UNIT 7 Lesson 1
Foreign exchange and borrowing costs
Welcome to Unit 7. Foreign exchange and borrowing costs. Lesson 1.
The effects of changes in foreign exchange rates.
An entity may carry out transactions in foreign currency or may conduct business through a
foreign operation. Lesson 1 focuses on accounting for unhedged transactions conducted in
foreign currency.
The objective of IAS 21 is the recognition, measurement and disclosure of foreign exchange
transactions and it is applicable to foreign transactions as well as foreign operations. Remember
a foreign operation is either a subsidiary, associate, joint arrangement or a branch of a reporting
entity, whose activities are conducted in a country or currency other than that of the reporting
entity. However, for the purposes of Accounting 3 foreign operations are not included in the
syllabus.
Foreign transactions. These need to be converted into the functional currency of the entity.
Further foreign transactions include: 1) the buying and selling of goods denominated in foreign
currency; 2) the borrowing or lending of funds payable or receivable in foreign currency; and 3)
the acquisition or disposal of assets or incurrence or settlement of liabilities in foreign currency.
Foreign currency transactions can either be hedged or unhedged. The principles of hedging are
not applicable to Accounting 3. An unhedged transaction means that a company's profit and
losses will not be protected against any effects of changes in foreign exchange rates.
Recognition. In recognising foreign exchange transactions, it is important to note a number of
relevant dates and these include the transaction date. This is the date the transaction first
qualifies for recognition. Basically, we are saying when do significant risks and rewards transfer
to the entity and you need to note whether it was free on board, cost insurance or freight.
Reporting date. This is the date which is the year-end date of the entity.
Settlement date. This is the date on which payment is made to the foreign creditor.
When dealing with the reporting date and the settlement days it is important to use the applicable
exchange rate on each of these dates and any exchange difference has to go to the entity's profit
and loss.
A foreign currency transaction has two elements to it which can be monetary item and a non-
monetary item. Monetary items are those items where the entity has a right to receive or an
obligation to deliver, a fixed or determinable foreign currency amount. A non-monetary item is
therefore the opposite of that which is, there is no right to receive or there is no obligation to
deliver a fixed or determinable foreign currency by the entity.
Measurement. When measuring a foreign currency transaction, it is important to recognise that
initially we shall record at the spot rate on transaction date and the spot rate on that date is the
exchange rate for immediate delivery of currencies to be exchanged at a particular time. And
subsequently to initial measurement where the foreign currency liability has not yet been settled
before yea-end it is important to remeasure that foreign currency liability at the closing rate on
reporting date, and the closing rate is the spot exchange rate at year-end date. The exchange
difference being the remeasured amount to what was initially measured is what gets taken to the
profit and loss.
Now let's look at an example to demonstrate the principles of a foreign exchange transaction.
Ladies and gentlemen do attempt to this and do it and it shall be discussed during a collaborative
session. In this example firstly what are you required to do? You are required to journalise,
including cash transactions, all the foreign currency exchange transactions that happened
between the 15th of June 20x7 and 31 December 20x7 and the results thereof for the reporting
period ended 31 December 20x7.
When you look at this example you will note that we are given the spot rate at different dates and
that piece of information is very key to answering the required. So, let us go through the example
highlighting some of the principles that we have covered in the previous slides and remember you
need to attempt this example and it shall be discussed later.
On 15 June 20x7 East Limited ordered plant from a manufacturer in Orlando the USA. The invoice
price of the plant is $200 000 and this amount must be settled on 30 April 20x8 as you can see
from this sentence. We are given the settlement date and if you remember a settlement date is
part of those relevant dates that we said we need to know. And then we are also given the date
at which the plant was ordered and that order date could be or not be the transaction date.
Number 2. The plant was shipped free on board on 15 September 20x7 and arrived in Durban
on 1 October 20x7. The question here becomes when did the risks and rewards transfer to East
Limited and that will give you what the transaction date is.
Number 3. Customs duty, shipping and freight charges amounted to R25 000 and was paid to
customs on 30 September 20x7 together with VAT of R111 300. The R111 300 VAT includes the
VAT on the customs duty, shipping and freight charges.
Number 4. The engineer from Orlando who monitored the installation of the plant requested
payment in Rands. His fee was R15 000 and was paid on 7 October 20x7.
Number 5. The plant was available for use and became operational on 1 November 20x7. The
directors are of the opinion that the useful life of the plant is five years with no residual value.
Given the example that we are currently doing it is important to plot a timeline. This step you shall
apply in any type of question that gets given to you. Plotting a timeline basically means that the
relevant dates being transaction date, year-end date and settlement date, needs to be plotted so
that you can have a walkthrough of this foreign exchange transaction.
Number 2. It is important to plot the spot rates. Only the spot rates relating to these relevant
dates. So, what was the rate on transaction date? What was the spot rate on year-end and what
was the spot rate on settlement date?
And then number 3. You need to identify the exchange difference from one relevant date to the
next. So, as you can see at year-end the exchange rate, the spot exchange rate, moved from
R5.80 to R6.10, so meaning that at year-end to buy one dollar it's more expensive than at the
31st of December than it was on the 15th of September.
Now go and attempt this example and it shall be discussed later in the collaborate session. Thank
you.
