IAS 21 *The Effects of Changes in Foreign Exchange Rates* establishes how entities should translate foreign currency transactions and balances into their functional currency, and how to recognise resulting exchange differences.

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Initial Recognition (IAS 21.20–21)

On initial recognition, a foreign currency transaction is translated into the functional currency using the spot exchange rate at the date of the transaction — i.e., the rate prevailing when the transaction first qualifies for recognition. For practical purposes, an average rate for a period may be used if exchange rates do not fluctuate significantly (IAS 21.22).

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Subsequent Reporting of Balances (IAS 21.23)

At the end of each reporting period, foreign currency items are retranslated as follows:

• Monetary items (cash, receivables, payables, loans) — retranslated at the closing rate (spot rate at the reporting date)
• Non-monetary items measured at historical cost — remain at the exchange rate at the date of the transaction (no retranslation)
• Non-monetary items measured at fair value — retranslated at the rate at the date when fair value was determined (IAS 21.23(c))

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Recognition of Exchange Differences (IAS 21.28)

Exchange differences arising on the settlement of monetary items, or on retranslation of monetary items at rates different from those used on initial recognition, are recognised in profit or loss in the period in which they arise (IAS 21.28).

A key exception exists for monetary items forming part of the net investment in a foreign operation — such exchange differences are recognised in Other Comprehensive Income (OCI) and reclassified to profit or loss only on disposal of the foreign operation (IAS 21.32).

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Practical Example

If a company with a USD functional currency purchases goods on credit for EUR 100,000 when the rate is 1.10, the liability is initially recorded at USD 110,000. If the closing rate moves to 1.15, the liability is retranslated to USD 115,000, and a USD 5,000 exchange loss is recognised in profit or loss.

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Hedging Considerations

IAS 21 does not address hedge accounting directly. Where an entity designates a foreign currency item as a hedging instrument, IFRS 9 *Financial Instruments* governs the accounting treatment, which may allow exchange differences to be deferred in OCI under a cash flow hedge or fair value hedge relationship.

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Disclosure Requirements (IAS 21.51–57)

Entities must disclose:

• The amount of exchange differences recognised in profit or loss (excluding those on financial instruments at FVTPL under IFRS 9)
• Net exchange differences classified in OCI and a reconciliation of opening to closing balances
• When the presentation currency differs from the functional currency, that fact must be disclosed along with the reason

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Key Takeaway

The core principle is that monetary items carry foreign exchange risk and must be updated at each reporting date, while non-monetary items measured at historical cost are effectively "locked in" at the original transaction rate. The distinction between monetary and non-monetary items is therefore critical to correct application of IAS 21.