Zimbabwe found itself in a unique position in the history of accountancy at the beginning of 2009. The country had been riddled by severe-hyperinflation, such that the Zimbabwean government had no choice but to adopt a multi-currency regime and demonetized the Z$. This therefore resulted in a circumstance regarded as very rare by the International Financial Reporting Standards (IFRS), of change in functional currency. Both the reporting accountants and auditors were thrown in the deep-end not directly addressed by the IFRS.
Thanks to the leadership taken by the accountancy profession, led by the Institute of Chartered Accountants of Zimbabwe (ICAZ), which resulted in the guidance paper for the conversion of balances from Zimbabwe dollar (Z$) to United States dollar (US$) “Conversion Guidance”). The paper was welcomed and adopted for reporting by the Public Accountants and Auditors Board (PAAB) and Zimbabwe Stock Exchange (ZSE) and it became the only way of reporting by reporting entities in Zimbabwe. It’s substance and recommendations were then adopted by the IASB in 2011 which as a result amended IFRS 1 (First-time Adoption of IFRS) by including the deemed value approach which became the way in which Zimbabwe achieved compliance with IFRS again. The initiative was applauded for being a solution for some countries who were struggling with severe hyper-inflation like Venezuela.
How did the reserve arise and what was its purpose?
The conversion guidance recommended the deemed value approach. The approach noted that the opening balances of 2009 made of an entity’s assets and liabilities in Z$ needed to be valued at US$ fair value “deemed value” at date of conversion (generally regarded as 1 January 2009). The difference between the deemed value of the assets and liabilities was recognized as the translation reserve or revaluation reserve or the foreign currency translation reserve (FCTR) and or non-distributable reserve (NDR).
Dr Assets (SFP)
Cr Liabilities (SFP)
Cr Translation Reserve/NDR (SFP/SCE)
The translation reserve represented the net equity in US$. However, equity in US$ could not be easily allocated to its respective components of share capital, distributable and non-distributable reserves at conversion, due to several factors. The US$ was earlier on used as a surrogate reporting currency as it was premature to classify it as the “functional currency” as per IFRS. The authorities had adopted a multi-currency regime, such that in the earlier years the rand (ZAR) was predominantly used in Bulawayo and the US$ was mostly common in Harare. The exchange rates for the US$ and the ZAR was publicly displayed in almost all areas of trade. Share capital was denominated in Z$ as laws and regulations had not yet been amended. The allocation was going to be arbitrary and thus there was consensus to maintain a translation reserve or NDR (NDR, henceforth) in its totality as equity is function of assets and liabilities. However, no guidance was given on the fate of the reserve post conversion, such that it is a common feature today in many entities’ financial statements. It took more than a year to conclude and for the US$ to emerge as the substantive functional currency (currency of the primary economic environment in which the entity operates) and the appropriate reporting currency. The authorities also amended the laws to refer to the US$ in 2010, at which time redenomination of share capital was gazzeted. The share capital par value was carved out of the NDR and presented separately in the Annual Financial Statements (AFS), but the distributable reserve was not separated and remained as part of the NDR.
What should happen to the reserve after recognition?
It is important that the reader note that non-distributable reserves are normally regarded as capital profits or unrealized profits that arises from remeasurement of assets and liabilities. It is normally required that they be reclassified to distributable reserves (RE) once realized. Realisation happens when the related asset from which the reserve emanated is used, when it is sold or when it is both used and sold at its residual value.
What is the recommendation to deal with the translation reserve/conversion NDR?
Two approaches are suggested as inspired by IFRS:
Approach 1: Retain the Conversion NDR
This approach means the NDR will be retained as is and shall not be reclassified in anyway. Resultantly, the reserve will remain a permanent feature of the AFS forever. The approach is easy as the reporting entity does not have to do any work but rather maintain the related disclosure note. There are circumstances in which IFRS allows this approach, for example in the case of mark-to-market reserve for financial assets classified as fair value through other comprehensive income (FVTOCI).
However, this approach does not achieve the objective of general purpose financial statements and may not be favoured by investors. It will not reflect that some of the assets and liabilities that make the NDR were since realized post conversion date. The realized amounts should be shown as realized and separately presented as part of the distributable reserves available for distribution to shareholders as dividends.
Thus, this approach even though justifiable, does not embody fully the spirit of the objective of financial reporting required by the Conceptual Framework, of providing relevant and faithfully represented useful financial information for decision making by users of financial statements.
Approach 2: Reclassify NDR directly to Retained Earnings (RE).
Generally, IFRS allows reclassification to be done either through P&L via OCI or directly to RE as required by the respective reporting standard. For example:
- Revaluation reserve is reclassified directly to RE as the asset is used or when derecognised.
- The FCTR is normally reclassified to P/L if asset is fully realised (i.e. used or derecognised) otherwise it is reclassified directly to RE.
- Mark-to-market could either be reclassified to RE or left as is when the asset is fully realized.
The bottom line is that if the underlying asset that caused the reserve is realised then the respective non-distributable reserve is reclassified to distributable reserve for possible distribution.
Approach 3: Modified Reclassification directly to RE
A modified reclassification approach is proposed: reclassification of the realized portion of the NDR directly to RE and not through P&L. This would be correct as the reserve is unique and non-recurring. The reserve is not clearly an FCTR reserve as FCTR would arise from translating functional currency used on the financial statements of a foreign investee into the reporting currency of the investor and not to translate the reporting entity itself. It may not also be the revaluation reserve as it arises on net assets and not property, plant and equipment. I chose to call it the “Conversion to Function Currency Reserve or rather Equity Reserve” as it was just a balancing figure representing the net assets at conversion date after re-measurement to US$.
First, the reserve is assumed to have been audited and represent assets and liabilities that existed at the conversion date. Rigorous exercises to verify existence and appropriate valuation were done and as such any subsequent issues identified post conversion date would have been appropriately addressed as prior period errors or change in accounting estimates. The recommendation is focused on a valid conversion reserve remaining after redenomination of share capital.
Thus, an analysis of the assets and liabilities that made the reserve need to be done and reclassification to RE should only be for the balances of valid assets and liabilities that were subsequently realised post conversion, e.g. inventory, trade receivables, trade payable, etc. The only portion left should be for some long-term assets and liabilities, e.g. PPE and other non-current assets held at Conversion date. If these are depreciable, the accumulated depreciation/amortization amount calculated on the part of the balance should be released reclassified to RE on date of reclassification and subsequently, the depreciation should annually be reclassified to RE. This approach will achieve fair representation and would identify part of the NDR that is realized and distributable.
What additional information should an entity provided to users?
An entity should clearly provide a policy of which approach (1, 2 or 3) it has adopted regarding treatment of the conversion reserve/NDR. It shall define the concept of realisation as either sale, derecognition or use indicated by depreciation/amortisation.
Dr NDR/FCTR (SFP/SCE)
Cr RE(SFP/SCE)
Will I be taxed when I reclassify to Retained Earnings?
Note that, no tax implications are expected as the reserve is already net of tax, assuming that tax was correctly dealt with at conversion.
Disclaimer
We hope that the above analysis and recommendation is of value to the reader. Note that it is neither law nor IFRS requirement and TAS/CAA or the author is not liable for any losses incurred after use. The authority for prescribing reporting standards is PAAB and this paper has not been adopted by PAAB. This is a TAS/CAA opinion piece of an issue that seem to be bothering many preparers and audit practitioners.
Written by TAS/CAA Technical Think Tank, Lead Author- Anesu Daka CA(SA)(Z)
Training & Advisory Service (TAS) is an associate of Chartered Accountants Academy (CAA). TAS/CAA philosophy is to integrate classroom knowledge and practice for education to remain relevant. TAS is the gateway of CAA to the market place where knowledge is integrated with practice. This paper is a product of many others from the TAS/CAA Technical Think Tank.