"Clear distinction in accounting is like a steady compass in the unpredictable sea of currency fluctuations."
Introduction:
Foreign currency transactions are a vital aspect of financial management for multinational enterprises. However, they present challenges in terms of proper classification and measurement, especially when it comes to distinguishing between monetary and non-monetary items. Ind AS 21: The Effects of Changes in Foreign Exchange Rates provides a framework for ensuring that foreign currency transactions are accounted for in a way that promotes consistency and transparency in financial reporting. This guidance note explores how these provisions apply in real-life scenarios, ensuring compliance with accounting standards.
Case Study: ABC Limited’s Foreign Currency Transactions
ABC Limited, an Indian multinational company, is involved in diverse industries and has a subsidiary in the United Kingdom. The company regularly engages in foreign currency transactions and needs to understand how to classify and account for monetary and non-monetary items as per Ind AS 21. Here, we will analyze several transactions to demonstrate the appropriate accounting treatment.
Transactions to be Analyzed:
Foreign Currency Loan:
- On April 1, 2023, ABC Limited took a loan of GBP 2,000,000 at an exchange rate of Rs.95/GBP.
- By March 31, 2024, the exchange rate had moved to Rs.98/GBP.
Purchase of Equipment:
- On May 1, 2023, the company bought equipment worth EUR 500,000 at an exchange rate of Rs.100/EUR.
- The equipment was put into use on July 15, 2023.
Advance Payment for Services:
- On June 1, 2023, the company paid an advance of USD 300,000 for consulting services at an exchange rate of Rs.89/USD.
- The services were rendered on August 1, 2023.
Relevant Provisions of Ind AS 21:
Monetary Items: These include assets and liabilities that represent a right to receive or an obligation to deliver a fixed or determinable number of units of currency (e.g., loans, receivables, payables).
Non-Monetary Items: These are items that do not involve a right to receive or an obligation to deliver a fixed or determinable amount of currency (e.g., property, plant, and equipment, inventories, prepaid expenses).
Key Provisions:
Para 8: The standard clearly defines monetary and non-monetary items. Monetary items are those which involve the receipt or payment of a fixed or determinable amount of currency, while non-monetary items are not tied to fixed currency amounts.
Para 23: It sets out how foreign currency monetary items should be translated at the closing exchange rate, and non-monetary items should be translated at the exchange rate on the transaction date.
Para 28: Exchange differences arising from monetary items are recognized in profit or loss in the period in which they arise.
Transaction Accounting and Treatment:
1. Foreign Currency Loan:
- Classification: The loan is a monetary item because it represents an obligation to deliver a fixed amount of foreign currency.
- Initial Recognition: On April 1, 2023, the loan is recognized at Rs.190,000,000 (GBP 2,000,000 × Rs.95).
- Subsequent Measurement: At March 31, 2024, the exchange rate has changed to Rs.98/GBP. The loan balance is retranslated at Rs.196,000,000 (GBP 2,000,000 × Rs.98).
- Exchange Difference: The exchange difference of Rs.6,000,000 (Rs.196,000,000 - Rs.190,000,000) is recognized in the profit and loss account as per Para 28 of Ind AS 21.
2. Purchase of Equipment:
- Classification: The purchase of equipment is a non-monetary item because it involves an asset with no fixed or determinable monetary settlement.
- Initial Recognition: On May 1, 2023, the equipment is recorded at Rs.50,000,000 (EUR 500,000 × Rs.100).
- Subsequent Measurement: Non-monetary items like property, plant, and equipment are recorded at the exchange rate on the date of the transaction and are not retranslated unless revalued or impaired (Para 23(b) of Ind AS 21).
- Adjustment: No retranslation is made as per the historical cost principle. The asset remains on the books at Rs.50,000,000.
3. Advance Payment for Services:
- Classification: An advance payment is a non-monetary item because it represents a right to receive goods or services in the future, not a fixed or determinable currency amount.
- Initial Recognition: On June 1, 2023, the advance payment is recognized at Rs.26,700,000 (USD 300,000 × Rs.89).
- Subsequent Measurement: Since it is a non-monetary item, no retranslation occurs upon receipt of the services on August 1, 2023.
- Adjustment: The amount remains unchanged in the books as no retranslation is required.
At a Glance:
| Transaction Type | Item Classification | Initial Recognition (Exchange Rate) | Subsequent Recognition (Exchange Rate) | Exchange Difference Treatment |
|---|---|---|---|---|
| Foreign Currency Loan | Monetary Item | Rs.190,000,000 (GBP 2,000,000 × Rs.95) | Rs.196,000,000 (GBP 2,000,000 × Rs.98) | Recognized in P&L as exchange gain/loss |
| Purchase of Equipment | Non-Monetary Item | Rs.50,000,000 (EUR 500,000 × Rs.100) | No change (historical cost basis) | No adjustment |
| Advance Payment for Services | Non-Monetary Item | Rs.26,700,000 (USD 300,000 × Rs.89) | No change (historical cost basis) | No adjustment |
Interpretation in Different Scenarios:
Scenario 1: Foreign Currency Loans with Fixed Repayments
- As per Ind AS 21, foreign currency loans are always considered monetary items. They must be retranslated at the closing exchange rate on the reporting date, with the difference recognized in profit or loss.
Scenario 2: Non-Monetary Items at Historical Cost
- Purchases of machinery, property, or inventory are non-monetary items, recorded at the exchange rate on the transaction date. They are not retranslated, except if there’s impairment or revaluation.
Scenario 3: Prepayments
- Prepaid expenses or advances for goods and services are classified as non-monetary items. They are recorded at the exchange rate on the transaction date and remain unchanged unless related goods or services are received. No retranslation occurs.
Conclusion:
Understanding the treatment of monetary and non-monetary items is essential for compliance with Ind AS 21 and for accurate financial reporting. By ensuring the correct classification and application of exchange rates—using the historical rate for non-monetary items and the closing rate for monetary items—companies like ABC Limited can avoid errors, ensure consistency, and present transparent financial statements. Recognizing exchange differences and applying the provisions as outlined in Ind AS 21 will also help companies align with international accounting standards and enhance the comparability and reliability of their financial results.
