Foreign Exchange Business Context: 1 The Functional Currency

FOREIGN EXCHANGE
Business Context
Business is becoming increasingly international in terms of trading goods and services and in
the operation of capital markets. One measure of the significance of globalisation is that most
developed countries have external trade in the range of 15% to 30% of their gross domestic
product.
International activity can vary enormously, from relatively straightforward import and export
transactions through to financing arrangements in multiple currencies or maintaining
operations overseas, for example in the form of a subsidiary or branch.
Operating in multi-currency locations presents a number of accounting challenges, including:
 conversion – accounting for transactions where one currency has been physically
changed into another currency;
 translation – restating assets and liabilities initially recognised in more than one
currency into a common currency; and
 exchange gains and losses – where relative currency values change and gains and
losses arise which need to be appropriately measured and recognised.
Objectives, Scope and Definitions of IAS 21

An entity may carry on foreign activities either by conducting transactions in foreign
currencies, for example purchasing a non-current asset from an overseas supplier, exporting
goods to an overseas customer or arranging a loan in a foreign currency, or by having foreign
operations, for example a subsidiary or branch located overseas.
In addition, an entity may choose to present its financial statements in a foreign currency.
The objective of IAS 21 is to prescribe how to include foreign currency transactions and
foreign operations in the financial statements of an entity, and how to translate financial
statements into a different currency for presentation purposes.
IAS 21 applies to: [IAS 21.3]
 accounting for transactions that the entity enters into which are in a foreign currency
and any resulting balances (note that items that fall within the scope of IAS 39
Financial instruments: recognition and measurement are dealt with by that standard);
 translating the financial statements of foreign operations that are included in the
financial statements of another entity, for example, on consolidation of subsidiaries or
the inclusion of associates by the equity accounting method; and
 translating an entity's results and financial position into a different currency for the
presentation of its financial statements.
Key Issues
1 The functional currency
The overall approach required by IAS 21 is for an entity to translate foreign currency items
and transactions into its functional currency.
A functional currency “is the currency of the primary economic environment in which the entity
operates” and the primary economic environment ”is normally the one in which it primarily
generates and expends cash”. [IAS 21.8, 21.9]
In a group, each entity, for example the parent, each subsidiary and associate, needs to
determine its own functional currency rather than adopting a single one which is common
across the whole group.
An entity cannot choose its functional currency; instead, management needs to make an
informed assessment of the facts. IAS 21 includes a number of practical indicators to assist
entities in identifying their functional currency, for example:
 the currency that mainly influences the prices at which goods and services are sold;
 the country whose competitive forces and regulations mainly influence the pricing
structure for the supply of goods and services;
 the currency in which financing is generated; and
 the currency in which cash generated from an entity’s operating activities is usually
retained.
Additional factors should be considered to determine whether the functional currency of a
foreign operation is the same as that of the reporting entity (the group). It should not be
assumed that this is the case. The overriding factor is whether the foreign operation operates
independently of the reporting entity or is merely an extension of that entity. Factors might
include, for example, whether the foreign operation requires additional funding from its parent
in order to continue in operation and whether transactions with the reporting entity are a high
proportion of its total operating activities.
Where an entity, for example a subsidiary, is not deemed to be autonomous of the parent (the
reporting entity), it will have the same functional currency as the parent.
As a functional currency is based on an entity’s underlying economic activity, it cannot be
changed unless its underlying economic activity changes.
2 The presentation currency
Although the overall approach required by IAS 21 is for an entity to translate foreign currency
items and transactions into its functional currency, it is not required to present its financial
statements using this currency. An entity has a completely free choice of the currency in
which its financial statements are presented. This is referred to as the presentation currency.
[IAS 21.8]
The approach that is required to translate the financial statements of an entity, or a group of
entities, into a different presentation currency is discussed below.
3 Monetary and non-monetary items
IAS 21 distinguishes between monetary and non-monetary items.
Monetary items are units of currency held, and assets and liabilities to be received or paid in a
fixed or determinable number of units of currency, for example cash, receivables, payables
and loans. [IAS 21.8]
Non-monetary items are therefore those which do not give rise to a right to receive (or an
obligation to deliver) a fixed or determinable amount of money, for example property, plant
and equipment, goodwill, inventories and intangible assets.
4 Summary of the approach of IAS 21
For a group of entities, IAS 21 requires a two stage process:
(1) individual entity level: treatment of foreign exchange transactions (functional
currency); and
(2) consolidation level: translation of the financial statements of entities, for example
subsidiaries, associates and branches, into a common currency for consolidated
financial statements purposes (presentation currency).
Transactions in the Functional Currency

1 Initial recognition
An entity should record foreign currency transactions, for example the buying or selling of
goods or services whose price is denominated in a foreign currency, in a consistent manner.
IAS 21 requires that an entity does this by recognising each transaction at the spot exchange
rate on the date that the transaction took place. [IAS 21.21]
Where there are high volumes of such transactions, for practical reasons an average
exchange rate over the relevant period may be used as an approximation. However, if
2 Reporting at the ends of subsequent reporting periods
At the end of each reporting period the following translations of foreign currency should be
carried out. [IAS 21.23]
Item Exchange rate

Monetary items Closing rate (i.e. the spot exchange
rate at the end of the reporting
period)
Non-monetary items measured at historical cost Rate of exchange at the date of the
original transaction (i.e. the date of
purchase of the non-current asset)
Non-monetary items measured at fair value Exchange rate at the date when fair
value was determined
3 Recognition of exchange differences
The difference that arises from translating the same amounts at different exchange rates is
referred to as an exchange difference. Such amounts will generally arise in the preparation of
a set of financial statements from the settlement of monetary amounts payable or receivable
in a foreign currency and the retranslation at the entity’s period end.
Exchange differences should normally be recognised as part of the profit or loss for the
period. However, where gains and losses on a non-monetary item are recognised in other
comprehensive income, for example a gain on the revaluation of a property in accordance
with IAS 16 Property, plant and equipment, any exchange difference resulting from
retranslation of the revalued asset is also reported as part of other comprehensive income.
[IAS 21.28, 21.30]
3.1 Transactions settled within the period
When a foreign currency transaction is settled within the same accounting period as that in
which it was originally recorded, any exchange differences arising are recognised in the profit
or loss of that period.
3.2 Transaction balance is outstanding at the end of the reporting period
When a foreign currency transaction is settled in a different accounting period to the one in
which the transaction originated, the exchange difference recognised in profit or loss for each
period, up to the date of settlement, is determined by the change in exchange rates during
each period.
4 Net Investment in a Foreign Operation

An entity may have a monetary amount receivable from, or payable to, a foreign entity (for
example an overseas subsidiary) that is not intended to be settled in the foreseeable future.
For a receivable, this amount essentially forms part of the overall investment in the foreign
entity. At the period-end, monetary amounts such as this are retranslated and any differences
recognised in profit or loss of the appropriate entity. But IAS 21 operates on the basis that as
such differences are part of the overall investment in the foreign entity, they should only be
recognised in profit or loss when the foreign entity is disposed of.
In the preparation of the consolidated financial statements, any exchange difference arising
from the net investment in a foreign operation should be reported initially in other
comprehensive income and not in the consolidated profit or loss for the period. If the foreign
entity is subsequently sold, any such exchange differences will form part of the reported profit
or loss on disposal by reclassifying the amount from equity to profit or loss. [IAS 21.32]
An amendment was made to IAS 21 in December 2005 in relation to loans considered to be
part of the net investment in a foreign entity. The amendment confirmed that the loan could
be made by a group entity other than the parent entity. [IAS 21.15A]
It is only differences relating to the overall investment in the foreign entity which are
recognised in other comprehensive income; differences on intra-group trading balances which
will be settled in the short term remain in the profit or loss of the period.
5 Change in Functional Currency

If the underlying economic activities change in such a way that there is a change in the
functional currency of an entity, the new functional currency should be applied prospectively
from the date of the change in circumstances. The entity should not restate amounts
previously recorded as these reflected the economic reality at that time. [IAS 21.35]
All amounts should be retranslated into the new functional currency at the date of the change.

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FOREIGN EXCHANGE

Objectives, Scope and Definitions of IAS 21

Transactions in the Functional Currency

Item Exchange rate

4 Net Investment in a Foreign Operation

5 Change in Functional Currency

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