Learning Outcomes
After reading this article, you will be able to explain the principles of translating the financial statements of foreign operations under IAS 21, define net investment in a foreign operation, identify how exchange differences on translation are accounted for in other comprehensive income, and understand their impact upon disposal for ACCA Financial Reporting (FR) exams.
ACCA Financial Reporting (FR) Syllabus
For ACCA Financial Reporting (FR), you are required to understand the treatment of foreign operations, including translation methods, net investment in foreign operations, and presentation requirements. In particular, you should be able to:
- Explain the concept of functional and presentation currency under IAS 21.
- Describe and account for the translation of the results and financial position of foreign operations, including subsidiaries.
- Define net investment in a foreign operation and recognize exchange differences arising on translation.
- Distinguish which translation differences are recorded in other comprehensive income (OCI), and understand their recycling on disposal.
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.
- When translating a foreign subsidiary into the group’s presentation currency, which rate is normally used for assets and liabilities?
- What is meant by a “net investment in a foreign operation” according to IAS 21?
- True or false? All translation differences arising from net investment in a foreign operation are taken directly to retained earnings.
- What happens to accumulated translation differences when a foreign subsidiary is fully disposed of?
Introduction
Many groups operate internationally and own foreign subsidiaries, associates, or branches. These entities often keep their accounting records in their local (functional) currency. When preparing consolidated financial statements, the results and financial position of these foreign operations must be translated into the parent’s presentation currency. IAS 21 The Effects of Changes in Foreign Exchange Rates sets out the rules for this process, including special treatment for net investments in foreign operations and how exchange differences are reported in Other Comprehensive Income (OCI).
Key Term: functional currency
The currency of the primary economic environment in which an entity operates.Key Term: presentation currency
The currency in which the financial statements are presented.Key Term: net investment in a foreign operation
The amount of the reporting entity’s interest in the net assets of a foreign operation, including long-term loans which in substance form part of the net investment.Key Term: exchange differences
Differences resulting from translating a given number of units of one currency into another currency at different exchange rates.
Translating Foreign Operations
Setting Functional and Presentation Currency
First, each entity within a group determines its functional currency—the currency of the main economic environment where it operates. The presentation currency is the currency in which the group’s consolidated financial statements are prepared and presented.
Translating Financial Statements of Foreign Operations
IAS 21 requires the following translation method for foreign operations (e.g., subsidiaries, associates, branches):
- Assets and liabilities: translate at the closing rate (rate at reporting date).
- Income and expenses: translate at exchange rates at the dates of the transactions (often allowed to use an average rate if rates do not fluctuate significantly).
- Equity items: share capital and reserves are translated at historic rates.
- All resulting exchange differences are recognised in Other Comprehensive Income (OCI).
Key Term: closing rate
The exchange rate at the end of the reporting period.
Net Investment in a Foreign Operation
Net investment in a foreign operation includes the parent’s equity interest and any long-term balances such as loans that in substance are part of the parent’s net investment. Repayment of such loans is neither planned nor likely in the foreseeable future.
Exchange differences arising on the translation of a foreign operation’s financial statements—and on related monetary items forming part of net investment—are not recognised in profit or loss, but are instead accumulated in a separate component of equity (foreign currency translation reserve), through OCI.
Other Comprehensive Income (OCI) and Exchange Differences
All translation differences arising from the translation of a foreign operation, including those on net investment-related monetary items, are recognised in OCI. These differences remain in equity until disposal of the foreign operation.
If the parent has foreign currency loans to the subsidiary which are treated as part of the net investment, exchange differences on these loans are also recognised in OCI, not profit or loss.
Disposal of a Foreign Operation
When a foreign operation is fully disposed of, any cumulative translation differences held in OCI relating to that operation (the foreign currency translation reserve) are reclassified from equity to profit or loss as part of the gain or loss on disposal. This is often referred to as “recycling” through profit or loss.
Worked Example 1.1
A UK parent (GBP functional and presentation currency) has a US subsidiary (USD functional currency). At year end, the subsidiary’s assets and liabilities are translated at the closing rate, while income and expenses are translated at average rates. The resulting translation differences are taken to equity through OCI.
Suppose the parent has also made a long-term USD loan to the subsidiary, intended to provide permanent funding. Exchange differences arising on this loan, measured between the date of making the loan and the reporting date, are also credited or debited to OCI.
Answer:
- The translation differences from converting the subsidiary’s net assets and the long-term loan will both be recognised in OCI and accumulated in a translation reserve in equity. They are not included in profit or loss.
Worked Example 1.2
Maple plc’s net investment in ForeignSub Inc. includes its share of equity and a $4 million long-term loan, for which settlement is neither planned nor likely. During the year, the GBP weakened relative to the USD, resulting in a translation gain.
What is the correct accounting treatment?
Answer:
- The translation gain arising on both the foreign subsidiary’s net assets and the qualifying loan is recorded in OCI and accumulated in a separate equity reserve. On full disposal of the subsidiary, this cumulative amount is transferred to profit or loss.
Exam Warning
A frequent error is posting translation differences on net investment loans directly to profit or loss. For the ACCA FR exam, remember: exchange differences on such loans are recognised in OCI—not in the statement of profit or loss—if considered part of the net investment.
Summary
IAS 21 requires foreign operations to be translated for group reporting using the closing rate for assets and liabilities, resulting in translation differences. These differences, including those on net investment monetary items, are taken to a separate component of equity through OCI. Only when the foreign operation is disposed of are these amounts recycled to profit or loss.
Key Point Checklist
This article has covered the following key knowledge points:
- Explain functional and presentation currency under IAS 21
- Describe translation of financial statements of foreign operations using closing and average rates
- Define net investment in a foreign operation and identify qualifying monetary items
- Account for exchange differences on foreign operations and related loans in OCI
- Explain recycling of cumulative translation differences from OCI to profit or loss upon disposal
Key Terms and Concepts
- functional currency
- presentation currency
- net investment in a foreign operation
- exchange differences
- closing rate