Functional Currency

The concept of functional currency is key to understanding translation of foreign currency financial statements. Functional currency is defined as being the currency of the primary economic environment in which an entity operates. This is normally, but not necessarily, the currency in which that entity principally generates and expends cash.

In determining the relevant functional currency, an entity would give primary consideration to the following factors:

1. The currency that mainly influences sales prices for goods and services, as well as the currency of the country whose competitive forces and regulations mainly determine the sales prices of the entity's goods and services; and
2. The currency that primarily influences labour, material and other costs of providing those goods or services.

Note that the currency which influences selling prices is often that currency in which sales prices are denominated and settled, while the currency that most influences the various input costs is normally that in which input costs are denominated and settled. There are many situations in which input costs and output prices will be denominated in or influenced by differing currencies (e.g., an entity which manufactures all of its goods in Mexico, using locally sourced labour and materials, but sells all or most of its output in Europe in euro-denominated transactions).

In addition to the foregoing, IAS 21 notes other factors which may provide additional evidence of an entity's functional currency. These may be deemed secondary considerations, and these are:

1. The currency in which funds from financing activities (i.e., from the issuance of debt and equity instruments) are generated; and
2. The currency in which receipts from operating activities are usually retained.

In making a determination of whether the functional currency of a foreign operation (e.g., a subsidiary, branch, associate or joint venture) is the same as that of the reporting entity (parent, investor, etc.), certain additional considerations may also be relevant. These include:

1. Whether the activities of the foreign operation are carried out as an extension of the reporting entity, rather than being executed more or less autonomously;
2. What proportion of the foreign operation's activities is comprised of transactions with the reporting entity;
3. Whether the foreign operation's cash flows directly impact upon the cash flows of the reporting entity, and are available for prompt remittance to the reporting entity; and
4. Whether the foreign operation is largely cash flow independent (i.e., if its own cash flows are sufficient to service its existing and reasonably anticipated debts without the injection of funds by the reporting entity).

Foreign operations are characterised as being adjuncts of the operations of the reporting entity when, for example, the foreign operation only serves to sell goods imported from the reporting entity and in turn remits all sales proceeds to the reporting entity. On the other hand, the foreign operation is seen as being essentially autonomous when it accumulates cash and other monetary items, incurs expenses, generates income and arranges borrowings, all done substantially in its local currency.

In practice, there are many gradations along the continuum between full autonomy and the state of being a mere adjunct to the reporting entity's operations. When there are mixed indications, and thus the identity of the functional currency is not obvious, judgement is required to make this determination. The selection of the functional currency should most faithfully represent the economic effects of the underlying transactions, events and conditions. According to IAS 21, however, priority attention is to be given to the identity of the currency (or currencies) that impact selling prices for outputs of goods and services, and inputs for labour and materials and other costs. The other factors noted above are to be referred to secondarily, when a clear conclusion is not apparent from considering the two primary factors.

In some cases, the determination of functional currency can be complex and time-consuming. The process is difficult especially if the foreign operation acts as an investment company or holding company within a group and has few external transactions. Management must document the approach followed in the determination of the functional currency for each entity within a group—particularly when factors are mixed and judgement is required.

Once determined, an entity's functional currency will rarely be altered. However, since the entity's functional currency is expected to reflect its most significant underlying transactions, events and conditions, there obviously can be a change in functional currency if there are fundamental changes in those circumstances. For example, if the entity's manufacturing and sales operations are relocated to another country, and inputs are thereafter sourced from that new location, this may justify changing the functional currency for that operation. When there is a change in an entity's functional currency, the entity should apply the translation procedures applicable to the new functional currency prospectively from the date of the change.

If the functional currency is the currency of a hyperinflationary economy, as that term is defined under IAS 29, Financial Reporting in Hyperinflationary Economies, the entity's financial statements are restated in accordance with the provisions of that standard. IAS 21 stresses that an entity cannot avert such restatement by employing tactics such as adopting an alternate functional currency, such as that of its parent entity. There are currently very few such economies in the world, but this situation of course may change in the future. There are also instances that have been noted where economies have experienced severe hyperinflation and have been unable to restate their financial statements in terms of the procedures required by IAS 29 due to the unavailability of reliable information on restatement factors. The difficulties experienced by reporters in such jurisdictions have been addressed by the IASB, in that IFRS 1, First-time Adoption of International Financial Reporting Standards, was amended and now permits the readoption of IFRS by such entities through the application of exceptions and exemptions provided for in this standard.

Monetary and Non-Monetary Items

For purposes of applying IAS 21, it is important to understand the distinction between monetary and non-monetary items. Monetary items are those granting or imposing “a right to receive, or an obligation to deliver, a fixed or determinable number of units of currency.” In contrast, non-monetary items are those exhibiting “the absence of a right to receive, or an obligation to deliver, a fixed or determinable number of units of currency.” Examples of monetary items include accounts and notes receivable; pensions and other employee benefits to be paid in cash; provisions that are to be settled in cash; and cash dividends that are properly recognised as a liability. Examples of non-monetary items include inventories; amounts prepaid for goods and services (e.g., prepaid insurance); property, plant and equipment; goodwill; other intangible assets; and provisions that are to be settled by the delivery of a non-monetary asset.

Translation of Functional Currency Financial Statements into a Presentation Currency

If the investor's presentation currency (e.g., Canadian dollar) differs from the foreign entity's functional currency (e.g., euro), the foreign entity's financial statements have to be translated into the presentation currency when preparing consolidated financial statements. In accordance with IAS 21, the method used for translation of the foreign currency financial statements from the functional currency into the presentation currency is essentially what is commonly called the current (closing) rate method under US GAAP. In general, the translation methods under both IFRS and US GAAP are the same, except for the translation of financial statements in hyperinflationary economies (see Chapter 35).

Under the translation to the presentation currency approach, all assets and liabilities, both monetary and non-monetary, are translated at the closing (end of the reporting period) rate, which simplifies the process compared to all other historically advocated methods. More importantly, this more closely corresponds to the viewpoint of financial statement users, who tend to relate to currency exchange rates in existence at the end of the reporting period rather than to the various specific exchange rates that may have applied in prior months or years.

However, financial statements of preceding years should be translated at the rate(s) appropriately applied when these translations were first performed (i.e., these are not to be updated to current closing or average rates). This rule applies because it would cause great confusion to users of financial statements if amounts once reported (when current) were now all restated even though no changes were being made to the underlying data, and, of course, the underlying economic phenomena, now one or more years in the past, cannot have changed since initially reported upon.

The theoretical basis for this translation approach is the “net investment concept,” whereby the foreign entity is viewed as a separate entity that the parent invested into, rather than being considered as part of the parent's operations. Information provided about the foreign entity retains the internal relationships and results created in the foreign environments (economic, legal and political) in which the entity operates. This approach works best, of course, when foreign-denominated debt is used to purchase the assets that create foreign-denominated revenues; these assets thus serve as a hedge against the effects caused by changes in the exchange rate on the debt. Any excess (i.e., net) assets will be affected by this foreign exchange risk, and this is the effect that is recognised in the parent company's statement of financial position, as described below.

The following rules should be used in translating the financial statements of a foreign entity:

1. All assets and liabilities in the current year-end statement of financial position, whether monetary or non-monetary, should be translated at the closing rate in effect at the date of that statement of financial position.
2. Income and expense items in each statement of comprehensive income should be translated at the exchange rates at the dates of the transactions, except when the foreign entity reports in a currency of a hyperinflationary economy (as defined in IAS 29), in which case they should be translated at the closing rates.
3. All resulting exchange differences should be recognised in other comprehensive income and reclassified from equity to profit or loss on the disposal of the net investment in a foreign entity.
4. All assets and liabilities in prior period statements of financial position, being presented currently (e.g., as comparative information) whether monetary or non-monetary, are translated at the exchange rates (closing rates) in effect at the date of each of the statements of financial position.
5. Income and expense items in prior period statements of income, being presented currently (e.g., as comparative information), are translated at the exchange rates as of the dates of the original transactions (or averages, where appropriate).

Under the translation to the presentation currency approach, all assets and liabilities are valued: (1) higher, as a result of a direct exchange rate increase, or (2) lower, as a result of a direct rate decrease. Since the liabilities offset a portion of the assets, constituting a natural hedge, only the subsidiary's net assets (assets in excess of liabilities) are exposed to the risk of fluctuations in the currency exchange rates. As a result, the effect of the exchange rate change can be calculated by multiplying the foreign entity's average net assets by the change in the exchange rate.

On the books of the parent, the foreign entity's net asset position is reflected in the parent's investment account. If the equity method is applied, the investment account should be adjusted upward or downward to reflect changes in the exchange rate; if a foreign entity is included in the consolidated financial statements, the investment account is eliminated. (See “Comprehensive example: translation into the presentation currency” later in this chapter.)

Translation (Remeasurement) of Financial Statements into a Functional Currency

When a foreign entity keeps its books and records in a currency other than its functional currency, translation of foreign currency items presented in the statement of financial position into functional currency (remeasurement) is driven by the distinction between monetary and non-monetary items. Foreign currency monetary items are translated using the closing rate (the spot exchange rate at the end of the reporting period). Foreign currency non-monetary items are translated using the historical exchange rates. There is a presumption that the effect of exchange rate changes on the foreign operation's net assets will directly affect the parent's cash flows, so the exchange rate adjustments are reported in the parent's profit or loss.

For example, branch sales offices or production facilities of a large, integrated operation (e.g., the European field operation of a US corporation, which is principally supplied by the home office, but which occasionally also enters into local currency transactions) would qualify for this treatment. Since the US dollar influences sales prices, most (but not all) of its sales are US dollar denominated, and most of its costs, including merchandise, are the result of US transactions, the application of the previously mentioned criteria would conclude that the functional currency of the European sales office is the US dollar, and translation of foreign currency-denominated assets and liabilities, and transactions would follow the monetary/non-monetary distinction noted above with the effect of exchange rate differences reported in profit or loss.

In general, translation of non-monetary items (inventory, plant assets, etc.) is done by applying the historical exchange rates. The historical rates usually are those in effect when the asset was acquired or (less often) when the non-monetary liability was incurred, but if there was a subsequent revaluation, if this is permitted under IFRS, then using the exchange rate at the date when the fair value was determined.

When a gain or loss on a non-monetary item is recognised in profit or loss (e.g., from applying lower of cost or realisable value for inventory), any exchange component of that gain or loss should be recognised in profit or loss. When, on the other hand, a gain or loss on a non-monetary item is recognised under IFRS in other comprehensive income (e.g., from revaluation of plant assets, or from fair value adjustments made to financial assets classified at fair value through other comprehensive income securities investments), any exchange component of that gain or loss should also be recognised in other comprehensive income.

As a result of conversion into functional currency, if a foreign unit is in a net monetary asset position (monetary assets in excess of monetary liabilities), an increase in the direct exchange rate causes a favourable result (gain) to be reported in profit or loss; if it is in a net monetary liability position (monetary liabilities in excess of monetary assets), it reports an unfavourable result (loss). If a foreign unit is in a net monetary asset position, a decrease in the direct exchange rate causes an unfavourable result (loss) to report, but if it is in a net monetary liability position, a favourable result (gain) is reported.

In cases when an entity keeps its books and records in a currency (e.g., Swiss franc) other than its functional currency (e.g., euro), and other than the presentation currency of the parent (e.g., Canadian dollar), the two-step translation process would be required: (1) translation of the financial statements (e.g., from Swiss franc) into the functional currency (e.g., euro) and (2) translation of the functional currency (e.g., euro) into the reporting currency (e.g., Canadian dollar).

Net Investment in a Foreign Operation

A special rule applies to a net investment in a foreign operation. According to IAS 21, when the reporting entity has 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, this is, in substance, a part of the entity's net investment in its foreign operation. This item should be accounted for as follows:

1. Exchange differences arising from translation of monetary items forming part of the net investment in the foreign operation should be reflected in profit or loss in the separate financial statements of the reporting entity (investor/parent) and in the separate financial statements of the foreign operation; but
2. In the consolidated financial statements, which include the investor/parent and the foreign operation, the exchange difference should be recognised initially in other comprehensive income and reclassified from equity to profit or loss upon disposal of the foreign operation.

Note that when a monetary item is a component of a reporting entity's net investment in a foreign operation and it is denominated in the functional currency of the reporting entity, an exchange difference arises only in the foreign operation's individual financial statements. Conversely, if the item is denominated in the functional currency of the foreign operation, an exchange difference arises only in the reporting entity's separate financial statements.

Consolidation of Foreign Operations

The most commonly encountered need for translating foreign currency financial statements into the investor entity reporting currency is when the parent entity is preparing consolidated financial statements, and one or more of the subsidiaries have reported in their respective (local) currencies. The same need presents itself if an investee or joint venture's financial information is to be incorporated via the proportionate consolidation or the equity methods of accounting. When consolidating the assets, liabilities, income and expenses of a foreign operation with those of the reporting entity, the general consolidation processes apply, including the elimination of intragroup balances and intragroup transactions. Goodwill and any fair value-based adjustments to the carrying amounts of foreign operation's assets and liabilities should be expressed in the functional currency and translated using the closing rate.

Taxation Effect

Gains and losses on foreign currency transactions and exchange differences arising on translating the results and financial position of an entity, including its foreign operations, into a different currency may have tax effects. IAS 12, Income Taxes, applies to these tax effects.

Non-Controlling Interests

When a foreign entity is consolidated, but it is not wholly owned by the reporting entity, there will be non-controlling interest reported in the consolidated statement of financial position. IAS 21 requires that the accumulated exchange differences resulting from translation and attributable to the non-controlling interest be allocated to and reported as non-controlling interest in net assets.

Goodwill and Fair Value Adjustments

Any goodwill arising on the acquisition of a foreign entity and any fair value adjustments to the carrying amounts of assets and liabilities arising on the acquisition of that foreign operation should be treated as assets and liabilities of the foreign operation. Thus, they should be expressed in the functional currency of the foreign operation and translated at the closing rate in accordance with IAS 21.

Exchange Differences Arising From Elimination of Intragroup Balances

While incorporating the financial statements of a foreign entity into those of the reporting entity, normal consolidation procedures such as elimination of intragroup balances and transactions are undertaken as required by IAS 28 and IFRS 3, 10, 11 and 12.

Different Reporting Dates

The financial statements of the parent and its subsidiaries used in the preparation of the consolidated financial statements shall have the same reporting date. When the end of the reporting period of the parent is different from that of a subsidiary, the subsidiary prepares, for consolidation purposes, additional financial information as of the same date as the financial statements of the parent to enable the parent to consolidate the financial information of the subsidiary, unless it is impracticable to do so.

If it is “impracticable” to do so, the parent shall consolidate the financial information of the subsidiary using the most recent financial statements of the subsidiary adjusted for the effects of significant transactions or events that occur between the date of those financial statements and the date of the consolidated financial statements. In any case, the difference between the date of the subsidiary's financial statements and that of the consolidated financial statements shall be no more than three months, and the length of the reporting periods and any difference between the dates of the financial statements shall be the same from period to period.

Disposal of a Foreign Operation

On the disposal of a foreign operation, the cumulative amount of the exchange differences relating to that foreign operation, recognised in other comprehensive income and accumulated in the separate component of equity, shall be reclassified from equity to profit or loss (as a reclassification adjustment) when the gain or loss on disposal is recognised.

Disposal has been defined to include a sale, liquidation, repayment of share capital or abandonment of all or part of the entity. Normally, payment of dividends would not constitute a repayment of capital. However, in rare circumstances, it does; for instance, when an entity pays dividends out of capital instead of accumulated profits, as defined in the companies' acts of certain countries, such as the United Kingdom, this would constitute repayment of capital. In such circumstances, obviously, dividends paid would constitute a disposal for the purposes of this standard.

In addition to the disposal of an entity's entire interest in a foreign operation, the following partial disposals are accounted for as disposals:

1. When the partial disposal involves the loss of control of a subsidiary that includes a foreign operation, regardless of whether the entity retains a non-controlling interest in its former subsidiary after the partial disposal; and
2. When the retained interest after the partial disposal of an interest in a joint arrangement or a partial disposal of an interest in an associate that includes a foreign operation is a financial asset that includes a foreign operation.

On disposal of a subsidiary that includes a foreign operation:

1. The cumulative amount of the exchange differences relating to that foreign operation that have been attributed to the non-controlling interests shall be derecognised, but shall not be reclassified to profit or loss;
2. On partial disposal of such a subsidiary the entity shall reattribute the proportionate share of the cumulative amount of the exchange differences recognised in other comprehensive income to the non-controlling interests in that foreign operation. In any other partial disposal of a foreign operation the entity shall reclassify to profit or loss only the proportionate share of the cumulative amount of the exchange differences recognised in other comprehensive income.

Change in Functional Currency

If there is a change in the functional currency, an entity should apply the translation procedures applicable to the new functional currency prospectively from the date of this change.

Reporting a Foreign Operation's Inventory

Under IAS 21, only a single method can be used for translating functional currency financial statements into the presentation currency. Specifically, the reporting entity is required to translate the assets and liabilities of its foreign operations and foreign entities at the closing (end of the reporting period) rate, and required to translate income and expenses at the exchange rates at the dates of the transactions (or at the average rate for the period, if this offers a reasonable approximation of actual transaction date rates).

As noted previously, sometimes an adjustment may be required to reduce the carrying amount of an asset in the financial statements of the reporting entity even though such an adjustment was not necessary in the separate, foreign currency-based financial statements of the foreign operation. This stipulation of IAS 21 can best be illustrated by the following case study.

Translation of Foreign Currency Transactions in Further Detail

According to IAS 21, a foreign currency transaction is a transaction that is “denominated in or requires settlement in a foreign currency.” Denominated means that the amount to be received or paid is fixed in terms of the number of units of a particular foreign currency, regardless of changes in the exchange rate.

Hedging a Net Investment in a Foreign Operation or Foreign Currency Transaction

Currency of Monetary Items Comprising Net Investment in Foreign Operations

Monetary items (whether receivable or payable) between any subsidiary of the group and a foreign operation may form part of the group's investment in that foreign operation. Thus, these monetary items can be denominated in a currency other than the functional currency of either the parent or the foreign operation itself, for exchange differences on these monetary items to be recognised in other comprehensive income and accumulated in a separate component of equity until the disposal of the foreign operation.