Implementation and Applications of IFRS on Currencies

1. Implementation and Applications of IFRS on Currencies Vienna, March 14, 2006 By Thierry Bertrand, Partner, E&Y Olivier Lemaire, Partner, E&Y Renaud Breyer, Manager, E&Y

2. Agenda • Foreign exchange • Functional currencies • Practical issues when identifying the functional currency • Branches • Non-monetary items • From the functional currency to the presentation currency • Recycling CTA • First-time adoption issues • Financial reporting in hyperinflationary economies

3. Functional currencies • Functional currency is the currency (IAS 21.9): • That mainly influences sales prices (i.e. often currency in which revenue is denominated) • Of the country whose competitive forces and regulations determine the sales prices • That mainly influences labour, material and other costs • Sometimes the functional currency may be the one in which • Funds from financing activities are generated • Receipts from operating activities are usually retained

4. Functional currencies • Additional factors to be considered (IAS 21.10 & 11): • Is the foreign operation an extension of the parent • Foreign operation mainly deals with parent • Foreign operation cash flows directly affect parent cash flows and are available for remittance • Foreign operation cash flows are sufficient to service existing and expected debts without funding from parent • Where the functional currency is not obvious, management needs to use its judgement and document its decision

5. Functional currencies – Case study • Case • The owner is Chinese • Customers are mainly Chinese • Employees are Chinese • 30% of the inputs are Chinese • Q: What is the functional currency of this company?

6. Functional currencies – Case study • Case • The owner is Chinese • Customers are mainly Chinese • Employees are Chinese • 30% of the inputs are Chinese • Q: What is the functional currency of this company? • A: Chinese restaurant near Leicester Square, therefore the functional currency is Sterling.

7. Practical issue when identifying thefunctionnal currency Issue • Do the additional factors described in paragraphs 10 and 11 of IAS 21 always have to be considered by management in determining an entity’s functional currency? Conclusion • No, the additional factors described in paragraphs 10 and 11 only have to be considered when it is not obvious from the primary indicators described in paragraph 9 what the entity’s functional currency is.

8. Branches • Branches are not defined in IFRS • In practice a branch contains some assets, usually a foreign currency liability and sometimes an activity • No activity (business or employees) means that it is an extension of another entity

9. Practical issue when identifying the functional currency for a branch Issue • What is a foreign operation? Can a single asset or group of assets be a foreign operation with its own functional currency? Conclusion • Applying guidance in IAS 21(§ 9, 10, 11) may provide mixed results in such case. The key is to determine whether a separate business exists.The activities of the asset or group of assets may be an extension of the parent company and as such should have the functionnal currency of the parent

10. UK parent GBP functional US Holding German Shipping AG Treasury (Netherlands) BV ??? ??? ??? Several US operating Single Ship GmbH subsidiaries ??? ??? Ship C o Inc. ??? Branches - Scenario • What are the functional currencies of the various entities?

11. Non-monetary items • Monetary items are • Units of currency held and assets and liabilities to be received or paid in a fixed or determinable number of units of currency • Everything else is non-monetary

12. Non-monetary items - reporting • Foreign currency monetary items shall be translated using the closing rate • Non-monetary items at historical cost … translated using the exchange rate at the date of the transaction (i.e. no retranslation at balance sheet date) • Non-monetary items at fair value … translated using exchange rate at the date of the valuation

13. Non-monetary items – date of transaction • Sometimes, the date of transaction may be difficult to determine. For instance: Date Event €1=C$ • 14 April 2005 - Goods are ordered 1.50 • 5 May 2005 - Goods are shipped from Canada and invoice dated that day 1.53 • 7 May 2005 - Invoice is received 1.51 • 10 May 2005 - Goods are received 1.54 • 14 May 2005 - Invoice is recorded 1.56 • 7 June 2005 - Invoice is paid 1.60

14. Non-monetary items – Examples • Non-monetary items that are not to be translated:PP&E, deferred income, goodwill, intangible assets, inventories • Non-monetary items are always recorded in the functional currency of the entity that uses them • Difficult to classify • Decommissioning provisions • Progress payments vs. Refundable deposits • Defined benefit schemes • Deferred tax • Provisions

15. Practical issue when considering a caption being monetary or non-monetary Issue • Should deposits or progress payments made when acquiring fixed assets or inventories from foreign suppliers be retranslated as monetary items or as non monetary items? Conclusion • Conclusion depends on the nature of the payments • If payments are regarded as prepayments or as progress payments, they should be treated as non monetary items • If payments are regarded as deposits which are refundable, they could possibly be treated as monetary items depending on the terms of the contract

16. From the functional currency to the presentation currency • Translate all the assets and liabilities in the balance sheet at the closing rate • Translate all the items in the income statement at the rates when the transactions were undertaken • For practical purposes, average rates may be used if not significant fluctuation • All resulting exchange differences are taken to equity until disposal of the foreign entity • Exchange differences on loans that hedge the net investment in a foreign operation are also taken to equity

17. Recycling of currency translation adjustments • When should a company recycle currency translation adjustments? • Sale of the foreign net investment or partial disposal • Dividends paid out of pre-acquisition profits • Liquidation or abandonment of investment

18. Recycling of currency translation adjustments • No recycling of currency translation adjustments • Upon write-down of the foreign operations, this is not considered a partial disposal • When monetary items ceases to be part of the foreign net investment, but has not been settled in cash

19. First-Time Adoption Issues • Cumulative translation differences: there is an exemption to recognise the cumulative exchange differences that existed at the date of transition to IFRS: deemed to be zero. • Goodwill and fair value adjustments: there is also an exemption to IAS 21 for first-time adopters. Previously recognized goodwill and fair value adjustments can be considered as assets and liabilities of the entity rather than as assets and liabilities of the acquiree. • In the circumstances where the functional currency under IFRS is different from the functional currency under previous GAAP, it may be difficult to apply the historical rates to non-monetary items. It may then be easier to use the option in IFRS 1 of the fair value treated as being the deemed cost.

20. Financial reporting in hyperinflationaryeconomies • Applies to the primary financial statements of any entity whose functional currency is the currency of a hyperinflationary economy • Hyperinflation is indicated by a number of factors and its identification requires judgement • Cumulative inflation over 3 years is approaching or exceeding 100 % International Financial Statistics published by the International Monetary Fund

21. Adjustments required to balance sheet items • Monetary items and non-monetary items at current cost: no adjustment • If any items are contractually adjusted by reference to inflation, such as index-linked bonds, they are restated in accordance with the terms of that contract • Non-monetary items carried at historical cost: updated by the index movement since they were acquired • Non-monetary items carried at fair value: updated by the index movement since they were valued

22. Adjustments required to income • All items of income and expense should be restated by the change in the index from the date at which they were first recorded in the accounts • Depreciation will be adjusted on the same basis as the asset to which it relates

23. Adjustments to equity • On first application of the standard, the components of opening equity (other than retained earnings and any revaluation surplus) are restated by indexation from the date they arose • Restated retained earnings is the balancing figure after restating all assets and liabilities • Each year, all components of equity are restated by indexation from the beginning of the year, or the date of contribution if later

24. Economy ceasing to be hyperinflationary • Companies should cease to apply the standard • The carrying values are not restated, but left at the amounts at which they were stated when the standard was last applied

25. Economy ceasing to be hyperinflationary after Q2 Issue • The fiscal year of Entity A agrees with the calendar year and Entity A prepares interim financial reports on a quarterly basis.  Until July the economy was hyperinflationary. Accordingly, Entity A applied IAS 29 in its interim reports for the first two quarters of the year. However, in August hyperinflation ceased. Can Entity A stop applying IAS 29 on its interim report for the third quarter of the year? Answer • Yes, if an entity concludes that the economy ceases to be hyperinflationary it should stop applying the requirements of IAS 29 during the relevant interim period. However, determining when a currency stops becoming hyperinflationary is not easy in practice.

26. Q&A