The International Accounting Standards Board (IASB) initiated a research project that examined the previous research conducted by the Korean Accounting Standards Board (KASB). This research considered whether any work on IAS 21, The Effects of Changes in Foreign Exchange Rates, was appropriate. This article looks at some of the issues raised by the project in the context of IAS 21^®.

The foreign exchange market is affected by many factors, and in countries with a floating exchange rate, their foreign exchange rates are inevitably exposed to volatility due to the effects of the different factors influencing the market. For example, the ongoing problem of Greece repaying its enormous debts has significantly affected the value of the euro. 

As the barriers to international flows of capital are further relaxed, the volatility of the foreign exchange market is likely to continue. This volatility affects entities that engage in foreign currency transactions and there has been a resultant call in some quarters to amend IAS 21.

IFRS^® 7, Financial Instrum­ents: Discl­osure requires disclosure of market risk, which is the risk that the fair value or cashflows of a financial instrument will fluctuate due to changes in market prices. Market risk reflects, in part, currency risk. In IFRS 7, the definition of foreign currency risk relates only to financial instruments. IFRS 7 and IAS 21 have a different conceptual basis. IFRS 7 is based upon the distinction between financial/non-financial elements, whereas IAS 21 utilises the monetary/non-monetary distinction. 

The financial/non-financial distinction determines whether an item is subject to foreign currency risk under IFRS 7, whereas translation in IAS 21 uses monetary/non-monetary distinction, thereby possibly causing potential conceptual confusion. Foreign currency risk is little mentioned in IAS 21 and on applying the definition in IFRS 7 to IAS 21, non-financial instruments could be interpreted as carrying no foreign currency risk. Under IAS 21, certain monetary items include executory contracts, which do not meet the definition of a financial instrument. These items would be translated at the closing rate, but as such items are not financial instruments, they could be deemed not to carry foreign currency risk under IFRS 7.

Foreign currency translation should be conceptually consistent with the conceptual framework. IAS 21 was issued in 1983 with the objective of prescribing how to include foreign currency transactions and foreign operations in the financial statements of an entity and how to translate financial statements into a presentation currency. 

There is little conceptual clarification of the translation requirements in IAS 21. The require­ments of IAS 21 can be divided into two main areas: the reporting of foreign currency transactions in the functional currency; and the translation to the presentation currency. Exchange differences arising from monetary items are reported in profit or loss in the period, with one exception which is that exchange differences arising on monetary items that form part of the reporting entity’s net investment in a foreign operation are recognised initially in other comprehensive income, and in profit or loss on disposal of the net investment. 

However, it would be useful to re-examine whether it is more appropriate to recognise a gain or loss on a monetary item in other comprehensive income instead of profit or loss in the period and to define the objective of translation. Due to the apparent lack of principles in IAS 21, difficulty could arise in determining the nature of the information to be provided on translation.

There is an argument that the current accounting standards might not reflect the true economic substance of long-term monetary assets and liabilities denominated in foreign currency because foreign exchange rates at the end of the reporting period are used to translate amounts that are to be repaid in the future. IAS 21 states that foreign currency monetary amounts should be reported using the closing rate with gains or losses recognised in profit or loss in the period in which they arise, even when the rate is abnormally high or low. 

There are cases where an exchange rate change is likely to be reversed, and thus it may not be appropriate to recognise foreign exchange gains or losses of all monetary items as realised gains or losses. Thus there is an argument that consideration should be given as to whether foreign exchange gains or losses should be recognised in profit or loss or in other comprehensive income (OCI) based on the distinction between current items and non-current items. 

Any potential fluctuation in profit or loss account would be reduced by recognising in OCI those foreign exchange gains or losses of non-current items with a high possibility of reversal. Furthermore, the question would arise as to whether these items recognised in OCI could be reclassified.

However, the IASB is currently determining via its conceptual framework project the purpose and nature of OCI, as there is no obvious principle that drives gains and losses out of profit or loss and into OCI, and there is no shared view among the IASB’s constituents about what should be in profit or loss and what should be in OCI.

IAS 21 does provide some guidance on non-monetary items by stating that when a gain or loss on a non-monetary item is recognised in OCI, any exchange component of that gain or loss shall be recognised in OCI. 

Conversely, when a gain or loss on a non-monetary item is recognised in profit or loss, any exchange component of that gain or loss shall be recognised in profit or loss.