would be recognised in other comprehensive income on consolidation. This is
discussed further in the following example.
Example 15.14: Monetary item becoming part of the net investment in a foreign
operation
A UK entity has a wholly owned Canadian subsidiary whose net assets at 31 December 2018 were
C$2,000,000. These net assets were arrived at after taking account of a liability to the UK parent of £250,000.
Using the closing exchange rate of £1=C$2.35 this liability was included in the Canadian company’s
statement of financial position at that date at C$587,500. On 30 June 2019, when the exchange rate was
£1=C$2.45, the parent decided that in order to refinance the Canadian subsidiary it would regard the liability
of £250,000 as a long-term liability which would not be called for repayment in the foreseeable future.
Consequently, the parent thereafter regarded the loan as being part of its net investment in the subsidiary. In
the year ended 31 December 2019 the Canadian company made no profit or loss other than any exchange
difference to be recognised on its liability to its parent. The relevant exchange rate at that date was £1=C$2.56.
The average exchange rate for the year ended 31 December 2019 was £1=C$2.50.
The financial statements of the subsidiary in C$ and translated using the closing rate are as follows:
Foreign
exchange
1151
Statement of financial
31 December 2019
31 December 2018
position
C$
£
C$
£
Assets 2,587,500
1,010,742
2,587,500
1,101,064
Amount due to parent 640,000
250,000
587,500
250,000
Net assets
1,947,500
760,742
2,000,000
851,064
Income statement
Exchange difference
(52,500)
If the amount due to the parent is not part of the parent’s net investment in the foreign operation, this exchange
loss would be translated at the average rate and included in the consolidated profit and loss account as
£21,000. As the net investment was C$2,000,000 then there would have been an exchange loss recognised in
other comprehensive income of £69,814, i.e. £851,064 less £781,250 (C$2,000,000 @ £1=C$2.56), together
with an exchange gain of £492, being the difference between profit or loss translated at average rate, i.e.
£21,000, and at the closing rate, i.e. £20,508.
However, the parent now regards the amount due as being part of the net investment in the subsidiary. The
question then arises as to when this should be regarded as having happened and how the exchange difference
on it should be calculated. No guidance is given in IAS 21.
In our view, the ‘capital injection’ should be regarded as having occurred at the time it is decided to
redesignate the inter-company account. The exchange differences arising on the account up to that date
should be recognised in profit or loss. Only the exchange difference arising thereafter would be
recognised in other comprehensive income on consolidation. The inter-company account that was
converted into a long-term loan becomes part of the entity’s (UK parent’s) net investment in the foreign
operation (Canadian subsidiary) at the moment in time when the entity decides that settlement is neither
planned nor likely to occur in the foreseeable future, i.e. 30 June 2019. Accordingly, exchange
differences arising on the long-term loan are recognised in other comprehensive income and
accumulated in a separate component of equity from that date. The same accounting treatment would
have been applied if a capital injection had taken place at the date of redesignation.
At 30 June 2019 the subsidiary would have translated the inter-company account as C$612,500 (£250,000 @
£1=C$2.45) and therefore the exchange loss up to that date was C$25,000. Translated at the average rate this
amount would be included in consolidated profit or loss as £10,000, with only an exchange gain of £234
recognised in other comprehensive income, being the difference between profit or loss translated at average
rate, i.e. £10,000, and at the closing rate, i.e. £9,766. Accordingly, £11,000 (£21,000 less £10,000) offset by
a reduction in the exchange gain on the translation of profit or loss of £258 (£492 less £234) would be
recognised in other comprehensive income. This amount represents the exchange loss on the ‘capital
injection’ of C$612,500. Translated at the closing rate this amounts to £239,258 which is £10,742 less than
the original £250,000.
Some might argue that an approach of regarding the ‘capital injection’ as having occurred at the beginning
of the accounting period would have the merit of treating all of the exchange differences for this year in the
same way. However, for the reasons provided above we do not regard such an approach as being acceptable.
Suppose, instead of the inter-company account being £250,000, it was denominated in dollars at C$587,500.
In this case the parent would be exposed to the exchange risk; what would be the position?
The subsidiary’s net assets at both 31 December 2018 and 2019 would be:
Assets C$2,587,500
Amount due to parent
C$587,500
Net assets
C$2,000,000
As the inter-company account is expressed in Canadian dollars, there will be no exchange difference thereon
in the subsidiary’s profit or loss.
1152 Chapter 15
There will, however, be an exchange loss in the parent as follows:
C$587,500
@ 2.35 =
£250,000
@ 2.56 =
£229,492
£20,508
Again, in the consolidated financial statements as the inter-company account is now regarded as part of the
equity investment some of this amount should be recognised in other comprehensive income. For the reasons
stated above, in our view it is only the exchange differences that have arisen after the date of redesignation,
i.e. 30 June 2019,that should be recognised in other comprehensive income.
On this basis, the exchange loss would be split as follows:
C$587,500
@ 2.35 =
£250,000
@ 2.45 =
£239,796
£10,204
@ 2.45 =
£239,796
@ 2.56 =
£229,492
£10,304
The exchange loss up to 30 June 2019 of £10,204 would be recognised in consolidated profit or loss and the
exchange loss thereafter of £10,304 would be recognised in other comprehensive income. This is different
from when the account was expressed in sterling because the ‘capital injection’ in this case is C$587,500
whereas before it was effectively C$612,500.
6.3.6
Monetary items ceasing to be part of the net investment in a foreign
operation
The previous section dealt with the situation where a pre-existing monetary item was
subsequently considered to form part of the net investment in a foreign operation.
However, what happens where a monetary item ceases to be considered part of the net
investment in a foreign operation, either because the circumstances have changed such
that it is now planned or is likely to be
settled in the foreseeable future or indeed that
the monetary item is in fact settled?
Where the circumstances have changed such that the monetary item is now planned or
is likely to be settled in the foreseeable future, then similar issues to those discussed
at 6.3.1 above apply; i.e. are the exchange differences on the intragroup balance to be
recognised in profit or loss only from the date of change or from the beginning of the
financial year? For the same reasons set out in Example 15.14 above, in our view, the
monetary item ceases to form part of the net investment in the foreign operation at the
moment in time when the entity decides that settlement is planned or is likely to occur
in the foreseeable future. Accordingly, exchange differences arising on the monetary
item up to that date are recognised in other comprehensive income and accumulated in
a separate component of equity. The exchange differences that arise after that date are
recognised in profit or loss.
Consideration also needs to be given as to the treatment of the cumulative exchange
differences on the monetary item that have been recognised in other comprehensive
income, including those that had been recognised in other comprehensive income in
prior years. The treatment of these exchange differences is to recognise them in other
comprehensive income and accumulate them in a separate component of equity until
the disposal of the foreign operation. [IAS 21.45]. The principle question is whether the
Foreign
exchange
1153
change in circumstances or actual settlement in cash of the intragroup balance
represents a disposal or partial disposal of the foreign operation and this is considered
in more detail at 6.6 below.
6.3.7 Dividends
If a subsidiary pays a dividend to the parent during the year the parent should record the
dividend at the rate ruling when the dividend was declared. An exchange difference will
arise in the parent’s own financial statements if the exchange rate moves between the
declaration date and the date the dividend is actually received. This exchange difference
is required to be recognised in profit or loss and will remain there on consolidation.
The same will apply if the subsidiary declares a dividend to its parent on the last day of its
financial year and this is recorded at the year-end in both entities’ financial statements.
There is no problem in that year as both the intragroup balances and the dividends will
eliminate on consolidation with no exchange differences arising. However, as the dividend
will not be received until the following year an exchange difference will arise in the parent’s
financial statements in that year if exchange rates have moved in the meantime. Again, this
exchange difference should remain in consolidated profit or loss as it is no different from
any other exchange difference arising on intragroup balances resulting from other types of
intragroup transactions. It should not be recognised in other comprehensive income.
It may seem odd that the consolidated results can be affected by exchange differences on
inter-company dividends. However, once the dividend has been declared, the parent now
effectively has a functional currency exposure to assets that were previously regarded as
part of the net investment. In order to minimise the effect of exchange rate movements
entities should, therefore, arrange for inter-company dividends to be paid on the same
day the dividend is declared, or as soon after the dividend is declared as possible.
6.3.8
Unrealised profits on intragroup transactions
The other problem area is the elimination of unrealised profits resulting from intragroup
transactions when one of the parties to the transaction is a foreign subsidiary.
Example 15.15: Unrealised profits on an intragroup transaction
An Italian parent has a wholly owned Swiss subsidiary. On 30 November 2019 the subsidiary sold goods to
the parent for CHF1,000. The cost of the goods to the subsidiary was CHF700. The goods were recorded by
the parent at €685 based on the exchange rate ruling on 30 November 2019 of €1=CHF1.46. All of the goods
are unsold by the year-end, 31 December 2019. The exchange rate at that date was €1=CHF1.52. How should
the intragroup profit be eliminated?
IAS 21 contains no specific guidance on this matter. However, US GAAP requires the rate ruling at the date
of the transaction to be used.
The profit shown by the subsidiary is CHF300 which translated at the rate ruling on the transaction of
€1=CHF1.46 equals €205. Consequently, the goods will be included in the statement of financial position at:
Per parent company statement of financial position
€685
Less unrealised profit eliminated
€205
€480
It can be seen that the resulting figure for inventory is equivalent to the original euro cost translated at the
rate ruling on the date of the transaction. Whereas if the subsidiary still held the inventory it would be included
at €461 (CHF700 @ €1=CHF1.52).
1154 Chapter 15
If in the above example the goods had been sold by the Italian parent to the Swiss
subsidiary then the approach in US GAAP would say the amount to be eliminated is the
amount of profit shown in the Italian entity’s financial statements. Again, this will not
necessarily result in the goods being carried in the consolidated financial statements at
their original cost to the group.
6.4
Non-coterminous period ends
IAS 21 recognises that in preparing consolidated financial statements it may be that a
foreign operation is consolidated on the basis of financial statements made up to a
different date from that of the reporting entity (see Chapter 7 at 2.5). In such a case, the
standard initially states that the assets and liabilities of the foreign operation are to be
translated at the exchange rate at the end of the reporting period of the foreign
operation rather than at the date of the consolidated financial statements. However, it
then goes on to say that adjustments are made for significant changes in exchange rates
up to the end of the reporting period of the reporting entity in accordance with IFRS 10
– Consolidated Financial Statements. The same approach is used in applying the equity
method to associates and joint ventures in accordance with IAS 28 – Investments in
Associates and Joint Ventures (see Chapters 11 and 12). [IAS 21.46].
The rationale for this approach is not explained in IAS 21. The initial treatment is that
required by US GAAP and the reason given in that standard is that this presents the
functional currency performance of the subsidiary during the subsidiary’s financial year
and its position at the end of that period in terms of the parent company’s reporting
(presentation) currency. The subsidiary may have entered into transactions in other
currencies, including the functional currency of the parent, and monetary items in these
currencies will have been translated using rates ruling at the end of the subsidiary’s
reporting period. The income statement of the subsidiary will reflect the economic
consequences of carrying out these transactions during the period ended on that date.
In order that the effects
of these transactions in the subsidiary’s financial statements are
not distorted, the financial statements should be translated using the closing rate at the
end of the subsidiary’s reporting period.
However, an alternative argument could have been advanced for using the closing rate
ruling at the end of the parent’s reporting period. All subsidiaries within a group should
normally prepare financial statements up to the same date as the parent entity so that
the parent can prepare consolidated financial statements that present fairly the financial
performance and financial position about the group as that of a single entity. The use of
financial statements of a subsidiary made up to a date earlier than that of the parent is
only an administrative convenience and a surrogate for financial statements made up to
the proper date. Arguably, therefore the closing rate that should have been used is that
which would have been used if the financial statements were made up to the proper
date, i.e. that ruling at the end of the reporting period of the parent. Another reason for
using this rate is that there may be subsidiaries that have the same functional currency
as the subsidiary with the non-coterminous year end that do make up their financial
statements to the same date as the parent company and therefore in order to be
consistent with them the same rate should be used.
Foreign
exchange
1155
6.5
Goodwill and fair value adjustments
The treatment of goodwill and fair value adjustments arising on the acquisition of a
foreign operation should depend on whether they are part of: [IAS 21.BC27]
(a) the assets and liabilities of the acquired entity (which would imply translating them
at the closing rate); or
(b) the assets and liabilities of the parent (which would imply translating them at the
historical rate).
In the case of fair value adjustments these clearly relate to the acquired entity. However,
International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards Page 228
