Foreign Currency Translation according to IAS 21 and IAS 39 in
Consolidated Financial Statements considering intragroup Foreign
Currency Hedging Strategies

Thesis of 

Chris Sebastian Heidrich

Department of Finance and Accounting,
University of Hohenheim, Germany

Date of Release: December 7, 2004

Acknowledgements

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Table of Contents 

Acknowledgements ...  I
Abbreviations ...  V
List of Tables ...  VII

1 Introduction ...  1

2 Management of Foreign Currency Risks ...  5
2.1 Currency Exposures ...  5
2.1.1 General Remarks ...  5
2.1.2 Translation Exposure ...  6
2.1.3 Transaction Exposure ...  6
2.1.4 Economic Exposure ...  8
2.2 Instruments of Foreign Currency Risk Management ...  9
2.2.1 General Remarks ...  9
2.2.2 Managing Translation Exposure ...  10
2.2.3 Managing Transaction Exposure ...  13
2.2.4 Managing Economic Exposure ...  16

3 Foreign Currency Translation according to IAS 21(revised 2004)  ...  19
3.1 General Remarks ...  19
3.2 The Concept of the Functional Currency ...  20
3.2.1 Background ...  20
3.2.2 Factors determining the Functional Currency ...  22
3.3 Translating Foreign Currency Transactions into the Functional Currency ...   25
3.3.1 Monetary Items ...  25
3.3.2 Non-Monetary Items ...  27
3.3.3 Net Investments in Foreign Operations.. ...  29
3.3.4 Recognition of Exchange Differences ...  32
3.3.5 Accounting for Hedges of a net Investment in a Foreign Operation ...  35
3.4 The Presentation Currency ...  38
3.4.1 Allowed Presentation Currencies ...  38
3.4.2 Translation from the Functional Currency into the Presentation Currency ...  39
3.4.3 Translation of Foreign Operations ...  40
3.4.4 Recognition of Exchange Differences ...  43
3.4.4.1 Exchange Differences in Separate Financials Statements ...  43
3.4.4.2 Exchange Differences in Consolidated Financial Statements using a Foreign Currency Hedge.. ...  46
3.4.4.3 Exchange Differences arising from Intragroup Monetary Items ...  51

4 Foreign Currency Hedge Accounting according to IAS 39 in multinational groups ...  53
4.1 Introducing Hedge Accounting under IFRS ...   53
4.1.1 Overview ...  53
4.1.2 Derivative Financial Instruments ...  54
4.1.3 Hedges for Foreign Currency Risk ...  55
4.1.4 Qualifying Instruments for Hedge Accounting ...  56
4.1.5 Effectiveness Criteria ...  57
4.1.6 Hedging of Net Positions  ...  59
4.2 Accounting for Fair Value Hedges ...  61
4.3 Accounting for Cash Flow Hedges ...  64
4.4 Exposure Draft ED-7 “Cash Flow Hedge Accounting of Forecast Intragroup Transactions”  ...  68
4.4.1 Planned Amendments of IAS 39(revised 2003)  ...  68
4.4.2 Reasons for the planned Amendments of IAS 39 ...  69
4.4.3 Review on the proposed Amendments ...  71

5 Summaries ...  72

Appendix A: Case Study: Intragroup Foreign Currency Hedging shown on the Example of the Consolidated Financial Statements of a Chilean Company ...  A-1

A.1 Information for the Reader ...  A-1
A.2 The Company ...  A-1
A.3 Significant Accounting Policies of the Company related to Hedge Accounting in Consolidated Financial Statements ...   A-1
A.4 Overview over Chilean Accounting Rule BT64 ...   A-2
A.5 Hedging Strategies and Functional Currencies ...  A-3
A.6 Net Investment Hedges ...   A-4
A.7 Differences between Chilean GAAP and IFRS ...  A-10
A.8 Disposal of a Subsidiary ...  A-13
A.9 Further Hedging Activities concerning Foreign Currency Risks ...  A-14
A.10 Assets and Liabilities denominated in Foreign Currencies ...  A-16
A.11 Conclusion ...  A-22

Bibliography ...   VIII

Abbreviations

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List of Tables
Table 1 Balance sheet as of the 31st December 2003 in US$ ...  44
Table 2 Balance sheet as of the 31st December 2003 in euros ...   44
Table 3 Balance sheet as of the 31st December 2004 in US$ ...   45
Table 4 Balance sheet as of the 31st December 2004 in euros ...   45
Table 5 Consolidation bookings as of the 31st of December 2003 ...   47
Table 6 Consolidation bookings as of the 31st of December 2004 ...   50
Table 7 Investments in related companies ...  A-5
Table 8 Exchange differences transferred to equity ...  A-7
Table 9 Details for other reserves in shareholder’s equity ...   A-7
Table 10 Detail for net cumulative foreign currency translation adjustment ...  A-8
Table 11 Equity changes due to foreign currency exchange differences related to each Subsidiary ...  A-9
Table 12 Detail of hedge ratios for net investment hedges ...  A-10
Table 13 Exchange Differences transferred to equity for individual and consolidated level ...  A-12
Table 14 Detail of forwards and swaps used for hedging ...  A-14
Table 15 Detail adjustment related to derivative contracts ...   A-15
Table 16a Current Assets denominated in foreign currencies as of the 31st of December 2003 ...   A-17
Table 16b Current Assets denominated in foreign currencies as of the 31st of December 2003, continued ...  A-18
Table 17a Current liabilities denominated in foreign currencies as of the 31st of December 2003 ...   A-19
Table 17b Current liabilities denominated in foreign currencies as of the 31st of December 2003, continued ...   A-20
Table 18 Long-term liabilities denominated in foreign currencies as of the 31st of December 2003 ...   A-21

1 Introduction

Globalization is not just a buzzword. It is reality. Big multinational companies as well as small and medium sized companies operate in many foreign markets by importing and exporting goods or by having production plants in countries other than the home country. Acquisitions or mergers of companies that are located in other countries are daily business and shareholders of companies are located all over the world. While companies’ activities are international, the currencies in which business contracts are contracted and settled are still a national affair. Hence, due to international activities, companies hold many items that are denominated in foreign currencies.¹

Fluctuating exchange rates may influence the companies economic situation, for example, provided that the order situation and the management are good, a company that pays two thirds of its bills in euros and generates two thirds of its revenues in US-dollars (US$) could, given constant exchanges rates, earn a profit. However, if the US$ becomes weaker against the euro during the fiscal year, the same company would possibly operate in the red, despite a good business situation. Thus, due to fluctuating exchange rates, companies face risks. These risks have to be systematized to be able to develop techniques, which can diminish risks arising from fluctuating exchange rates. To protect themselves against these kinds of risks or to limit them, companies have various possibilities; mainly these possibilities involve the use of financial instruments. Limitation or protection against risks arising from fluctuating exchange rates is known as foreign currency hedging.

Not any kind of hedging activity really limits risks. Depending on the kind of risk that shall be hedged, the respective hedging instruments and strategies have to be implemented. Fluctuating exchange rates result in several kinds of risks and thus, hedging foreign currency risks requires the use of several instruments and hedging strategies. Hence, the kinds of risks have to be identified before hedging strategies are developed. As this paper focuses accounting aspects of foreign currency translation and –hedging, hedging strategies are not discussed here.² Some hedging strategies suggest or require the use of currency options as the hedging instrument. The valuation of options requires comprehensive knowledge of capital market theory and option-pricing models. Hedges using options as the hedging instruments cannot be discussed here, as option pricing is not an accounting problem. ³

For financial reporting purposes, all these items have to be translated to a single currency, for example, the currency of a company’s home country. Various translation methods have been created in the last years, but the main question when doing so is which exchange rate shall be used for the translation process.⁴ Items could be translated into another currency by using the exchange rate of the transaction date, by using the exchange rate of the reporting-day (e.g. the balance sheet day), by using average exchange rates or any other kind of exchange rates. This leads to the question, whether currency translation shall be a process of translating one currency into another, or if it also is a method to remesurement. To answer this question, it has to be found out, which economical effects (on cash flow, income, balance sheet etc.) items that are denominated in foreign currency have on the company.

When translating an item using different exchange rates, exchange differences arise. These exchange differences could be treated in different ways. They could either be recognized in the income statement, although gains or losses arising from items denominated in foreign currencies might not be realized yet, or exchange differences could initially be realized in equity and be transferred to profit or loss when they are realized. As well as in the case mentioned above, the economical effects have to be regarded to make sure, that exchange differences are treated in a way, which insures fair presentation and decision usefulness of financial statements.⁵

As a company’s income might be affected by currency translation processes, income taxes are affected. As the recognition of exchange differences for the calculation of income tax might differ from the treatment required by accountingstandards, the recognition of deferred taxes might be necessary.⁶ However, tax effects are not discussed in this paper because its focus is set on currency translation and hedge accounting.

In order to limit or even to eliminate the risks companies face due to fluctuating exchange rates they implement foreign currency hedges. In the majority of the cases, financial instruments are used as the hedging instruments. 
The accounting of financial instruments is a very complex topic, because their value may be influenced by various determinants and their “character” (i.e. whether they have to be regarded as an asset or a liability, or if they have to be recognized in the balance sheet at all) is not, in the majority of the cases, a trivial question. Furthermore, some financial instruments may, due to their leverage effect, dramatically effect a company’s financial and liquidity situation. The risks and awards of financial instruments have to be shown in the financial statements to make the reader able to judge the company’s (risk-) situation. The accounting of financial instruments in general and the accounting of hedging relationships is within the scope of IAS 39 “Financial Instruments: Recognition and Measurement”, which was issued to make sure that companies use the same accounting base for the accounting of financial instruments and for the accounting of hedging relationships.

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1 Cp. Arbeitskreis „Rechnungslegungsvorschriften der EG-Kommission“ (1993), P. 746; Lachnit/Ammann (1998), P. 751.

2 For implementation of hedging strategies cp. Chang/Wong (2003), P. 555-574; Hautsch/Inkmann (2003), P. 173-198.

3 For option pricing and option pricing models cp., for example, Hiller (1996), P. 112-192; Linkwitz (1992), P. 80-120; Mehl (1991), P. 64-153; Lombard/Marteau (1990), P. 45-62.

4 An overview of translation methods is provided by Langenbucher (1998), Mn. 1028-1076; Busse von Colbe/Ordelheide (1993), P. 133-146; Wiley et. al. (2003), P. 830-832; Küting/Weber (2001), P. 154-176; Lachnit/Ammann (1998), P. 754-759.

5 Fair presentation is requiered by IAS 1.10.

6 Cp. IAS 12 „Income Taxes“.