International Accounting Standard No. 21, The Effects of Changes in Foreign Exchange Rates, deals with foreign...

        

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International Accounting Standard No. 21, "The Effects of Changes in Foreign Exchange Rates," deals with foreign currency. It was originally issued in 1983 and was revised and reissued in 1993 as part of the IASC's Comparability Project. The original IAS No. 21 (along with the corresponding standards in Canada and the United Kingdom) was issued shortly after SFAS No. 52 in the United States. It is therefore not surprising that it adopts the same basic approach to foreign currency translation as SFAS No. 52. However, there are differences in the terminology used in the two standards. IAS No. 21 does not use the term functional currency. Rather, it uses terms such as foreign entity and foreign operations that are integral to the operations of the reporting enterprise. Under IAS No. 21, a foreign entity is one that "accumulates cash and other monetary items, incurs expenses, generates income, and perhaps arranges borrowings, all substantially in its local currency." Thus, a foreign entity under IAS No. 21 is essentially similar to those entities under SFAS No. 52 for whom the local currency is the functional currency. Similarly, foreign operations that are integral to the operations of the reporting enterprise under IAS No. 21 are similar to those foreign subsidiaries for which the functional currency is the U.S. dollar under SFAS No. 52. IAS No. 21 requires the use of the temporal method of translation for foreign opera- tions that are integral to the operations of the reporting enterprise. Translation gains or losses are included in the income statement. Under IAS No. 21, the current rate method of translation is required for a foreign entity. The translation gains and losses are transferred to reserves and reported in shareholders' equity. There is at least one important difference between IAS No. 21 and SFAS No. 52. Under IAS No. 21, the financial statements of subsidiaries in highly inflationary economies must be adjusted to reflect changes in general price levels before translation. This approach, often referred to as "restate/translate," is similar to that followed in the United Kingdom. The approach adopted under SFAS No. 52 in the United States is "translate/restate." The FASB did consider the "restate/translate" approach while working on SFAS No. 52 but decided against it. Many regard the "restate/translate" approach as being the more accurate of the two because it actually accounts for changes in purchasing power. The "translate/restate" approach, on the other hand, assumes that the effects of inflation are captured by the change in the exchange rate. As with a number of other international accounting standards that are criticized for allowing alternative accounting treatments, IAS No. 21 also permits alternative treatments in two situations. The first situation relates to exchange losses on a liability for the recent acquisition of an asset purchased in a foreign currency. Similar to SFAS No. 52, the benchmark treatment under IAS No. 21 requires that the exchange losses be charged to expense. However, the alternative treatment under IAS No. 21 allows exchange losses to be added to the cost of the asset when the related liability cannot be settled and there is no practical means of hedging. Another area where IAS No. 21 permits alternative treatments is in translating goodwill and fair value adjustments to assets and liabilities that arise from purchase accounting for the acquisition of a foreign entity for which the local currency is the functional currency. When the local currency is the functional currency, SFAS No. 52 requires use of the current exchange rate to translate all balance sheet items, including goodwill and fair value adjust- ments. IAS No. 21 allows the use of either the current exchange rate or the historical exchange rate. There could be significant differences in the results of current rate translation relative to historical rate translation of goodwill, fair value adjustments of balance sheet items, and related depreciation, amortization, and other expenses. SUMMARY 1. Most companies engaged in international business are affected by the fluctuation in the value of currencies (relative to other currencies). Currencies can be traded in the spot market or the forward market. The exchange rate of currencies can be quoted direct (the price of one unit of a foreign currency in your currency) or in- direct (the units of the foreign currency available for one unit of your currency). 2. There are three main types of foreign exchange exposure: 1) translation exposure, 2) transaction exposure, and 3) economic exposure. 3. There is a distinction in the accounting treatment of foreign currency transla- tion gains and losses and foreign currency transaction gains and losses. Foreign currency transaction gains and losses are required to be included in the income statement. The treatment of foreign currency translation gains and losses depends on the accounting method used. 4. The four methods of accounting for foreign currency translation are the current rate method, the current/non-current method, the monetary/non-monetary method, and the temporal method. 5. In the United States, FASB Statement No. 52 introduced the concept of functional cur- rency to be used in determining the foreign currency translation method to be used. QUESTIONS 1. What are the different types of foreign exchange exposure faced by companies engaged in international business? Explain what causes each type of exposure. 2. What are the accounting issues related to gains or losses from foreign currency trans- actions? What are the alternatives for foreign currency transaction accounting? 3. Why is translation exposure also referred to as accounting exposure? In what respects is translation exposure different from transaction exposure? 4. Explain the different foreign currency translation methods. What are the pros and cons of each of the translation methods? 5. Which foreign currency translation method did the FASB mandate under SFAS No. 8? What was the reaction of the U.S. business community to SFAS No. 8? How did the FASB respond to the criticism of SFAS No. 8? 6. 7. Describe the requirements for foreign currency translation under SFAS No. 52. 8. Discuss the concept of functional currency under SFAS No. 52. What purpose does the functional currency serve? In your view, was it really necessary to include functional currency in SFAS No. 52? 9. In choosing the foreign currency translation method under SFAS No. 52, the FASB included an important exception. What was this exception, and why was it necessary? International Accounting Standard No. 21, "The Effects of Changes in Foreign Exchange Rates," deals with foreign currency. It was originally issued in 1983 and was revised and reissued in 1993 as part of the IASC's Comparability Project. The original IAS No. 21 (along with the corresponding standards in Canada and the United Kingdom) was issued shortly after SFAS No. 52 in the United States. It is therefore not surprising that it adopts the same basic approach to foreign currency translation as SFAS No. 52. However, there are differences in the terminology used in the two standards. IAS No. 21 does not use the term functional currency. Rather, it uses terms such as foreign entity and foreign operations that are integral to the operations of the reporting enterprise. Under IAS No. 21, a foreign entity is one that "accumulates cash and other monetary items, incurs expenses, generates income, and perhaps arranges borrowings, all substantially in its local currency." Thus, a foreign entity under IAS No. 21 is essentially similar to those entities under SFAS No. 52 for whom the local currency is the functional currency. Similarly, foreign operations that are integral to the operations of the reporting enterprise under IAS No. 21 are similar to those foreign subsidiaries for which the functional currency is the U.S. dollar under SFAS No. 52. IAS No. 21 requires the use of the temporal method of translation for foreign opera- tions that are integral to the operations of the reporting enterprise. Translation gains or losses are included in the income statement. Under IAS No. 21, the current rate method of translation is required for a foreign entity. The translation gains and losses are transferred to reserves and reported in shareholders' equity. There is at least one important difference between IAS No. 21 and SFAS No. 52. Under IAS No. 21, the financial statements of subsidiaries in highly inflationary economies must be adjusted to reflect changes in general price levels before translation. This approach, often referred to as "restate/translate," is similar to that followed in the United Kingdom. The approach adopted under SFAS No. 52 in the United States is "translate/restate." The FASB did consider the "restate/translate" approach while working on SFAS No. 52 but decided against it. Many regard the "restate/translate" approach as being the more accurate of the two because it actually accounts for changes in purchasing power. The "translate/restate" approach, on the other hand, assumes that the effects of inflation are captured by the change in the exchange rate. As with a number of other international accounting standards that are criticized for allowing alternative accounting treatments, IAS No. 21 also permits alternative treatments in two situations. The first situation relates to exchange losses on a liability for the recent acquisition of an asset purchased in a foreign currency. Similar to SFAS No. 52, the benchmark treatment under IAS No. 21 requires that the exchange losses be charged to expense. However, the alternative treatment under IAS No. 21 allows exchange losses to be added to the cost of the asset when the related liability cannot be settled and there is no practical means of hedging. Another area where IAS No. 21 permits alternative treatments is in translating goodwill and fair value adjustments to assets and liabilities that arise from purchase accounting for the acquisition of a foreign entity for which the local currency is the functional currency. When the local currency is the functional currency, SFAS No. 52 requires use of the current exchange rate to translate all balance sheet items, including goodwill and fair value adjust- ments. IAS No. 21 allows the use of either the current exchange rate or the historical exchange rate. There could be significant differences in the results of current rate translation relative to historical rate translation of goodwill, fair value adjustments of balance sheet items, and related depreciation, amortization, and other expenses. SUMMARY 1. Most companies engaged in international business are affected by the fluctuation in the value of currencies (relative to other currencies). Currencies can be traded in the spot market or the forward market. The exchange rate of currencies can be quoted direct (the price of one unit of a foreign currency in your currency) or in- direct (the units of the foreign currency available for one unit of your currency). 2. There are three main types of foreign exchange exposure: 1) translation exposure, 2) transaction exposure, and 3) economic exposure. 3. There is a distinction in the accounting treatment of foreign currency transla- tion gains and losses and foreign currency transaction gains and losses. Foreign currency transaction gains and losses are required to be included in the income statement. The treatment of foreign currency translation gains and losses depends on the accounting method used. 4. The four methods of accounting for foreign currency translation are the current rate method, the current/non-current method, the monetary/non-monetary method, and the temporal method. 5. In the United States, FASB Statement No. 52 introduced the concept of functional cur- rency to be used in determining the foreign currency translation method to be used. QUESTIONS 1. What are the different types of foreign exchange exposure faced by companies engaged in international business? Explain what causes each type of exposure. 2. What are the accounting issues related to gains or losses from foreign currency trans- actions? What are the alternatives for foreign currency transaction accounting? 3. Why is translation exposure also referred to as accounting exposure? In what respects is translation exposure different from transaction exposure? 4. Explain the different foreign currency translation methods. What are the pros and cons of each of the translation methods? 5. Which foreign currency translation method did the FASB mandate under SFAS No. 8? What was the reaction of the U.S. business community to SFAS No. 8? How did the FASB respond to the criticism of SFAS No. 8? 6. 7. Describe the requirements for foreign currency translation under SFAS No. 52. 8. Discuss the concept of functional currency under SFAS No. 52. What purpose does the functional currency serve? In your view, was it really necessary to include functional currency in SFAS No. 52? 9. In choosing the foreign currency translation method under SFAS No. 52, the FASB included an important exception. What was this exception, and why was it necessary?

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