3.4.1 Intermediate holding companies or finance subsidiaries

For many entities the determination of functional currency will be relatively straightforward. However, for some entities, particularly entities within a group, this may not be the case. One particular difficulty is the determination of the functional currency of an intermediate holding company or finance subsidiary within an international group.

As for other entities within a group, the circumstances of each entity should be reviewed against the indicators and factors set out in Section 30. This requires management to use its judgement in determining the functional currency that most faithfully represents the economic effects of the underlying transactions, events and conditions applicable to that entity.

3.4.2 Branches and divisions

Section 30 uses the term ‘branch’ to describe an operation within a legal entity that may have a different functional currency from the entity itself. However, it contains no definition of that term, nor any further guidance on what arrangements should be regarded as a branch.

Many countries' governments have established legal and regulatory regimes that apply when a foreign entity establishes a place of business (often called a branch) in that country. Where an entity has operations that are subject to such a regime, it will normally be appropriate to regard them as a branch and evaluate whether those operations have their own functional currency. In this context, the indicators in paragraph 5 used to assess whether an entity has a functional currency that is different from its parent (see 3.4 above) will be particularly relevant.

An entity may also have an operation, e.g. a division, that operates in a different currency environment to the rest of the entity but which is not subject to an overseas branch regime. If that operation represents a sufficiently autonomous business unit it may be appropriate to view it as a branch and evaluate whether it has a functional currency that is different to the rest of the legal entity. However, in our experience, this situation will not be a common occurrence.

3.5.1 Initial recognition

A foreign currency transaction is a transaction that is denominated or requires settlement in a foreign currency, including transactions arising when an entity: [FRS 102.30.6]

1. buys or sells goods or services whose price is denominated in a foreign currency;
2. borrows or lends funds when the amounts payable or receivable are denominated in a foreign currency; or
3. otherwise acquires or disposes of assets, or incurs or settles liabilities, denominated in a foreign currency.

On initial recognition, foreign currency transactions should be translated into the functional currency using the spot exchange rate between the foreign currency and the functional currency on the date of the transaction. [FRS 102.30.7].

The date of a transaction is the date on which the transaction first qualifies for recognition in accordance with FRS 102. For practical reasons, a rate that approximates the actual rate at the date of the transaction is often used, for example, an average rate for a week or a month might be used for all transactions in each foreign currency occurring during that period. However, if exchange rates fluctuate significantly, the use of the average rate for a period is inappropriate. [FRS 102.30.8].

3.5.2 Identifying the date of transaction

The date of a transaction is the date on which it first qualifies for recognition in accordance with FRS 102. Although this sounds relatively straightforward, the following example illustrates the difficulty that can sometimes arise in determining the transaction date:

Example 27.2 above illustrated that the date that a transaction is recorded in an entity's books and records is not necessarily the same as the date at which it qualifies for recognition under FRS 102. Other situations where this is likely to arise is where an entity is recording a transaction that relates to a period, rather than one being recognised at a single point in time, as illustrated below:

3.5.3 Using average rates

Rather than using the actual rate ruling at the date of the transaction ‘an average rate for a week or month may be used for all foreign currency transactions occurring during that period’, if the exchange rate does not fluctuate significantly (see 3.5.1 above). [FRS 102.30.8]. For entities which engage in a large number of foreign currency transactions it will be more convenient for them to use an average rate rather than using the exact rate for each transaction.

3.5.4 Dual rates or suspension of rates

One practical difficulty in translating foreign currency amounts is where there is more than one exchange rate for that particular currency depending on the nature of the transaction. In some cases the difference between the exchange rates can be small and therefore it probably does not matter which rate is actually used. However, in other situations the difference can be quite significant. So what rate should be used?

There is no specific guidance on this matter in FRS 102. So in accordance with the hierarchy set out in Section 10 – Accounting Policies, Estimates and Errors, an entity could look to the requirements in IFRS for guidance. IAS 21 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’. [IAS 21.26]. Companies would therefore normally look at the nature of the transaction and apply the appropriate exchange rate.

Another practical difficulty which could arise is where, for some reason, exchangeability between two currencies is temporarily lacking at the transaction date or subsequently at the end of the reporting period. Again FRS 102 provides no specific guidance but IAS 21 requires that the rate to be used is ‘the first subsequent rate at which exchanges could be made’. [IAS 21.26].

3.5.5 Reporting at the ends of the subsequent reporting periods

At the end of each reporting period, an entity should: [FRS 102.30.9]

1. translate foreign currency monetary items using the closing rate;
2. translate non-monetary items that are measured in terms of historical cost in a foreign currency using the exchange rate at the date of the transaction; and
3. translate non-monetary items that are measured at fair value in a foreign currency using the exchange rates at the date when the fair value was determined.

The treatment of exchange differences arising from this is set out at 3.5.6 and 3.5.7 below for monetary and non-monetary items respectively.

3.5.6 Treatment of exchange differences – monetary items

The general rule in Section 30 is that exchange differences on the settlement or retranslation of monetary items should be recognised in profit or loss in the period in which they arise. [FRS 102.30.10].

These requirements can be illustrated in the following examples:

There are situations where the general rule above will not be applied. The first exception relates to exchange differences arising on a monetary item that, in substance, forms part of an entity's net investment in a foreign operation (see 3.7.4 below). In this situation the exchange differences should be recognised in other comprehensive income and accumulated in equity. However, in general, this treatment applies only in the financial statements that include the foreign operation and the reporting entity (e.g. consolidated financial statements when the foreign operation is a subsidiary). It does not normally apply to the reporting entity's separate financial statements or the financial statements of the foreign operation. This is discussed further at 3.7.6 below.

The next exception relates to hedge accounting for foreign currency items, to which Section 12 applies. The application of hedge accounting requires an entity to account for some exchange differences differently from the treatment required by Section 30. For example, Section 12 requires that exchange differences on monetary items that qualify as hedging instruments in a cash flow hedge are recognised initially in other comprehensive income to the extent the hedge is effective. Hedge accounting is discussed in more detail in Chapter 10.

Another situation where exchange differences on monetary items are not recognised in profit or loss in the period they arise would be where an entity capitalises borrowing costs under Section 25 – Borrowing Costs – since that section of FRS 102 requires exchange differences arising from foreign currency borrowings to be capitalised to the extent that they are regarded as an adjustment to interest costs (see Chapter 22 at 3.5.4). [FRS 102.25.1].

3.5.7 Treatment of exchange differences – non-monetary items

When non-monetary items are measured at fair value in a foreign currency they should be translated using the exchange rate as at the date when the fair value was determined. [FRS 102.30.9(c)]. Therefore, any re-measurement gain or loss will include an element relating to the change in exchange rates. In this situation, the exchange differences are recognised as part of the gain or loss arising on the fair value re-measurement.

When a gain or loss on a non-monetary item is recognised in other comprehensive income, any exchange component of that gain or loss should also be recognised in other comprehensive income. [FRS 102.30.11]. For example, Section 17 – Property, Plant and Equipment – requires some gains and losses arising on a revaluation of property, plant and equipment to be recognised in other comprehensive income (see Chapter 15 at 3.6.3). When such an asset is measured in a foreign currency, the revalued amount should be translated using the rate at the date the value is determined, resulting in an exchange difference that is also recognised in other comprehensive income.

Conversely, when a gain or loss on a non-monetary item is recognised in profit or loss, e.g. financial instruments that are measured at fair value through profit or loss in accordance with Section 12 (see Chapter 10 at 8.4) or an investment property accounted for using the fair value model (see Chapter 14 at 3.3), any exchange component of that gain or loss should be recognised in profit or loss. [FRS 102.30.11].

The carrying amount of some items is determined by comparing two or more amounts. For example, Section 13 – Inventories – requires the carrying amount of inventories to be determined as the lower of cost and estimated selling price less costs to complete and sell. Similarly, in accordance with Section 27 – Impairment of Assets – the carrying amount of an asset for which there is an indication of impairment should be the lower of its carrying amount before considering possible impairment losses and its recoverable amount. When such an asset is non-monetary and is measured in a foreign currency, the carrying amount is determined by comparing:

• the cost or carrying amount, as appropriate, translated at the exchange rate at the date when that amount was determined (i.e. the rate at the date of the acquisition for an item measured in terms of historical cost); and
• the estimated selling price less costs to complete or recoverable amount, as appropriate, translated at the exchange rate at the date when that value was determined (e.g. the closing rate at the end of the reporting period).

The effect of this comparison may be that an impairment loss is recognised in the functional currency but would not be recognised in the foreign currency, or vice versa.

3.5.8 Determining whether an item is monetary or non-monetary

Section 30 generally requires that monetary items denominated in foreign currencies be retranslated using closing rates at the end of the reporting period and non-monetary items should not be retranslated (see 3.5.6 and 3.5.7 above). Monetary items are defined as ‘units of currency held and assets and liabilities to be received or paid in a fixed or determinable number of units of currency’. [FRS 102 Appendix I]. Section 30 does not elaborate further on this, however IAS 21 states that ‘the essential feature of a monetary item is a right to receive (or an obligation to deliver) a fixed or determinable number of units of currency’. Some examples given by IAS 21 (and which would also apply under FRS 102) are pensions and other employee benefits to be paid in cash; provisions that are to be settled in cash; and cash dividends that are recognised as a liability. More obvious examples are cash and bank balances; trade receivables and payables; and loan receivables and payables.

Conversely, the essential feature of a non-monetary item is the absence of a right to receive (or an obligation to deliver) a fixed or determinable number of units of currency. Examples are amounts prepaid for goods and services (e.g. prepaid rent); goodwill; intangible assets; inventories; property, plant and equipment; and provisions that are to be settled by the delivery of a non-monetary asset. Investments in equity instruments are generally non-monetary items. However there are a number of situations where the distinction may not be altogether clear.

3.5.9 Deposits or progress payments

Entities may be required to pay deposits or progress payments when acquiring certain assets, such as property, plant and equipment or inventories, from foreign suppliers. The question then arises as to whether such payments should be retranslated as monetary items or not.

3.5.10 Investments in preference shares

Entities may invest in preference shares of other entities. Whether such shares are monetary items or not will depend on the rights attaching to the shares. As discussed at 3.5.8 above investments in equity instruments are generally considered to be non-monetary items. Thus, if the terms of the preference shares are such that they are classified by the issuer as equity, rather than as a financial liability, then they are non-monetary items. However, if the terms of the preference shares are such that they are classified by the issuer as a financial liability (e.g. a preference share that provides for mandatory redemption by the issuer for a fixed or determinable amount at a fixed or determinable future date), then it would appear that they should be treated as monetary items.

3.5.11 Assets and liabilities arising from insurance contracts

FRS 103 – Insurance Contracts – states that for the purposes of applying the requirements of Section 30 an entity should treat all assets and liabilities arising from an insurance contract as monetary items. [FRS 103.2.26]. This means that items such as deferred acquisition costs and unearned premiums that arose in a foreign currency will be retranslated into the entity's functional currency at the closing exchange rate at each reporting date even though they have characteristics that are more akin to a non-monetary item.

3.7.1 Translation to the presentation currency

The method of translation depends on whether the entity's functional currency is that of a hyperinflationary economy or not, and if it is, whether it is being translated into a presentation currency which is that of a hyperinflationary economy or not. A hyperinflationary economy is defined in Section 31 – Hyperinflation (see Chapter 28 at 3.2). This chapter covers only the requirements for translating an operation into a presentation currency of a non-hyperinflationary economy. For information on translation to the presentation currency which is that of a hyperinflationary economy refer to Chapter 28.

The results and financial position of an entity whose functional currency is not the currency of a hyperinflationary economy should be translated into a different presentation currency using the following procedures: [FRS 102.30.18]

1. assets and liabilities for each balance sheet presented (i.e. including comparatives) are translated at the closing rate at the date of each respective balance sheet;
2. income and expenses for each statement of comprehensive income (i.e. including comparatives) are translated at exchange rates at the dates of the transactions; and
3. all resulting exchange differences are recognised in other comprehensive income.

For practical reasons, the reporting entity may use a rate that approximates the actual exchange rate, e.g. an average rate for the period, to translate income and expense items. However, if exchange rates fluctuate significantly, the use of the average rate for a period is inappropriate. [FRS 102.30.19].

The exchange differences referred to in item (c) above result from: [FRS 102.30.20]

• translating income and expenses at the exchange rates at the dates of the transactions and assets and liabilities at the closing rate; and
• translating the opening net assets at a closing rate that differs from the previous closing rate.

This is not completely accurate because, if the entity has had any transactions with equity holders that have resulted in a change in the net assets during the period, there are likely to be further exchange differences that need to be recognised to the extent that the closing rate differs from the rate used to translate the transaction. For example, this would be the case if a parent had subscribed for further equity shares in a subsidiary.

The application of these procedures is illustrated in the following example.

When the exchange differences relate to a foreign operation that is consolidated but not wholly-owned, accumulated exchange differences arising from translation and attributable to non-controlling interests are allocated to, and recognised as part of, non-controlling interests in the consolidated balance sheet. [FRS 102.30.20].

3.7.2 Functional currency is that of a hyperinflationary economy

A UK based group preparing consolidated financial statements under FRS 102 might have a subsidiary that operates in, and has a functional currency of, a country subject to hyperinflation. In this case, FRS 102 requires the subsidiary's results and financial position to be adjusted using the procedures specified in Section 31 (see Chapter 28) before translating them into a different presentation currency as follows: All amounts (i.e. assets, liabilities, equity items, income and expenses, including comparatives) are translated at the closing rate at the date of the most recent statement of financial position. However, when amounts are translated into the currency of a non-hyperinflationary economy, comparative amounts should be those that were presented as current year amounts in the relevant prior period financial statements. [FRS 102.30.21].

3.7.3 Exchange differences on intragroup balances

The incorporation of the results and financial position of a foreign operation with those of the reporting entity should follow normal consolidation procedures, such as the elimination of intragroup balances and intragroup transactions of a subsidiary. [FRS 102.30.22]. On this basis, there is a tendency sometimes to assume that exchange differences on intragroup balances should not affect the reported profit or loss for the group in the consolidated financial statements. However, an intragroup monetary asset (or liability), whether short-term or long-term, cannot be eliminated against the corresponding intragroup liability (or asset) without the entity with the currency exposure recognising an exchange difference on the intragroup balance.

This exchange difference will be reflected in that entity's profit or loss for the period (see 3.5.6 above) and, except as indicated at 3.7.4 below, Section 30 requires this exchange difference to continue to be included in profit or loss in the consolidated financial statements. This is because the monetary item represents a commitment to convert one currency into another and exposes the reporting entity to a gain or loss through currency fluctuations. [FRS 102.30.22].

3.7.4 Monetary items included as part of the net investment in a foreign operation – general

As an exception to the general rule at 3.7.3 above, where an exchange difference arises on an intragroup balance that, in substance, forms part of an entity's net investment in a foreign operation, the exchange difference is not recognised in profit or loss in the consolidated financial statements, but is recognised in other comprehensive income and accumulated in a separate component of equity. [FRS 102.30.13, 22].

The ‘net investment in a foreign operation’ is defined as being ‘the amount of the reporting entity's interest in the net assets of that operation’. [FRS 102 Appendix I]. This will include a monetary item that is receivable from or payable to a foreign operation for which settlement is neither planned nor likely to occur in the foreseeable future (often referred to as a ‘permanent as equity’ loan) because it is, in substance, a part of the entity's net investment in that foreign operation. Such monetary items may include long-term receivables or loans. They do not include trade receivables or trade payables. [FRS 102.30.12].

In our view, trade receivables and payables can be included as part of the net investment in the foreign operation, but only if cash settlement is not made or planned to be made in the foreseeable future. However, if a subsidiary makes payment for purchases from its parent, but is continually indebted to the parent as a result of new purchases, then in these circumstances, since individual transactions are settled, no part of the inter-company balance should be regarded as part of the net investment in the subsidiary. Accordingly, exchange differences on such balances should be recognised in profit or loss.

These requirements are illustrated in the following example.

The question of whether or not a monetary item is as permanent as equity can, in certain circumstances, require the application of significant judgement.

3.7.5 Monetary items included as part of the net investment in a foreign operation – currency of the monetary item

When a monetary item is considered to form part of a reporting entity's net investment in a foreign operation and is denominated in the functional currency of the reporting entity, an exchange difference will be recognised in the foreign operation's individual financial statements. If the item is denominated in the functional currency of the foreign operation, an exchange difference will be recognised in the reporting entity's separate financial statements, normally in profit or loss, although an unrealised gain is recognised in other comprehensive income (see 3.7.6 below).

In the financial statements that include the foreign operation and the reporting entity (i.e. financial statements in which the foreign operation is consolidated or accounted for using the equity method), such exchange differences are recognised in other comprehensive income and accumulated in a separate component of equity. [FRS 102.30.12-13].

In most situations, intragroup balances for which settlement is neither planned nor likely to occur in the foreseeable future will be denominated in the functional currency of either the reporting entity or the foreign operation. However, this will not always be the case. If a monetary item is denominated in a currency other than the functional currency of either the reporting entity or the foreign operation, the exchange difference arising in the reporting entity's separate financial statements and in the foreign operation's individual financial statements is also recognised in other comprehensive income, and accumulated in the separate component of equity, in the financial statements that include the foreign operation and the reporting entity (i.e. financial statements in which the foreign operation is consolidated or accounted for using the equity method).

3.7.6 Monetary items included as part of the net investment in a foreign operation – treatment in individual financial statements

The exception for exchange differences on monetary items forming part of the net investment in a foreign operation applies only in the consolidated financial statements. It does not normally apply to the reporting entity's separate financial statements or the financial statements of the foreign operation. Rather, the exchange differences will normally be recognised in profit or loss in the period in which they arise in the financial statements of the entity that has the foreign currency exposure. However, as an exception, an unrealised exchange gain is recognised in other comprehensive income. [FRS 102.30.12-30.13]. This treatment results from the general restriction in the CA 2006 from recognising unrealised profits in the profit and loss account. The ICAEW/ICAS Technical Release TECH 02/17BL – Guidance on realised and distributable profits under the Companies Act 2006 (TECH 02/17BL) explains that a receivable for which settlement is neither planned nor likely to occur in the foreseeable future is not qualifying consideration and therefore any cumulative exchange gain on such on an asset is not a realised profit (see 4 below). [TECH 02/17BL.3.11].

3.7.7 Monetary items becoming part of the net investment in a foreign operation

An entity's plans and expectations in respect of an intragroup monetary item may change over time and the status of such items should be assessed each period. For example, a parent may decide that its subsidiary requires refinancing and instead of investing more equity capital in the subsidiary decides that an existing inter-company account, which has previously been regarded as a normal monetary item, should become a long-term deferred trading balance and no repayment of such amount will be requested within the foreseeable future. In our view, such a ‘capital injection’ should be regarded as having occurred at the time it is decided to redesignate the inter-company account. Consequently, the exchange differences arising on the account up to that date should be recognised in profit or loss and the exchange differences arising thereafter would be recognised in other comprehensive income on consolidation. This is discussed further in the following example.

3.7.8 Monetary items ceasing to be part of the net investment in a foreign operation

The situation where a pre-existing monetary item was subsequently considered to form part of the net investment in a foreign operation was discussed at 3.7.7 above. However, what happens where a monetary item ceases to be considered part of the net investment in a foreign operation, either because the circumstances have changed such that it is now planned or is likely to be settled in the foreseeable future or indeed that the monetary item is in fact settled?

Where the circumstances have changed such that the monetary item is now planned or is likely to be settled in the foreseeable future, then similar issues to those discussed at 3.7.4 above apply; i.e. are the exchange differences on the intragroup balance to be recognised in profit or loss only from the date of change or from the beginning of the financial year? For the same reasons as set out in Example 27.11 above, in our view, the monetary item ceases to form part of the net investment in the foreign operation at the moment in time when the entity decides that settlement is planned or is likely to occur in the foreseeable future. Accordingly, exchange differences arising on the monetary item up to that date are recognised in other comprehensive income and accumulated in a separate component of equity. The exchange differences that arise after that date are recognised in profit or loss.

Consideration also needs to be given as to the treatment of the cumulative exchange differences on the monetary item that have been recognised in other comprehensive income, including those that had been recognised in other comprehensive income in prior years. The treatment of these exchange differences is to recognise them in other comprehensive income and accumulate them in a separate component of equity. [FRS 102.30.22]. The principle question is whether the change in circumstances or actual settlement in cash of the intragroup balance represents a disposal or partial disposal of the foreign operation and this is considered in more detail at 3.8 below.

3.7.9 Dividends

If a subsidiary pays a dividend to the parent during the year the parent should record the dividend at the rate ruling when the dividend was declared. An exchange difference will arise in the parent's own financial statements if the exchange rate moves between the declaration date and the date the dividend is actually received. This exchange difference is required to be recognised in profit or loss and will remain there on consolidation.

The same will apply if the subsidiary declares a dividend to its parent on the last day of its financial year and this is recorded at the year-end in both entities' financial statements. There is no problem in that year as both the intragroup balances and the dividends will eliminate on consolidation with no exchange differences arising. However, as the dividend will not be received until the following year an exchange difference will arise in the parent's financial statements in that year if exchange rates have moved in the meantime. Again, this exchange difference should remain in consolidated profit or loss as it is no different from any other exchange difference arising on intragroup balances resulting from other types of intragroup transactions. It should not be recognised in other comprehensive income.

It may seem odd that the consolidated results can be affected by exchange differences on inter-company dividends. However, once the dividend has been declared, the parent now effectively has a functional currency exposure to assets that were previously regarded as part of the net investment. In order to minimise the effect of exchange rate movements entities should, therefore, arrange for inter-company dividends to be paid on the same day the dividend is declared, or as soon after the dividend is declared as possible.

3.7.10 Unrealised profits on intragroup transactions

The other problem area is the elimination of unrealised profits resulting from intragroup transactions when one of the parties to the transaction is a foreign subsidiary.

If in the above example the goods had been sold by the UK parent to the Swiss subsidiary then the approach in US GAAP would say the amount to be eliminated is the amount of profit shown in the UK entity's financial statements. Again, this will not necessarily result in the goods being carried in the consolidated financial statements at their original cost to the group.

3.7.11 Non-coterminous period ends

Unlike IAS 21, Section 30 does not deal with situations where a foreign operation is consolidated on the basis of financial statements made up to a different date from that of the reporting entity. However, in accordance with the hierarchy set out in Section 10 an entity could apply the guidance in IAS 21. In such a case, IAS 21 initially states that the assets and liabilities of the foreign operation are translated at the exchange rate at the end of the reporting period of the foreign operation rather than at the date of the consolidated financial statements. However, it then goes on to say that adjustments are made for significant changes in exchange rates up to the end of the reporting period of the reporting entity (i.e. the date of the consolidated financial statements). This approach is consistent with the requirements in paragraph 16(a) of Section 9 – Consolidated and Separate Financial Statements – which requires that adjustments be made for the effects of significant transactions that occur between the date of subsidiary financial statements and the date of the consolidated financial statements. The same approach is used in applying the equity method to associates and joint ventures in accordance with IAS 28 – Investments in Associates and Joint Ventures.

3.7.12 Goodwill and fair value adjustments

Any goodwill arising on the acquisition of a foreign operation and any fair value adjustments to the carrying amounts of assets and liabilities arising on the acquisition of that foreign operation are treated as assets and liabilities of the foreign operation. Therefore, they are expressed in the functional currency of the foreign operation and translated at the closing rate in accordance with paragraph 30.18. [FRS 102.30.23].