In this article, we examine the requirements of the International Accounting Standard (IAS) 21, the effects of changes in foreign exchange rates, and the reasonable method for accounting and reporting foreign currencies.
As Nigeria approaches the 2023 General Elections, one of the most talked about performance indicators of its economy is the exchange rate of the Nigerian Naira for foreign currencies. As the Naira continues to lose value in official and parallel markets, corporate organizations struggle with the financial reporting implications of the effects of foreign exchange transactions. The major problem is that the forex is scarce, and many organizations are not able to source them at the official rate of the Central Bank of Nigeria (CBN). This, therefore, means that entities will be faced with the dilemma of adopting the appropriate exchange rate for reporting foreign exchange transactions and booking liabilities denominated in foreign currencies.
Nigeria’s Foreign Exchange Crisis
Over the years, the Naira has continuously depreciated against global currencies with USD being the major trade currency. From September 2020 to September 2022, the Naira weakened against the USD by 14% from the rate of N379/$1 to N432/$1. Compared with the official rate in September 2015 of N196.45, the Naira has weakened by 120% in 8 years. Many factors have been blamed for the cause of the Naira crisis, ranging from the combination of misplaced monetary and fiscal policies to increased demand for foreign currencies. The primary concern for businesses whose continued operation and survival largely depend on the availability of foreign currency to either import raw materials or raise foreign funds is the restricted access to the USD in Nigeria. A parallel market has not helped improve the situation, as the gap between the official and parallel rates has dramatically widened. As of September 2022, the parallel rate was reported to be N720/$1 which is 67% more than the official CBN rate.
In a bid to curtail the crisis and discharge its regulatory function, the CBN had, in July 2021, announced that they would stop the sale of Forex to BDC (Bureau de Change) operators in Nigeria. As a result of the announcement, companies were expected to source forex themselves. Again, the CBN in July 2022 banned the purchase of dollars with Naira in commercial banks, culminating in the inability for companies to access foreign currencies required to process foreign transactions easily.
Implications for Businesses in Nigeria
Most companies in Nigeria have a business model that is linked to the ability to source foreign currencies. Major problems faced by companies include:
- Acute shortage of USD needed for importations from the central bank’s official window.
- Sourcing of required USD from alternative markets at a much higher cost/rate
- Payment of commission and premium to middlemen to obtain the USD.
- Settlement of old L.C. liabilities initially booked at the central bank’s official rate at the parallel market rates.
- Huge realized / unrealized exchange losses. A review of the financial statements of listed companies in Nigeria reveals that in the past 5 years, most entities had reported increased foreign exchange losses in their financial statements.
- Adoption of multiple and confusing exchange rates of NGN/USD for similar underlying transactions: raw materials purchased, closing inventory valuation, and recognition of foreign liabilities.
- Disrupted financial planning and cash flow management
- Repatriation of funds affecting some industries including aviation sector.
Considering the above issues, a typical business could find itself in a situation where importing all or part of the raw materials required for production could give rise to liabilities denominated in foreign currencies for credit purchases. Due to fluctuating exchange rates and continuous depreciation of the Nigerian Naira against the U.S. dollar, a company may be exposed to foreign exchange risks because of payables, including Letters of Credit arising from the foreign purchase of raw materials. More so, the purchased inventory is stated at cost while the exchange rate continues to affect the outstanding balance of their payables denominated in foreign currency. The outstanding balance of payables is expected to be converted at the official exchange rate but might not be realistically settled at the same rate, and this practice causes accounting mismatch and subsequent recognition of foreign exchange losses.
Practically, the liabilities would not be settled at the official rate due to scarcity of the foreign currency and rationing/quota restriction by the CBN. The pertinent question, in the analysis above is whether IAS 21 supports using parallel market rates instead of official rates for converting year-end foreign liabilities. If the parallel rate is not acceptable, how would entities account for the material difference to suit the company’s business model?
Financial Reporting Considerations
Paragraph 20 of IAS 21 on the effects of changes in foreign exchange rates defined a foreign currency transaction as a transaction that is denominated or requires settlement in a foreign currency, including transactions arising when an entity:
- buys or sells goods or services whose price is denominated in a foreign currency
- borrows or lends funds when the amounts payable or receivable are denominated in a foreign currency; or
- otherwise acquires or disposes of assets or incurs or settles liabilities denominated in a foreign currency.
Paragraph 21 further states that a foreign currency transaction shall be 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. Taking it further to paragraph 26, the standard states that when several exchange rates are available, the rate used is that at which the future cash flows represented by the transaction or balance could have been settled if those cash flows had occurred at the measurement date. If exchangeability between two currencies is temporarily lacking, the rate used is the first subsequent rate at which exchanges could be made.
As mentioned above, IAS 21 requires that foreign currency transactions should be measured at the rate at which the future cashflows should reasonably be settled at the measurement date. This requirement is necessary when there are multiple exchange rates available. The wording of the standard is not specific about the use of official rates but requires the use of an appropriate rate required to settle the obligation, where there is the availability of multiple exchange rates, or where exchangeability is lacking. Taking this requirement into perspective, it is fair to say that since companies are not able to easily obtain forex at the CBN official rate, and the apex bank has requested that entities should source for forex through various windows, there is proof for the existence of multiple rates and exchangeability is indeed lacking.
In Nigeria, multiple exchange rates include CBN official rate, the I & E (Import & Export) window, the NAFEX rate and the Parallel rate. Applying IAS 21, companies are expected to recognize foreign transactions or book foreign liabilities at the most likely amount required to settle the obligation, regardless of the source of the exchange rate. This is, of course, arguable in terms of the legality of the use of parallel rates for transactions but considering the commercial reality of foreign transactions in Nigeria, it is more realistic for entities to book these foreign transactions at the most likely amount that is required to settle them after an entity has reasonably assessed the rate at which it is able to obtain forex. The requirement is consistent with the concept of substance over form in accounting, where the commercial reality of a transaction is meant to be considered ahead of its legal form for accounting purposes. Again, it is consistent with IAS 37, which requires that provisions that are genuine obligations should be recognized at the best estimate of the expenditures required to settle them when they become due.
Accounting for foreign currency transactions in Nigeria is a sensitive matter due to the forex crisis that has impacted the operations of most entities. The financial reporting implication is that most entities end up recording transactions at the CBN rate and eventually settle the transactions at the parallel or other rates they can obtain the foreign currency. Entities have incurred more operational losses occasioned by foreign exchange losses which could be realized or unrealized. Considering the requirement of IAS 21, it is reasonable to say that entities should recognize foreign currency transactions and book foreign liabilities at the best estimate of the amount that is required to settle the obligation. This requirement is also consistent with the requirement for recognition provisions that are genuine liabilities in line with IAS 37. In doing this, management is expected to liaise with a financial reporting expert, to develop a robust analysis and documentation that supports the applied rates.
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