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IFRS Question 024: How to deal with exchange differences on foreign currency loans?

Dear Silvia, we are a real estate constructor and we took a loan to finance our new construction. In Russia the interest rates are quite high and therefore we negotiated the loan in EUR from one international bank.

I know that at the year-end we have to translate the EUR loan to Russian rubles with the closing rate and as a result a foreign exchange loss arose. Can we capitalize it as a borrowing cost? How can we calculate how much exchange difference on the loan we can capitalize?
 

IFRS Answer 024

So, the borrowing costs in general are arranged by the standard IAS 23 Borrowing Costs.

This standard defines what the borrowing cost is and lists a few items as examples.

One of these items is exchange differences arising from foreign currency borrowings to the extent that they are regarded as an adjustment to interest costs.

Therefore, by definition, YOU CANNOT capitalize the full exchange difference that arose on translation or revaluation of your EUR loans to rubles at the end of the reporting period because not all of it is a borrowing cost.

What part ends up in profit or loss?

And, what exchange differences actually are borrowing costs under IAS 23?
 

How to determine what part of your total exchange difference to capitalize?

Unfortunately, IAS 23 is silent on how to do it or what method you should use.

It means that you have to use your judgment.

The gains and losses regarded as adjustment to interest cost are mainly the difference between:

  • The borrowing costs that would be incurred if you borrowed in your own functional currency (RUB in this case); and
  • The borrowing costs actually incurred on foreign currency borrowings (EUR in this case, translated to RUB with appropriate rates).

I’ve read that IFRIC (Interpretation committee for IFRS) considered 2 methods:

  1. You can estimate the portion of exchange loss or gain to capitalize based on forward currency rates at the inception of the loan, or
  2. You can estimate it based on interest rates on similar borrowings in your own functional currency – for me, this method is maybe easier.

Practically, you can just limit the exchange differences to capitalize so that the total borrowing costs capitalized do not exceed the amount of hypothetical borrowing costs on similar loan in your functional currency.
 

Illustration: Exchange differences to capitalize

Let’s say you took a loan of 100 000 EUR to finance the building of your new offices in June 20X1 when the rate was 67,54 RUB (rubles) for 1 EUR.

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The reason why you took the loan in EUR was that the interest rate on EUR loan was 2% and the interest rate on RUB loans was 4%.

Then, you keep recognizing the loan at amortized cost and it’s carrying amount at the end of 20X1 is 83 700 EUR which is 5 700 000 RUB.

You recognized the interest cost on that loan in 20X1 amounting to 1 000 EUR (that’s roughly interest for 6 months at 2% annual agreed rate) which makes 68 300 RUB in your accounts.

Let’s say that the interest accrues monthly and you always used month-end rate to book the interest expense.

Please don’t start analyzing where I got these numbers from – I just made them up based on effective interest method table, but rounded them a bit.

So, let’s say that the closing rate at 31 December 20X1 is 69,39 RUB per 1 EUR and thus your foreign currency loan translates to RUB as 83 700 EUR times the rate of 69,39 = 5 808 000 RUB.

You have a foreign currency loss of 108 000 RUB (5 808 000-5 700 000). And, let’s say this is a full foreign currency loss on retranslating the loan to RUB during 20X1.

How to deal with this loan?

First, let’s compare the interest costs:

  • The actual interest cost on EUR loan was 1 000 EUR or 68 300 RUB (please see above)
  • The hypothetical interest cost on the same loan in RUB would be 133 755 RUB. The calculation is:
    • Amount of loan in RUB: 100 000 EUR x historical rate of 67,54 RUB/EUR = 6 754 000 RUB
    • Interest for 6 months at 4% annual rate: 6 754 000*(1,04^(6/12)-1) = 133 755 RUB (the calculation in brackets is deriving semi-annual rate from 4% annual rate, because you can’t simply divide it by 2)
  • The difference is 133 755 – 68 300 = 65 455 RUB

Therefore, the journal entry to deal with the full foreign currency loss is:

  • Debit PPE – new offices: 65 455 RUB
  • Debit Profit or loss – FX loss: 42 545 RUB (which is 108 000 of total loss less 65 455)
  • Credit Loan: 108 000 RUB

Total capitalized interest on the loan is the actual interest of CU 68 300 plus the capitalized exchange difference related to adjustment of interest of CU 65 455 and that makes 85 855 CU.

Any questions? Please leave a comment below – thank you!