Foreign Currency and Foreign Operations
Groups
Foreign Currency and Foreign Operations
Syllabus tag: KASNEB CPA | Advanced Level | CA32 Advanced Financial Reporting and Analysis | Topic 5 Foreign Currency and Foreign Operations
Lesson objectives
By the end of this topic, you will be able to:
- Determine an entity's functional currency
- Translate individual foreign currency transactions
- Distinguish monetary from non-monetary items at the reporting date
- Translate a foreign operation for consolidation
- Explain where exchange differences are recognised and why
Why this matters
A Kenyan group with a Ugandan subsidiary must express everything in shillings. Which rate applies to which item, and where the resulting difference goes, is what this topic settles.
Functional currency
The currency of the primary economic environment in which the entity operates — not necessarily the currency of the country it sits in.
Primary indicators: the currency that mainly influences selling prices, and the currency that mainly influences labour, material and other costs.
Secondary: the currency in which financing is raised and in which receipts are retained.
Functional currency is determined, not chosen. A Kenyan company selling oil priced in dollars, buying in dollars and financed in dollars may have a US dollar functional currency despite operating in Nairobi. Presentation currency, by contrast, is a free choice — a group may present in shillings whatever its subsidiaries' functional currencies are.
Individual transactions
On initial recognition, translate at the spot rate on the transaction date.
At the reporting date:
| Item | Rate | Difference |
|---|---|---|
| Monetary — cash, receivables, payables, loans | Closing rate | Profit or loss |
| Non-monetary at historical cost — inventory, PPE | Historical rate | None arises |
| Non-monetary at fair value | Rate when fair value was measured | Follows the gain or loss |
The monetary test is whether the item is a right to receive, or an obligation to deliver, a fixed or determinable number of currency units. A receivable is monetary; the inventory it paid for is not.
Worked example. Goods bought for FC 500,000 when the rate is 12.5, settled when the rate is 13.2:
| KES | |
|---|---|
| Initial recognition (500,000 × 12.5) | 6,250,000 |
| Cash paid on settlement (500,000 × 13.2) | 6,600,000 |
| Exchange loss to profit or loss | 350,000 |
Note the inventory stays at 6,250,000. It is non-monetary and is never retranslated — the loss arises on the payable, not on the goods.
:::checkpoint A company buys machinery for FC 800,000 on credit. By the year end the exchange rate has moved and the invoice is unpaid. State which of the machine and the payable is retranslated, and where any difference goes. :::
Translating a foreign operation
For consolidation, the whole subsidiary is translated:
| Item | Rate |
|---|---|
| Assets and liabilities | Closing rate |
| Income and expenses | Average rate for the period |
| Equity and pre-acquisition reserves | Historical rate |
| Goodwill on the foreign operation | Closing rate — it is a foreign currency asset |
Exchange differences go to other comprehensive income and accumulate in a separate translation reserve in equity.
Worked example. Net assets FC 40,000,000 at the start and 46,000,000 at the end; profit FC 6,000,000. Opening rate 12.0, closing 14.0, average 13.0.
| KES | |
|---|---|
| Closing net assets (46m × 14.0) | 644,000,000 |
| Less opening net assets (40m × 12.0) | (480,000,000) |
| Less profit at average rate (6m × 13.0) | (78,000,000) |
| Exchange difference to OCI | 86,000,000 |
Why OCI rather than profit or loss. The difference arises from retranslating a net investment the group has no intention of realising. It is not a trading gain, and putting it through profit would make reported earnings swing with exchange rates for reasons unconnected with performance.
On disposal of the foreign operation, the accumulated translation reserve is reclassified to profit or loss — the gain is realised at that point, and that is when it belongs in earnings.
Why the average rate for income
Income and expenses arise throughout the year, so a single date's rate would misstate them. The average approximates translating each transaction at its own date, and is permitted unless rates fluctuated significantly, in which case actual rates for the periods concerned should be used.
Goodwill on a foreign subsidiary
Goodwill is treated as an asset of the foreign operation, denominated in its currency, and retranslated at the closing rate each year. The movement forms part of the exchange difference in OCI.
Treating goodwill as a shilling asset fixed at the acquisition rate is a common error, and it leaves the translation reserve failing to reconcile.
:::checkpoint A group reports a large exchange loss in OCI while its foreign subsidiary traded profitably. Explain to a director how both can be true, and what would have to happen for the loss to reach profit or loss. :::