Presentation of exchange differences under IFRS 18

Whenever new accounting standards are published and entities begin the work to implement them, application issues inevitably emerge that were not thought about at the time the requirements were drafted.  IFRS 18 Presentation and Disclosure in Financial Statements, published in April 2024 and effective for the first time for periods beginning on or after 1 January 2027, is no exception.  One such issue that was recently considered by the IFRS IC is the presentation of foreign exchange gains and losses in consolidated financial statements on intercompany payables and receivables.

What IFRS 18 and IAS 21 require?

The headline change brought about by IFRS 18 is the need to allocate all items of income and expense in the profit and loss account into one of 5 categories:

• The operating category;
• The investing category;
• The financing category;
• The income taxes category; and
• The discontinued operations category.

Where an entity has a monetary asset or liability denominated in a foreign currency IAS 21 The Effects of Changes in Foreign Exchange Rates requires the retranslation gain or loss to be presented in profit or loss.  The general principle in IFRS 18 is that foreign exchange gains and losses are classified in the same category as the income and expense from the items that gave rise to those foreign exchange differences.  Thus, for example:

• exchange differences on foreign currency payables and receivables arising from the production and supply of goods and services are presented in the operating category; and
• unless the reporting entity is a financial institution, exchange differences on foreign currency debt instruments issued for the purposes of raising finance will typically be presented in the financing category (along with the interest expense on such borrowings).

What’s the challenge under IFRS 18?

At first glance the principle seems logical and straightforward to apply. However, it isn’t when considering how exchange differences on intercompany loans in consolidated financial statements should be presented.

Where one group entity has an intercompany payable or receivable denominated in a currency different to its functional currency, the exchange gain or loss arising in its separate financial statements on retranslation follows the above principle.  When it comes to the consolidated financial statements, if the monetary item is judged to form part of the group’s net investment in a foreign operation (i.e. settlement is neither planned nor likely to occur in the foreseeable future) then the FX arising on retranslating the intercompany balance will be wrapped up as part of retranslating the foreign operations net assets presented in other comprehensive income (OCI), and so the question as to which category the exchange gain or loss should be presented in profit or loss does not arise.

In all other cases, however, the exchange gain or loss arising in separate financial statements remains in the consolidated profit and loss account, despite the intercompany item giving rise to the exchange difference (the intercompany payable or receivable and any interest thereon) having been eliminated in full.

What the IFRS IC concluded?

In deliberating the question of which profit and loss category to present such exchange gains and losses in consolidated financial statements, the IC tentatively concluded two views are acceptable:

• View 1: present the exchange differences in the operating category as this is the default category for any item that cannot be specifically allocated to one of the other four categories.
• View 2: the intercompany balance still exists in the consolidated accounts, with the process of elimination really being the “offset” of one group entity’s receivable against another’s payable.  Therefore, the exchange differences should be presented in the same category as it would in the profit and loss account of the separate financial statements of the group entity concerned.  Where the balance arises from a lending transaction this will likely be in the investing or financing section (depending on whether the exchange difference is recognised in the lender’s or borrower’s accounts).

Neither view feels like an ideal solution, despite both views not being in obvious conflict with IFRS 18.  View 2 gives rise to further challenges in the case of a loan that is not denominated in the functional currency of either borrower or lender because the lender would likely record its exchange difference in the investing category and the borrower in the financing category. As such, View 2 would result in the presentation of an investing FX gain/(loss) and a separate counterbalancing financing FX (loss)/gain in consolidated profit or loss on a lending (including any interest thereon) that is fully eliminated in the consolidated accounts.  Because they appear in different categories, IFRS 18 seems not to allow these separate FX gains and losses to be offset in the consolidated profit and loss account either.

Should IAS 21 be changed to resolve the issue?

One can’t help but feel that perhaps the problem is not so much an absence of guidance in IFRS 18, but with the accounting required by IAS 21, which dates back to 1983.  That exchange gains and losses remain in the consolidated profit and loss account on intercompany monetary items is a consequence of IAS 21 asserting that monetary items not forming part of the group’s net investment in a foreign operation “represent a commitment to convert one currency into another and exposes the [group] to a gain or loss through currency fluctuations.  Accordingly… such an exchange difference is recognised in profit or loss.”

This may well be true, but that commitment is an intercompany one, and therefore perhaps it too should be eliminated on consolidation along with the actual intercompany payable and receivable.  This would result in exchange differences on intragroup monetary items being accounted for consistently irrespective of whether they form part of the group’s net investment in a foreign operation, i.e. exchange gains and losses would only arise on the retranslation of assets and liabilities “external” to the group, all of which would be presented in OCI, and which in turn results in this IFRS 18 conundrum being “eliminated”.

The possibility of amending IAS 21 has not been considered as part of the IC’s deliberations and so we await to see the comment letters on the IC’s tentative agenda decision and whether the conclusion on the acceptability of either of the two views is ultimately ratified.