IAS 21 The Effects of Changes in Foreign Exchange Rates requires companies to convert foreign transactions into their functional currency and to translate foreign operations into a presentation currency by using spot exchange rates.
But what if those exchange rates are not available? The original version of IAS 21 assumed that any lack of exchangeability between two currencies would be temporary, instructing entities to use “the first subsequent rate at which exchanges could be made” once exchangeability was restored.
However, after observing instances of prolonged lack of exchangeability in certain regions (notably in Venezuela) and diversity in how IAS 21 was applied in practice, the International Accounting Standards Board (IASB) decided to amend the standard by:
1) Clarifying how to assess exchangeability;
2) Providing guidance on what to do in case a currency lacks exchangeability; and
3) Providing disclosures to help users assess the impact on the financial statements of currencies that lack exchangeability.
The amended standard states that a currency is exchangeable when an entity is:
a) able to obtain more than an insignificant amount of the other currency for a specified purpose at the measurement date;
b) within a timeframe that allows for a normal administrative delay; and
c) through a market or exchange mechanism in which an exchange transaction would create enforceable rights and obligations.
If any of these conditions is not met, then a currency is not considered exchangeable, and a spot rate will have to be estimated.
The objective when estimating a spot exchange rate is to reflect the rate:
The standard does not prescribe a specific method for estimating the rate but suggests that an entity may use:
a) an observable exchange rate without adjustment; or
b) another estimation technique (including adjusting observable rates that do not create enforceable rights and obligations).
If a currency lacks exchangeability, the following information will have to be disclosed:
The requirements in the IAS 21 standard remain largely unchanged after the amendments, aside new disclosures for currencies lacking exchangeability. However, the new guidance may pose challenges for entities in countries with strict capital controls. Treasury departments are usually best equipped to handle these issues, which may include:
The introduced guidance will require professional judgement (for example, when evaluating if the currency amount obtained for a specific purpose is more than insignificant, or determining if a delay in an exchange transaction is solely due to normal administrative reasons).
Spot rates need to be estimated when currencies lack exchangeability. This new approach may require additional data and complex estimation processes, particularly in volatile or restricted currency markets.
Further, entities will need to adopt consistent methods and implement controls to ensure that their estimates meet the standard's guidelines, which could increase both preparation time and audit scrutiny.
Most countries publish "official" exchange rates, but foreign currency transactions typically use rates from commercial banks or exchange houses. In stable economies, the rates are similar, posing no issue.
However, in countries where official and commercial rates differ significantly, entities should use the rate at which cash flows could realistically be settled. Additionally, some countries require reporting at official rates, which creates system challenges as entities must maintain records at both the IFRS-compliant rate and the official rate for local reporting.
Some countries set different exchange rates for various purposes to control transactions in foreign currencies. In such cases, different rates should be used to reflect the rates at which future cash flows from transactions or balances could have been settled, had those cash flows occurred on the measurement date.
Although this is not a new requirement, it is not uncommon for accounting systems to keep only one spot rate for each currency pair at any given time. Entities should use the opportunity provided by the IAS 21 amendments to review and address any practices that do not comply with IFRS.
The amendments take effect for reporting periods starting on or after 1 January 2025. Systems and processes may need adjustments, so assessing and addressing the impacts early is recommended.
David Passarinho is a senior financial reporting expert at Huawei Global Finance (UK) Ltd
