6.4 IAS 21 Foreign Currency Transactions & IAS 33 Earnings Per Share

6.4 IAS 21 Foreign Currency Transactions & IAS 33 Earnings Per Share

Core Principle: Global commerce and public capital markets demand rigorous consistency across foreign currencies and share capital structures. In the ACCA Financial Reporting (FR) examination, this section addresses two vital standards:

1. IAS 21 The Effects of Changes in Foreign Exchange Rates: Governs how foreign currency transactions are recorded, retranslated, and reported in financial statements.
2. IAS 33 Earnings Per Share: Establishes standardized rules for calculating and presenting historical profitability per share (Basic EPS) and potential future dilution (Diluted EPS).

---

1. IAS 21: Functional Currency vs. Presentation Currency

Definitions

• Functional Currency: The currency of the primary economic environment in which the entity operates (IAS 21.8). It is the currency in which the entity primarily generates and expends cash.
• Presentation Currency: The currency in which the financial statements are presented. An entity may present its financial statements in any currency.
• Foreign Currency: Any currency other than the functional currency of the entity.

Determining Functional Currency (IAS 21.9–10)

An entity determines its functional currency using a hierarchy of indicators established by management:

                             Determining Functional Currency
                                           │
                   ┌───────────────────────┴───────────────────────┐
                   ▼                                               ▼
           PRIMARY INDICATORS                              SECONDARY INDICATORS
  1. The currency that MAINLY INFLUENCES          1. The currency in which funds from
     SALES PRICES for goods and services             FINANCING ACTIVITIES are generated
     (and competitive market forces)                 (debt and equity instruments)
  2. The currency that MAINLY INFLUENCES          2. The currency in which receipts from
     LABOUR, MATERIAL, and OTHER costs of            OPERATING ACTIVITIES are retained
     providing goods or services

Hierarchy Rule: Management gives priority to the primary indicators. If primary indicators are mixed or ambiguous, management uses judgment to evaluate secondary indicators to reflect the underlying economic reality.

---

2. Foreign Currency Transactions (IAS 21)

Initial Recognition

Under IAS 21.21, a foreign currency transaction is recorded on initial recognition in the functional currency by applying to the foreign currency amount the spot exchange rate between the functional currency and the foreign currency at the date of the transaction.

• An average rate for a week or month may be used for practical reasons if exchange rates do not fluctuate significantly.

Subsequent Reporting Dates: Monetary vs. Non-Monetary Items

At each subsequent balance sheet date, items must be classified and treated according to IAS 21.23:

                           Subsequent Balance Sheet Retranslation
                                             │
                   ┌─────────────────────────┴─────────────────────────┐
                   ▼                                                   ▼
            MONETARY ITEMS                                      NON-MONETARY ITEMS
  • Right to receive/deliver fixed units             • No contractual right to cash
    of currency: Cash, Receivables, Payables,        • Inventory, PPE, Intangibles, Share Capital
    Loans, Bank Overdrafts                                             │
                   │                                 ┌─────────────────┴─────────────────┐
                   ▼                                 ▼                                   ▼
          RETRANSLATE AT                        HISTORICAL COST                     FAIR VALUE
           CLOSING RATE                         Do NOT Retranslate!               Retranslate at
  • Exchange differences -> PROFIT OR LOSS      Remain at HISTORICAL              rate when fair
                                                SPOT RATE                         value determined

Summary Table: Translation Rules for Balance Sheet Items

---

3. IAS 33: Purpose and Scope of Earnings Per Share

IAS 33 Earnings Per Share applies to entities whose ordinary shares are publicly traded or in the process of being issued in public securities markets.

• Objective: Provides a standardized financial metric to compare the performance of different entities in the same reporting period and evaluate the performance of an entity over time.
• Core Components: Public entities must present both Basic EPS and Diluted EPS with equal prominence on the face of the Statement of Profit or Loss.

---

4. Basic EPS Mechanics

The Fundamental Formula

Basic EPS = Earnings / Weighted Average Number of Ordinary Shares (WANOS)

Earnings (The Numerator)

• Profit or Loss attributable to ordinary equity holders of the parent entity from continuing operations (and total operations).
• Mandatory Deductions:
  1. Profit attributable to Non-Controlling Interests (NCI) in group accounts.
  2. Preference Dividends:
     • Cumulative Preference Shares: Deduct the full dividend for the period, whether declared or not!
     • Non-Cumulative Preference Shares: Deduct only if formally declared during the period.

Weighted Average Number of Ordinary Shares (The Denominator)

• Shares issued for full market price (full consideration) are time-weighted from the date consideration is receivable (usually cash subscription date).

---

5. Capital Adjustments: Bonus Issues and Rights Issues

When share capital changes without a corresponding change in corporate resources, special adjustments are mandatory to maintain comparability across periods.

A. Bonus Issue (Scrip / Capitalisation Issue)

• Existing shareholders receive free shares in proportion to their existing shareholding; zero cash proceeds are received.
• Because no new resources entered the entity, the bonus shares are treated as if they had always been in issue from the beginning of the earliest period reported!
• Current Year Shares: Multiply shares in issue before the bonus date by the Bonus Fraction:

  Bonus Fraction = (Number of Shares AFTER Bonus Issue) / (Number of Shares BEFORE Bonus Issue)
  

• Prior Year Comparative EPS: Restated retrospectively by multiplying prior year EPS by the reciprocal of the bonus fraction:

  Restated Prior Year EPS = Original Prior EPS x (Shares BEFORE Bonus / Shares AFTER Bonus)
  

B. Rights Issue (Issue at a Discount to Market Price)

A rights issue offers new shares to existing shareholders at a discount to current market price (e.g. "1 for 4 at $2.00 when market price is $3.00"). A rights issue contains a dual character: partly an issue at full price, and partly a free bonus issue.

                                Rights Issue Step-by-Step
  ┌─────────────────────────────────────────────────────────────────────────────────┐
  │ Step 1: Calculate Theoretical Ex-Rights Price (TERP)                            │
  │                                                                                 │
  │         (Existing Shares x Cum-Rights Price) + (Rights Shares x Issue Price)    │
  │ TERP = ──────────────────────────────────────────────────────────────────────   │
  │                                Total Post-Rights Shares                         │
  ├─────────────────────────────────────────────────────────────────────────────────┤
  │ Step 2: Calculate the Bonus Fraction                                            │
  │                                                                                 │
  │                  Cum-Rights Market Price                                        │
  │ Bonus Fraction = ────────────────────────                                       │
  │                           TERP                                                  │
  ├─────────────────────────────────────────────────────────────────────────────────┤
  │ Step 3: Compute WANOS for Current Year                                          │
  │ • Pre-rights shares: Time-weight x Bonus Fraction                               │
  │ • Post-rights shares: Time-weight (no fraction)                                 │
  ├─────────────────────────────────────────────────────────────────────────────────┤
  │ Step 4: Retrospectively Restate Prior Year EPS                                  │
  │                                             TERP                                │
  │ Restated Prior EPS = Original Prior EPS x ─────────────────────────             │
  │                                           Cum-Rights Market Price               │
  └─────────────────────────────────────────────────────────────────────────────────┘

---

6. Diluted EPS: Principles and Potential Ordinary Shares

Objective of Diluted EPS

Diluted EPS warns investors of the maximum potential reduction in earnings per share (or increase in loss per share) that would occur if all potential ordinary shares were converted or exercised into ordinary shares.

Treatment of Potential Ordinary Shares

1. Convertible Instruments (Convertible Debt / Preference Shares)

• Assumption: The instruments were converted at the beginning of the period (or date of issue if later).
• Numerator Adjustment (Earnings): Add back the finance costs saved, net of tax (for debt):

  Earnings Add-Back = Gross Finance Cost Saved x (1 - Tax Rate)
  

  (For convertible preference shares, add back the full preference dividend with no tax deduction).
• Denominator Adjustment (WANOS): Add the maximum number of ordinary shares issuable upon conversion.

2. Share Options and Warrants (The Treasury Stock Method)

• Options do not generate finance costs, so the numerator remains unchanged.
• Options bring cash into the entity (exercise price). Under the treasury stock method, that cash is assumed to be used to repurchase shares on the open market at the average fair value (market price) during the period.
• Therefore, the only dilutive effect is the free (bonus) shares issued at zero consideration:

  Free / Dilutive Shares = Number of Options x [1 - (Exercise Price / Average Market Price)]
  

3. Test for Anti-Dilution (IAS 33.41)

Potential ordinary shares are dilutive only if their conversion would decrease profit per share (or increase loss per share) from continuing operations. If an instrument increases EPS, it is anti-dilutive and must be excluded from the calculation of diluted EPS!

---

7. Comprehensive Worked Example: Foreign Currency, Rights Issue & Diluted EPS

Scenario Details

Sterling plc (functional currency GBP £) presents the following transactions for the year ended 31 December 20X4:

1. Foreign Currency Sale:
   • On 1 October 20X4, Sterling sold manufactured goods to a US customer for $1,200,000 on 120 days credit. The spot rate on 1 October 20X4 was £1 = $1.50.
   • On 31 December 20X4 (reporting date), the receivable remained uncollected. The closing spot rate was £1 = $1.60.
   • On 28 January 20X5, the customer paid the $1,200,000 in full when the spot rate was £1 = $1.45.
2. Share Capital & Rights Issue:
   • Ordinary shares in issue on 1 January 20X4: 2,000,000 shares of £1 each.
   • On 1 April 20X4, Sterling conducted a 1 for 4 rights issue at an exercise price of £2.00 per share. The market price immediately prior to the rights issue (cum-rights price) was £3.00.
   • Profit attributable to ordinary parent equity holders for 20X4 was £950,000.
   • Reported Basic EPS for 20X3 was £0.40 (based on profit of £800,000 and 2,000,000 shares).
3. Potential Ordinary Shares for Diluted EPS:
   • Share Options: 200,000 share options outstanding throughout 20X4 with an exercise price of £1.80. The average market price of Sterling's shares during 20X4 was £3.00.
   • Convertible Debt: £1,000,000 of 6% convertible bonds in issue throughout 20X4. Each £100 bond is convertible into 40 ordinary shares. Corporate tax rate is 25%.

Step 1: Accounting for Foreign Currency Transaction (IAS 21)

• Initial Recognition (1 October 20X4):
  • Recorded Revenue & Receivable = $1,200,000 / 1.50 = £800,000

  Debit:  Trade Receivables (Monetary Asset)  £800,000
  Credit: Revenue                           £800,000
  

• Reporting Date Retranslation (31 December 20X4): Trade receivables is a monetary item and must be retranslated at the closing rate (£1 = $1.60):
  • Carrying Amount at 31 Dec 20X4 = $1,200,000 / 1.60 = £750,000
  • Exchange Loss in 20X4 P&L = £800,000 - £750,000 = £50,000

  Debit:  Operating Expenses (Exchange Loss in P&L)  £50,000
  Credit: Trade Receivables (SFP)                     £50,000
  

• Settlement in Subsequent Period (28 January 20X5):
  • Cash Received = $1,200,000 / 1.45 = £827,586
  • Exchange Gain in 20X5 P&L = £827,586 - £750,000 = £77,586

  Debit:  Cash                                      £827,586
  Credit: Trade Receivables                          £750,000
  Credit: Finance / Operating Income (Exchange Gain)  £77,586
  

Step 2: Compute Basic EPS for 20X4 (IAS 33)

1. Rights Issue Mechanics:
   • Existing shares: 2,000,000; New rights shares issued = 2,000,000 / 4 = 500,000 shares.
   • Total post-rights shares: 2,500,000 shares.
   • Theoretical Ex-Rights Price (TERP):

     TERP = [(4 x £3.00) + (1 x £2.00)] / 5 = (£12.00 + £2.00) / 5 = £14.00 / 5 = £2.80
     

   • Bonus Fraction:

     Bonus Fraction = Cum-Rights Price / TERP = £3.00 / £2.80 = 1.0714 (or 15/14)
     

2. WANOS Calculation for 20X4:
   • 1 Jan – 31 Mar (3 months pre-rights): 2,000,000 x (15/14) x (3/12) = 535,714 shares
   • 1 Apr – 31 Dec (9 months post-rights): 2,500,000 x (9/12) = 1,875,000 shares
   • Total WANOS for 20X4: 535,714 + 1,875,000 = 2,410,714 shares
3. Basic EPS 20X4:

   Basic EPS 20X4 = £950,000 / 2,410,714 = £0.3941 (39.4 pence per share)
   

4. Restated Comparative Basic EPS for 20X3:

   Restated 20X3 EPS = £0.40 x (TERP £2.80 / Cum-Rights £3.00) = £0.40 x (14/15) = £0.3733 (37.3 pence per share)
   

Step 3: Compute Diluted EPS for 20X4 (IAS 33)

1. Share Options (Treasury Stock Method):
   • Free / Dilutive shares = 200,000 x [1 - (£1.80 / £3.00)] = 200,000 x 0.40 = 80,000 shares
   • Earnings effect: £0.
2. Convertible Debt:
   • Gross interest saved: £1,000,000 x 6% = £60,000
   • Net post-tax interest add-back: £60,000 x (1 - 0.25) = £45,000
   • Additional shares: (£1,000,000 / £100) x 40 = 400,000 shares
3. Combined Diluted EPS Calculation:
   • Adjusted Earnings: £950,000 + £45,000 = £995,000
   • Adjusted WANOS: 2,410,714 + 80,000 + 400,000 = 2,890,714 shares

   Diluted EPS 20X4 = £995,000 / 2,890,714 = £0.3442 (34.4 pence per share)
   

   • Anti-Dilution Test: Basic EPS is 39.4p; Diluted EPS is 34.4p. Because 34.4p < 39.4p, the potential ordinary shares are dilutive and correctly reported!

---

8. Exam Traps & ACCA Examiner Tips

[!WARNING] ACCA Examiner Trap 1: Retranslating Non-Monetary Assets at Year-End Candidates frequently retranslate foreign plant or inventory at the closing rate. Inventory and PPE measured at historical cost remain at the spot rate on the acquisition date. Only monetary assets/liabilities (receivables, payables, bank loans) are retranslated at closing rate!

[!WARNING] ACCA Examiner Trap 2: Forgetting Post-Tax Effect on Convertible Debt Interest When computing the numerator adjustment for convertible debt in Diluted EPS, you must multiply by (1 - tax rate). Forgetting to deduct tax overstates the earnings add-back and produces an incorrect Diluted EPS.

[!TIP] ACCA Examiner Tip: Inverting the Bonus Fraction on Comparative EPS When restating prior year EPS for a rights issue, multiply by TERP / Cum-Rights, which is less than 1.0. Prior year EPS must decrease to maintain comparability with the expanded share base!