Ind AS 21 – Effects of changes in Foreign Exchange rates – Monetary and non-monetary items

Let us understand what is meant a monetary item and a non-monetary item.

Monetary item

Monetary item represents a right to receive or an obligation to deliver a fixed or determinable number of units of a currency.

Some of the examples of a monetary item are investment in debt security in foreign currency classified as amortised cost.  This is recorded as a monetary item, because the entity would hold this item till maturity and on maturity would receive the stated maturity amount from the issuer in a pre-determined number of units of the foreign currency.

  • Pension benefits payable in cash
  • Provisions to be settled in cash
  • Dividends payable by an entity recognised as liability

Non-monetary item

In a non-monetary item, there is no existence of a right to receive or an obligation to pay a fixed or determinable number of units of a currency.

For example, investment in equity shares denominated in foreign currency.  This is recorded as a non-monetary item because the entity will be able to get the investment back only by selling the same either in a stock exchange or privately.  In other words, the entity has no right to receive a fixed or determinable number of units of such foreign currency from the issuer.

  • Pre-paid expenses
  • Investment in intangible assets
  • Investment in DPE

Now for all these examples, the entity will not be able to receive a fixed or determinable number of units of a specified currency.

Ind AS 21 – Effects of changes in Foreign Exchange rates – Functional Currency

Let us see how the functional currency is determined for an entity.

Functional currency is determined based on the primary economic environment in which it operates.

The primary economic environment is determined based on two primary factors as specified in the Standard viz., the currency in which cash is generated and the currency in which major expenses are incurred by the entity.

When there is a conflict between the two primary factors, then the entity should look for further indicators viz., the currency in which funds are generated which could be either equity or debt instruments and the currency in which the receipts from the customers are retained.

These two are known as the secondary indicators.  The entity need to look for secondary indicators only when there is conflict in the primary factors.

It should be noted that the functional currency is determined separately for every entity, as there is no concept of group functional currency.

The importance of functional currency cannot be over-emphasized, as it has a serious impact on the financial statements.

Exchange differences may not be correctly recorded if the functional currency is not determined properly.

Profits may also be completely distorted.

These are the consequences of incorrect determination of functional currency.

Functional currency for entities in the same group

Let us assume Parent ‘P’ as the functional currency of INR.  It may have subsidiaries and each of the subsidiaries can have different functional currency as can be seen in this graphical representation.

Ind AS 21 – Effects of changes in Foreign Exchange rates – Foreign Operations

Let us see how the functional currency is determined for a foreign operation.  So what are the factors to be considered in determining the functional currency of a foreign operation?

Basically, there are four factors to be considered. Let us see those factors one by one.

The first factor to be considered is the degree of autonomy.  The question that needs to be asked is whether the foreign operation is conducted as an extension of the reporting entity. Are the activities in such foreign operation carried out without significant autonomy? If the answer is ‘No’, then the local currency would be the functional currency of such foreign operation. However, if the answer is ‘Yes’, then the reporting entity’s currency would be the functional currency of the foreign operation.

The second factor to be considered is the transactions of the foreign operation with the reporting entity.  The question that needs to be asked is – Is the percentage and frequency of transaction with the reporting entity significant?  If the answer is ‘Yes’, then the reporting entity’s currency would be the functional currency of the foreign operation.  If the answer is ‘No’, then the local currency would be the functional currency of such foreign operation.

The third factor to be considered is the effect of cash flows. The question that should be asked is – Does the cash flow of foreign operation affect the cash flows of the reporting entity.  If the answer is ‘No’, then the local currency would be the functional currency of the foreign operation. If the answer is ‘Yes’, then the reporting entity’s currency would be the functional currency of such foreign operation.

The fourth factor to be considered is about financial and debt servicing. The question that should be asked is whether the cash flows of foreign operations is sufficient to service its own debt? If the answer is ‘Yes’, then the reporting entity’s currency would be the functional currency of such foreign operation. If the answer is ‘No’, then the local currency would be the functional currency of the foreign operation.

If the indicators are mixed, the management should use its discretion to determine the functional currency of the foreign operation.

A change in the functional currency is not generally permitted.

It is changed only when there is a change in underlying factors.

Ind AS 21 – Effects of changes in Foreign Exchange rates – What is covered?

Ind AS 21 deals with the effects of changes in exchange rates.

So, what are the issues that are involved here?

An entity may have foreign currency transactions and/or it may have foreign operations.

So, first we need to determine what is foreign currency.

Assume that an entity based in India purchases inventory from Denver in USD terms. The question arises as to in which currency the financial statements should be prepared. Should it be in INR or should it be in USD?

The financial statements should be prepared in the functional currency of the entity.  This leads us to the next important question viz., what is meant by a functional currency. This is covered by Ind AS 21.

Next, an entity may have foreign operations, in the form of say a subsidiary or a joint venture. In that case, first we need to understand what is meant by a foreign operation and how should the functional currency be determined in respect of such foreign operations.

The next question arises as to whether the financial statements can be prepared in any currency which leads us to the next topic viz., what is meant by presentation currency?

Ind AS 21 covers all of these and in addition, it also gives guidance as to how the account balances should be translated into the functional currency, which exchange rate should be used and how the exchange differences should be accounted for.

Message by CA P.B. Sampath, Director & Secretary, Tractors and Farm Equipments Limited

I have knownPB Sampath R. Venkata Subramani for more than two decades now and he is known for his penchant for topics on financial instruments. He has dumped down the complex topic on the treatment of financial instruments as per Ind AS which I am sure is completely new for most of the professional accountants both in India and elsewhere. The timing of the release of the book coincides with the standards on financial instruments becoming applicable for the top corporate India including Banks and finance companies as per the road map issued by the MCA. I am sure this publication would be found quite useful for all professionals in their regular day-to-day official work, be it in practice or in Industry. My best wishes for the success of this publication.

CA P.B. Sampath
Director & Secretary
Tractors and Farm Equipments Limited

Message / Review from CA P. R. Ramesh, Chairman, Deloitte Haskins & Sells LLP

CA P R RameshFinancial Instruments is by far the most complex and difficult subject in the field of accounting. The varied nature of such instruments with a wide range of derivatives and associated risk makes the task of measuring and reporting extremely challenging even for experts in the subject. A number of books have been written on IFRS and more recently on Ind AS but very few books have dwelt at length on the subject of financial instruments.

This book by CA R. Venkata Subramani demystifies the subject of accounting for Financial Instruments and is extremely useful for practitioners, preparers, finance professionals and even for any person with basic knowledge of this subject. Written in a lucid manner with practical examples and screen shots of real data, it enables readers to very quickly grasp the principles and facilitates easy application of these principles. The inclusion of extracts from Annual Reports and FAQs enhances the utility of this book.

A book of this nature is very useful at a time when India has transitioned to Ind AS for certain large ‘public interest’ entities effective April 1, 2016 and the financial services sector too following soon.

I have no doubt this book will be a treasure for every professional and my compliments and best wishes to CA R. Venkata Subramani.

CA P. R. Ramesh,
Chairman,
Deloitte Haskins & Sells LLP,
Mumbai.Book cover

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