IAS 21 Effect of changes in foreign currency rates

An entity that buys or sells abroad, borrows abroad, or holds a bank account in another country ends up holding amounts in a currency that is not its own. Those amounts cannot simply be added to the rest: a set of financial statements is arithmetic in one currency, and every figure in it has to be in that currency before anything can be totalled. IAS 21 The Effects of Changes in Foreign Exchange Rates is the standard that says how.

Two quite different questions hide inside that. The first is which currency the entity actually measures in — not where its head office happens to be, but which currency its business really runs on. IAS 21 answers that with the functional currency, and everything else follows from it. The second is how a transaction denominated in some other currency gets into those books — at what rate, which balances get revisited at the year end, and where the resulting gains and losses go.

Neither question is hard, and the marks in this area are among the easiest in the paper. What loses them is answering the first question with an instinct rather than the indicators, and answering the second by retranslating everything in sight.

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1 Functional currency

Everything else in IAS 21 depends on this one decision, so the standard makes it first.

The primary economic environment is normally the one in which the entity primarily generates and expends cash — where the money it earns comes from, and where the money it spends goes. IAS 21 turns that into indicators: two that carry the most weight, and further ones considered where the first two do not settle the question.

The two primary indicators come first and normally decide it. The additional indicators are evidence to weigh where the primary ones are silent or point in different directions. Where the indicators are genuinely mixed, management uses its judgement to determine the currency that most faithfully represents the economic effects of the underlying transactions, events and conditions — but it starts from the indicators, not from a preference.

1.1 It is determined, not chosen

This is the point most often got wrong, and it is worth stating flatly. The functional currency is a matter of fact about the entity's circumstances. Management applies the indicators to those facts and arrives at an answer. It does not pick the currency it would prefer, and it cannot arrive at a different answer by changing its mind.

1.2 Changing the functional currency

Because it is determined rather than chosen, an entity changes its functional currency only when there is a change in the underlying transactions, events and conditions that determined it in the first place — a business that starts invoicing and buying in a different currency, for example, not a business that would find a different currency more convenient to report.

A change is applied prospectively from the date of the change. All items are translated into the new functional currency at the exchange rate at that date, and for non-monetary items the resulting translated amounts become their historical cost from then on. Comparatives are not restated and nothing is recalculated as though the new functional currency had always applied. A change of functional currency is not a change of accounting policy.

2 Presentation currency

The functional currency is the currency an entity measures in. The presentation currency is the currency the financial statements are displayed in — and, unlike the functional currency, it is a free choice.

An entity may present its financial statements in any currency it chooses. Where the presentation currency differs from the functional currency, the results and financial position are translated into the presentation currency — and the mechanics of doing that are exactly the ones the chapter Foreign subsidiaries applies to a subsidiary that keeps its books in another currency, because it is the same problem.

3 Recording a foreign currency transaction

A foreign currency transaction is one denominated in, or requiring settlement in, a currency other than the functional currency. It covers buying or selling goods and services whose price is fixed in a foreign currency, borrowing or lending amounts denominated in one, and acquiring or disposing of assets priced in one.

On initial recognition the foreign currency amount is translated into the functional currency at the spot exchange rate at the date of the transaction — the rate at which the two currencies could actually have been exchanged that day.

Amount in the functional currency = Foreign currency amount ÷ Spot rate

Translating every transaction at the rate on its own day would mean a different rate for every invoice. IAS 21 therefore allows a rate that approximates the actual rate at the date of the transaction to be used instead — in practice an average rate for a week or a month, applied to all the transactions in that period. The expedient is not available where exchange rates fluctuate significantly, because then an average is not an approximation of anything.

4 Monetary and non-monetary items

Once a transaction is recorded, the question at the reporting date is whether the balance it left behind is revisited. That turns on one classification, and IAS 21 defines it precisely.

Everything else is non-monetary. The test is that definition — a right to receive, or an obligation to deliver, a fixed or determinable number of currency units — and not whether the item could be turned into cash quickly. Plenty of non-monetary assets can be sold for cash tomorrow; that is not what makes an item monetary.

5 At the reporting date

Three rules, and the rule that applies to an item follows the basis on which that item is measured.

Exchange difference = (Foreign currency amount ÷ Closing rate) − Carrying amount already recorded

Nothing else is touched. That one sentence disposes of most of the marks in a computational question: work down the statement of financial position, tick the monetary balances that are denominated in a foreign currency, retranslate those, and leave everything else exactly where it is.

6 Settlement

When a monetary item is settled, the cash actually paid or received is translated at the spot rate on the day of settlement — the same rule as for any other transaction. If the rate has moved since the item was last translated, the cash will not equal the carrying amount, and the difference is an exchange gain or loss.

Where a transaction is settled in the same reporting period in which it arose, there is one difference, measured between the transaction date and the settlement date. Where it straddles a reporting date there are two: one measured from the transaction date to the reporting date and recognised in that period, and a second measured from the reporting date to the settlement date and recognised in the next. Both are real gains or losses of their own periods; the second is not a correction of the first. Section 8 works exactly that case.

7 Where exchange differences go

Exchange differences arising on monetary items — whether on retranslation at a reporting date or on settlement — are recognised in profit or loss in the period in which they arise. They are not deferred, not spread and not parked on the statement of financial position until the item is settled.

For a non-monetary item measured at fair value, the exchange component follows the gain or loss on the item itself. Where the remeasurement is recognised in other comprehensive income — a revalued property, as in Example 2 — the exchange component is recognised in other comprehensive income too. Where the remeasurement goes to profit or loss, so does the exchange component. IAS 21 does not require the two halves to be split out.

7.1 The one exception to learn

There is one case in which an exchange difference on a monetary item does not go to profit or loss, and it is examinable.

Exchange differences on such an item are recognised in other comprehensive income in the consolidated financial statements, and accumulated in equity, instead of in profit or loss. In the separate financial statements of the entity that holds the item they are still recognised in profit or loss; it is on consolidation that they are taken to other comprehensive income. The accumulated amount is reclassified from equity to profit or loss when the foreign operation is disposed of.

The mechanics belong to the chapter Foreign subsidiaries. What matters here is the exception and the reason for it: a balance that both parties know will never actually be settled is funding, not trade, and reporting its swings as this year's profit would describe the group badly.

8 A transaction from start to finish

Everything above meets in one short example: a purchase on credit in a foreign currency, straddling a reporting date, with the non-monetary and the monetary halves of the same transaction going different ways.

9 Where this appears under IFRS 18

IFRS 18 Presentation and Disclosure in Financial Statements replaces IAS 1 Presentation of Financial Statements for accounting periods beginning on or after 1 January 2027. Recognition and measurement are unchanged — IAS 21 is not amended, every figure in this chapter is calculated exactly as it is now, and not one amount moves. What changes is the line the amount lands on.

IFRS 18 requires every item of income and expense to be classified into one of five categories, three of them main: the operating category, the investing category and the financing category, with income taxes and discontinued operations making up the other two. The rule for exchange differences recognised in profit or loss is that they are classified in the same category as the income and expenses of the item that gave rise to them.

The relief matters as much as the rule. Where identifying the item that gave rise to an exchange difference would involve undue cost or effort, the difference is classified in the operating category. That is a relief, not a default: an entity may not simply elect to sweep every exchange difference into one line because it would rather not analyse them. The relief is for what cannot reasonably be traced, not for what has not been looked at.

The casualty is the single “net exchange gains and losses” caption that many pre-2027 statements of profit or loss carried. Netted like that, an operating loss and a financing gain cancel each other out and both categories are misstated. From 2027 the analysis has to be done.

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