. IAS 21 The Effects of Changes in Foreign Exchange Rates provides the principles to ensure comparability, reliability, and faithful representation of group results and positions.
Key Term: functional currency
The currency of the primary economic environment in which an entity operates. It is usually the currency that mainly influences sales prices and costs.Key Term: presentation currency
The currency in which a group's consolidated financial statements are presented.
Translation Process for Foreign Subsidiaries
When a parent company consolidates a foreign subsidiary, the subsidiary’s financial statements—prepared in its functional currency—must be translated into the group’s presentation currency. This process consists of:
Step 1: Identify Currencies
- Functional currency: The currency relevant to the subsidiary’s economic environment.
- Presentation currency: The currency in which the group’s consolidated accounts are presented. This may be the parent’s functional currency, but need not be.
Step 2: Translate the Financial Statements
IAS 21 prescribes the following translation methods for subsidiaries being consolidated:
- Assets and liabilities: Translate at the closing rate (the rate at the reporting date).
- Income and expenses: Translate at the exchange rates at the dates of the transactions. In practice, an average rate for the period is often used if rates do not fluctuate significantly.
- Equity items: Share capital and retained earnings at historic rates (when shares were issued or profits arose), but opening balances are brought forward, and movements within the year are translated at appropriate rates.
Key Term: closing rate
The exchange rate at the end of the reporting period used for translating assets and liabilities of a foreign operation.Key Term: exchange difference
The difference arising on translating a foreign operation’s financial statements into the group’s presentation currency, often due to changes in exchange rates.
Step 3: Recognise and Present Exchange Differences
- The resulting exchange differences from translating the subsidiary’s net assets are not taken to the group’s profit or loss.
- Instead, these differences are presented in other comprehensive income (OCI) and accumulated in a separate component of equity (a foreign currency translation reserve).
Worked Example 1.1
An international group presents its accounts in pounds sterling (£). Its 100%-owned subsidiary, Delta S.A., operates in the Eurozone and has the euro (€) as its functional currency. The subsidiary's statement of financial position at 31 December 20X3 has assets of €1,000,000 and liabilities of €400,000. Share capital was issued when €1 = £0.90. At 31 December 20X3, €1 = £0.85.
Translate Delta S.A.'s assets, liabilities, and equity for group consolidation, and explain how exchange differences are reported.
Answer:
- Assets: €1,000,000 × £0.85 = £850,000 (translated at closing rate).
- Liabilities: €400,000 × £0.85 = £340,000 (closing rate).
- Share capital: If issued at €500,000 when €1 = £0.90, then share capital = €500,000 × £0.90 = £450,000 (historic rate).
- Retained earnings (for illustration): Use average rate for the year, or calculate movement translated at average rate.
- The balancing figure in consolidated equity represents an exchange difference. This amount is allocated to the foreign currency translation reserve within equity and shown in OCI.
Exam Warning
A frequent mistake is to take exchange differences arising on group translation to profit or loss. For group translation under IAS 21, all exchange differences are shown in other comprehensive income, not in the group profit or loss.
Common Consolidation Adjustments
When preparing group accounts:
- Eliminate the investment in the foreign subsidiary against the translated net assets of the subsidiary.
- Calculate goodwill in the presentation currency, using rates at the date of acquisition.
Key Term: goodwill (in group translation)
The excess of the parent’s cost of investment over the parent’s share of the fair value of the subsidiary’s net assets, both stated in the parent’s presentation currency at the acquisition date.
Special Considerations
- Translation of foreign subsidiaries for consolidation differs from the translation of individual foreign currency transactions (e.g., trade payables) within single-entity accounts.
- Hyperinflationary economies and partial disposals require special treatment, beyond the basics covered here.
Worked Example 1.2
Omega plc acquired 80% of Beta GmbH in Germany when €1 = £0.95. At year-end, €1 = £0.80. Beta’s net assets at acquisition were €600,000; at year-end, €800,000. All are translated using applicable rates.
Calculate the exchange difference arising for consolidation and show its treatment.
Answer:
- Net assets at acquisition: €600,000 × £0.95 = £570,000
- Net assets at year-end: €800,000 × £0.80 = £640,000
- Movement: £640,000 – £570,000 = £70,000 increase.
- The translation difference due to rate changes is not taken to group profit, but credited to OCI in the foreign currency translation reserve.
Summary
IAS 21 establishes the rules for translating foreign operations to the group presentation currency. Under these rules, assets and liabilities are brought in at closing rates, income and expenses at actual or average rates, and equity at historic rates, with all exchange differences recognised in other comprehensive income, not profit or loss.
Key Point Checklist
This article has covered the following key knowledge points:
- Define and distinguish between functional currency and presentation currency
- State the rates used for translating a subsidiary’s financial statements for group accounts
- Show how exchange differences are recognised in consolidated financial statements
- Outline where exchange differences appear in group equity and OCI
- Explain basic consolidation adjustments required for foreign operations
Key Terms and Concepts
- functional currency
- presentation currency
- closing rate
- exchange difference
- goodwill (in group translation)