Accounting Science

Exploring IAS 21 International Accounting Standard: The Effects of Changes in Foreign Exchange Rates

Posted by

mariam elghandour

March 15, 2025

On February 17, 2025

In an increasingly interconnected world, foreign currency transactions have become commonplace for many businesses .IAS 21 International Accounting Standard The Effects of Changes in Foreign Exchange Rates” provides an accounting roadmap for dealing with these transactions and their impact on financial statements. In this article, we will delve into IAS 21 International Accounting Standard, discussing its objectives, scope, and key requirements, focusing on how to translate financial statements of foreign operations, handle foreign currency transactions, and required disclosures, in addition to highlighting the importance of this standard and its impact on companies with international activities.

What is IAS 21 International Accounting Standard: The Effects of Changes in Foreign Exchange Rates?

IAS 21 International Accounting Standard is one of the International Financial Reporting Standards that sets out how to account for foreign currency transactions and how to translate the financial statements of foreign operations into an entity’s presentation currency. The standard aims to ensure that the effects of changes in foreign exchange rates are correctly reflected in the financial statements and to provide useful and reliable information to users of these statements.

Objectives of International Accounting Standard 21 (IAS 21):

To prescribe how to include foreign currency transactions and foreign operations in an entity’s financial statements.
To prescribe how to translate financial statements into a presentation currency.
To provide information about the effects of changes in foreign exchange rates on an entity’s financial position, financial performance, and cash flows.
To enhance the comparability of financial statements between entities that conduct transactions in foreign currencies or have foreign operations.
To improve the quality and transparency of financial reporting.

Scope of International Accounting Standard 21 (IAS 21):

IAS 21 International Accounting Standard applies to:

Accounting for transactions and balances in foreign currencies, except for those transactions and balances related to derivatives that fall within the scope of International Financial Reporting Standard 9 (IFRS 9) “Financial Instruments.”
Translating the results and financial position of foreign operations that are included in the entity’s financial statements by consolidation, proportionate consolidation, or the equity method.
Translating an entity’s results and financial position into a presentation currency.

IAS 21 International Accounting Standard does not apply to:

The presentation of cash flows arising from foreign currency transactions in the statement of cash flows (which is governed by International Accounting Standard 7).
The hedge accounting of foreign currency items (which is governed by IFRS 9).

Key Definitions in IAS 21 International Accounting Standard:

Foreign Operation: An entity that is a subsidiary, associate, joint arrangement, or branch of a reporting entity, the activities of which are based or conducted in a country or currency other than those of the reporting entity.
Presentation Currency: The currency in which the financial statements are presented.
Functional Currency: The currency of the primary economic environment in which the entity operates.
Exchange Rate: The ratio of exchange for two currencies.
Closing Rate: The spot exchange rate at the end of the reporting period.
Spot Exchange Rate: The exchange rate for immediate delivery.
Exchange Difference: The difference resulting from translating a given number of units of one currency into another currency at different exchange rates.
Net Investment in a Foreign Operation: The reporting entity’s share of the net assets of that operation.

Determination of Functional Currency:

Determining an entity’s functional currency is a fundamental step in applying IAS 21 International Accounting Standard. An entity must determine its functional currency based on the primary economic environment in which it operates, considering the following factors:

The currency that mainly influences sales prices for goods and services.
The Currency of the country whose competitive forces and regulations mainly determine the sales prices of goods and services.
The Currency in which labor, material, and other costs of providing goods or services are mainly compiled.
The currency in which funds from financing activities are generated.
The currency in which receipts from operating activities are usually retained.

Accounting for Foreign Currency Transactions:

Initial Recognition: Upon initial recognition, a foreign currency transaction must be recorded in the functional currency by applying the spot exchange rate between the functional currency and the foreign currency at the date of the transaction.
Subsequent Measurement at the End of Each Reporting Period:
- Foreign currency monetary items: Must be translated using the closing rate.
- Non-monetary items that are measured at historical cost in a foreign currency: Must be translated using the exchange rate at the date of the transaction.
- Non-monetary items that are measured at fair value in a foreign currency: must be translated using the exchange rates that existed when the fair value was determined.
Recognition of Exchange Differences:
- Exchange differences arising from the settlement of monetary items or from translating monetary items at rates different from those at which they were translated on initial recognition are recognized in profit or loss in the period in which they arise.
- When a gain or loss on a non-monetary item is recognized in other comprehensive income, any exchange difference relating to that gain or loss is recognized in other comprehensive income.
- When there is a net investment in a foreign operation, exchange differences arising from this investment are recognized in other comprehensive income until the disposal of the foreign operation.

Translation of Financial Statements of Foreign Operations:

When preparing consolidated financial statements, a parent entity must translate the financial statements of its foreign operations into the presentation currency. IAS 21 International Accounting Standard specifies two methods for translating the financial statements of foreign operations:

Closing Rate/Net Investment Method:
- This method is used when the functional currency of the foreign operation is the same as the presentation currency of the parent entity, or when the foreign operation is integrated with the operations of the parent entity.
- Assets and liabilities: All assets and liabilities are translated using the closing rate at the date of the financial statements.
- Income and expense items: All income and expense items are translated using the exchange rates at the dates of the transactions (or using a weighted average of exchange rates during the period).
- Exchange differences: Exchange differences resulting from the translation are recognized as a separate component of other comprehensive income.
Temporal Method:
- This method is used when the functional currency of the foreign operation is not the same as the presentation currency of the parent entity, and the foreign operation is not considered integrated with the operations of the parent entity.
- Monetary items: Are translated using the closing rate.
- Non-monetary items: Are translated using the exchange rate at the date of the transaction (for items measured at historical cost) or the exchange rate at the date the fair value was determined (for items measured at fair value).
- Income and expense items: Are translated using the exchange rates at the dates of the transactions.
- Exchange differences: Exchange differences resulting from the translation are recognized in profit or loss.

Disclosures Required under IAS 21 International Accounting Standard:

IAS 21 International Accounting Standard requires entities to disclose the following information:

The amount of exchange differences recognized in profit or loss during the period.
The amount of exchange differences classified as a separate component of equity, and a reconciliation between the opening and closing balances of these differences.
The functional currency if it is different from the presentation currency.
The reason for using a presentation currency different from the functional currency (if applicable).
The Reason for any change in the functional currency.
When additional information is presented in a currency other than the presentation currency, this currency must be clearly disclosed, and the functional currency and the exchange rate used for conversion must be disclosed.

Importance of IAS 21 International Accounting Standard for Companies:

IAS 21 International Accounting Standard is an important International Financial Reporting Standard that helps companies:

Comply with International Financial Reporting Standards: IAS 21 International Accounting Standard ensures that companies account for foreign currency transactions and the effects of changes in exchange rates consistently with International Financial Reporting Standards.
Improve the quality of financial reporting: The application of IAS 21 International Accounting Standard enhances the quality, relevance, and reliability of financial information relating to foreign currency transactions and operations.

Enhance investor confidence: IAS 21 International Accounting Standard helps build investor confidence by providing more accurate and transparent information about the impact of changes in exchange rates on an entity’s financial position and performance.
Better manage foreign currency risks: IAS 21 International Accounting Standard provides a clear accounting framework for dealing with foreign currency risks, helping companies to assess and manage these risks more effectively.
Make better decisions: IAS 21 International Accounting Standard helps management to make better decisions regarding pricing, financing, and investment in foreign operations.

Challenges in Applying IAS 21 International Accounting Standard:

Determining the functional currency: It may be difficult in some cases to determine an entity’s functional currency, especially for multinational companies with complex operations.
Selecting the appropriate translation method: Companies must choose the translation method (closing rate/net investment or temporal) that suits the circumstances of each foreign operation.
Gathering the necessary data: It may be difficult to gather the data necessary to translate the financial statements of foreign operations, especially if these operations operate in countries with different accounting systems.
Dealing with exchange rate fluctuations: Companies must keep pace with constant changes in foreign exchange rates and assess their impact on financial statements.
Understanding the requirements of the standard: IAS 21 International Accounting Standard is a relatively complex standard, and its proper understanding and application may require specialized accounting expertise.

The Role of Technology in Applying IAS 21 International Accounting Standard:

Accounting software and Enterprise Resource Planning (ERP) systems help in applying IAS 21 International Accounting Standard more efficiently and accurately by:

Automating the process of translating the financial statements of foreign operations.
Tracking and updating foreign exchange rates continuously.
Calculating and automatically recognizing exchange differences in the financial statements.
Issuing the necessary reports to comply with disclosure requirements.
Improving the accuracy and comprehensiveness of financial information relating to foreign currency transactions and operations.

Examples of Applying IAS 21 International Accounting Standard:

Example (1): Foreign Currency Transaction
- Situation: Company “A” (whose functional currency is Saudi Riyal) purchased goods from a foreign supplier for $10,000 on December 1, 2023, when the exchange rate was 3.75 riyals per dollar. The company paid for the goods on December 31, 2023, when the exchange rate was 3.80 riyals per dollar.
- Accounting Treatment:
  - December 1, 2023 (Purchase Date):
    - 37,500 riyals Dr./ Purchases
    - 37,500 riyals Cr./ Creditors
  - December 31, 2023 (Payment Date):
    - 37,500 riyals Dr./ Creditors
    - 500 riyals Dr./ Exchange Difference Expense
    - 38,000 riyals Cr./ Cash
Example (2): Translation of the Financial Statements of a Foreign Operation
- Situation: Company “B” (whose functional currency is the Egyptian Pound) owns a subsidiary in the United Kingdom (whose functional currency is the British Pound). Company “B” wishes to translate the financial statements of its subsidiary into Egyptian Pounds for the purpose of preparing consolidated financial statements.
- Accounting Treatment:
  - Company “B” will determine the appropriate translation method (closing rate/net investment or temporal) based on the relationship between the subsidiary and the parent company.
  - Company “B” will translate the assets, liabilities, income, and expense items of the subsidiary using the appropriate exchange rates according to the selected method.
  - Company “B” will recognize the resulting translation differences in profit or loss or other comprehensive income, depending on the translation method used.

Conclusion

International Accounting Standard 21 (IAS 21) provides a comprehensive accounting framework for dealing with the effects of changes in foreign exchange rates in financial statements. The application of this standard ensures that financial information relating to foreign currency transactions and operations is presented fairly and transparently, thereby enhancing the quality and reliability of financial reporting. Understanding IAS 21 International Accounting Standard is essential for accountants, auditors, investors, and anyone seeking to understand how changes in foreign exchange rates affect an entity’s financial position and performance. With increasing globalization and the prevalence of multinational corporations, IAS 21 International Accounting Standard is increasingly important as a tool to enhance the comparability and consistency of financial reporting worldwide.