IAS 21 is dealing with the determination of the functional currency; reporting foreign currency transactions; use of a presentation currency other than the functional currency; tax effect of all exchange differences; and relevant disclosures.
Many reporting entities preparing financial statements in accordance with IFRS realised that the application of the revised IAS 21 (effective 1 January 2005) was more difficult than originally thought especially in relation to the determination of the functional currency. A summary of the main changes between the old guidance and revised IAS 21 is provided in APPENDIX I.
This article will concentrate on the basics for determining the functional currency; and explain under which circumstances companies preparing consolidated financial statements are allowed to transfer foreign exchange gains/losses on their net investment in foreign operations in equity.
Functional currency
Functional currency is the currency of the primary economic environment in which the entity operates. Before the introduction of IAS 21 revised, the emphasis was put on the currency which was used to a significant extent in the transactions of a company. Therefore it is obvious that for the determination of the functional currency, the application of the old and new guidance will not always give the same result.
The determination of the functional currency is important because all foreign currency transactions are measured in the functional currency of an entity therefore the functional currency drives exchange gains/ losses recognised in income statement. Details about “recognition and measurement of items in the functional currency” is provided in APPENDIX II.
The primary economic environment in which an entity operates is normally the one in which it primarily generates and expends cash. An entity’s management considers the following factors in determining its functional currency:
- The currency that dominates the determination of the sales prices; and
- The currency that most influences operating costs.
The currency that dominates the determination of sales prices will normally be the currency in which the sales prices for goods and services are denominated and settled; and whose competitive forces and regulations have the greatest impact on sales prices. The currency that most influences operating costs will often be the currency in which such costs are denominated and settled. However, the emphasis is on the currency of the economy that determines the pricing of transactions, as opposed to the currency in which transactions are denominated, if these are different.
The determination of functional currency is a matter of fact. In some cases the facts will identify the primary economic environment clearly. For example we can easily conclude that the primary economic environment of an entity is Cyprus, if that entity is domiciled in Cyprus, purchases from Cypriot suppliers, manufactures in Cyprus and sells finished goods in Cyprus. Such a company should have the Cyprus Pound as its functional currency.
However in other cases, the facts are not so clear and factors other than the dominant currency for sales prices and operating costs are also considered. These are:
- The currency in which an entity’s finances are denominated. Financing activities include issuing debt and equity instruments; and
- The currency in which receipts from operating activities are retained.
Additional factors are also considered in determining the functional currency of a foreign operation and whether its functional currency is the same as that of the reporting entity. These include considerations of the autonomy of a foreign operation from the reporting entity; the proportion of transactions with the reporting entity; the flow of cash between the two entities (ie whether the cash flows of the foreign operation directly affect those of the reporting entity); and the sufficiency of cash flows (ie can the foreign operation generate sufficient cash flows to meet its cash needs).
When the above indicators are mixed and the functional currency is not obvious, management has to use its judgement. In doing so, management gives priority to the currency most affecting sales prices and operating costs before considering the currency most relevant to the financing of an entity and the degree of autonomy and independence. The latter factors are designed to provide additional supporting evidence in determining an entity’s functional currency.
Functional currency must be determined on an entity by entity basis. There is no group functional currency.
Finally it should be noted, that management reserves the right to choose a currency for presenting the financial statements (presentation currency).
Net investment in a foreign operation
Foreign operation is an entity that is a subsidiary, associate, joint venture or branch of a reporting entity, the activities of which are based or conducted in a country or currency other than those of the reporting entity.
When the reporting entity has a monetary item that is: receivable from or payable to a foreign operation (either directly or through any other subsidiary of the reporting entity); and whose settlement is neither planned nor likely to occur in the foreseeable future (such monetary items may include long-term receivables or loans, however they do not include trade receivables or trade payables), it is considered to be part of the entity's net investment in that foreign operation and has the following accounting implications:
- Exchange differences arising on a monetary item that forms part of a reporting entity's net investment in a foreign operation shall be recognised in profit or loss in the separate financial statements of the reporting entity/ foreign operation, as appropriate.
- In the consolidated financial statements, such exchange differences shall be recognised initially in a separate component of equity and recognised in profit or loss on disposal of the net investment.
APPENDIX I - The changes between the “old” and “new” guidance
- The functional currency is defined as the currency of the primary economic environment. This is one of the major changes since it clarifies that the functional currency is a matter of fact (see “Functional currency” below).
- Goodwill should now be treated as an asset of the foreign operation and shall be expressed in the functional currency of the foreign operation. Under the old standard, there was an option and goodwill could also be treated as an asset of the parent entity and therefore be expressed in the functional currency of the parent entity.
- The revised standard uses the terms “presentation currency” and “functional currency”. Following the completion of 2004 financial statements, preparers should cease using the terms “reporting currency” and “measurement currency”.
- IAS 21 revised provides guidance for translating the results and financial position (except for items reported within shareholder’s equity) from the functional currency into a different presentation currency. Under the old guidance [SIC-30.6(c)], items reported within shareholder’s equity were translated at closing rates. This requirement was removed from the exposure draft to the revised guidance. Management has to select an accounting policy for translation of items and apply it consistently. Management could use historic rates for share capital and retained earnings or closing rates.
- The limited option to capitalise exchange differences from severe currency devaluation (SIC-11: “Foreign exchange – capitalisation of losses resulting from severe currency devaluations”) has been removed.
APPENDIX II - reporting foreign currency transactions
IAS 21 requires:
- All foreign currency transactions to be initially recognised at the spot rate at the date of the transaction;
- Non-monetary items carried at cost are not subsequently remeasured;
- Non-monetary items carried at fair value are subsequently remeasured at the spot rate at the date of revaluation;
- Monetary items are always measured at the spot rate at the reporting date.
An entity may use average rates (rather than the spot rate) for practical reasons (ie weekly or monthly averages). However the average rate may not be used in cases where the exchange rate fluctuates significantly.
For example:
- A building is remeasured at the spot rate at the date of the revaluation when it is subsequently revalued:
- If it is an investment property carried at fair value: exchange differences are included within fair value gains, recognised in income statement.
- If it is a property, plant and equipment using the allowed alternative treatment to revalue: exchange differences are included within fair value gains that are recognised in equity.
- A foreign currency loan is remeasured at the period-end spot rate:
- If classified as loans and receivables/ borrowings carried at amortised cost: exchange differences are included in the income statement.
- If classified as available for sale: exchange differences are included in the income statement (please note that the entity must prepare detailed calculations to be able to split the two elements – fair value and foreign currency gains/ losses are recognised in equity and income statement respectively).
- A foreign currency equity security is remeasured at the spot rate at the date of valuation (ie period-end date):
- If classified as available for sale: exchange differences are included within fair value gains that are recognised in equity.
- Financial assets at fair value through profit or loss: exchange differences are included within fair value gains that are recognised in the income statement.
