BUACC3706 Financial Accounting Online Tutoring

Topic 1 – What are the major issues addressed by accountants when dealing with international financial transactions? How and why do accountants mitigate risk in such instances?

The major issues addressed by accountants in dealing with international financial transactions include:

(i) Conversion of individual transactions incurred in foreign currency into the functional currency (or the currency of economic environment where the reporting entity operates) and/or presentation currency if difference from functional currency;
(ii) Translation of year-end balances denominated in various foreign currencies into a single currency for reporting purpose;
In case of foreign operations whose financial statements are made in a foreign currency, those figures need to be translated into a common currency for the purpose of consolidation of financial statements;
(iv) Where financial assets and liabilities are incurred in foreign currencies, the entity is exposed to the risk of fluctuation in assets and liabilities owing to the changes in foreign exchange rates. To minimize this risk entities often enter into hedging arrangements which need to be reporting according to the requirements of hedge accounting.

How these risks are mitigated by accountants and the problems encountered therein are briefly discussed hereunder:

(i) Individual transactions incurred in foreign currency

To determine a single currency into which all international transactions shall be translated, the concept of functional currency is used and several factors are considered in determine what is reporting entity’s functional currency in accordance with paragraph 9 and 10 of AASB 121. These include:

Currency that influences the sales price of goods and services sold by the entity,
Currency of the country whose competitive demand and supply forces determine the sales price for the entity’s goods and services,
Currency that influences the labor costs, material costs and other overhead incurred,
Currency in which fundraising activities (issuing shares or bonds) are done,
Currency in which profits are retained by the entity.

These factors combinely determine the functional currency of entity and thereafter all foreign currency transactions are recognized in the financial statement of reporting entity by applying the spot exchange rate on the date of transaction. Similarly, the settlement of this transaction in cash or otherwise should be recorded using the spot exchange rate on the settlement date. The resulting exchange differences that arise due to difference in exchange rates are required to be recognized in profit and loss statement in the period in which they are incurred (paragraph 28, AASB 121).

(ii) Translation of year-end balances in foreign currency

Once the functional currency is determined, an issue arises for the translation into functional currency of different line items of financial statements that are measured using different measurement models, such as fixed assets measured using cost or revaluation model of AASB 116 or financial liabilities measured under the requirements of AASB 9 Financial Instruments.

This issue is resolved by making a simple classification of all assets and liabilities into monetary and non-monetary assets, and the respective accounting treatment under AASB 121 is as follows:

	Monetary items	Non-monetary items
	Monetary items	measured under cost model	measured under revaluation model
Description of items	These are the items whose realization is determinable in the fixed amounts of currency units. Such as loans, bonds, cash and receivables/payables.	Non-monetary assets such as items of fixed assets and inventories that are measured using the historical cost model.	Non-monetary assets such as investment properties under AASB 140 and biological assets under AASB 141 that are measured under the revaluation model or at fair value at various dates.
Accounting treatment required under paragraph 23 to deal with the issue	These items are retranslated into functional currencies at each reporting date using the closing exchange rate.	Once recorded at the spot exchange rate on the date of acquisition these items are not retranslated into functional currency again.	These items are translated using the exchange rates at the date when the fair value was determined.

(iii) Re-translation of foreign operations

In translating various items of a subsidiary or other foreign operation denominated in foreign currency the rules and procedures described above are followed. However, when translating the profit and loss balances of the transactions incurred by foreign entity another issue arises to translate item of expense and revenue at the spot exchange rate. This would be an extremely time-consuming exercise and yield no fruitful purpose, therefore paragraph 22 of AASB 121 allows the use of average rate as an approximation. Accordingly, a monthly average or quarterly average rate can be used to translate at once all transactions incurred during that period.

Hence the following method is prescribed as standard to prohibit multiple practices and to encourage consistency in the application of accounting policies.

Year end balances of foreign operations reporting balances in foreign currency	Translated at the closing exchange rate between the reporting currency of foreign operation and the functional currency of the parent entity.
Revenue and expenses incurred during the reporting period by foreign entity	Translated using the average rate as an approximation.

Any resulting exchange differences are specifically required by AASB 121 to be recognized in other comprehensive income, and practically shown as a separate line item in that statement.

(iv) Hedge accounting

Here the main issue arises in respect of matching the profit or loss on hedging instrument with the profit or loss on the hedged item. In such circumstances AASB 9 requires the hedge to be classified into a fair value hedge or a cash flow hedge and accordingly prescribed different accounting treatment and recycling of gains or losses into profit or loss and other comprehensive income. Accounting of both hedging instrument and hedge item is required to be done independently and separately of each other.

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