The crucial role of determining functional currency in IAS 21

Determining the functional currency is a critical aspect of IAS 21 The Effects of Changes in Foreign Exchange Rates. The functional currency is the currency of the primary economic environment in which an entity operates. It is the currency that mainly influences the sales prices of goods and services, the competitive forces and regulations, and the costs of providing those goods or services.

The functional currency reflects the underlying transactions, events and conditions that are relevant to the entity. Once determined, the functional currency does not change unless there is a change in the underlying nature of the transactions and relevant conditions and events. For example, a change in the currency that mainly influences the sales prices of goods and services following a relocation of a significant component of the entity’s business may lead to a change in the functional currency.

The effects of a change in the functional currency are accounted for prospectively. All items are translated into the new functional currency using the exchange rate at the date of change, and the resulting translated amounts for non-monetary items are treated as their historical cost. Exchange differences arising from the translation of a foreign operation previously recognized in other comprehensive income are not reclassified from equity to profit and loss until the disposal of the operation.

The responsibility to determine the functional currency lies with the entity’s management. However, it is also the responsibility of the auditors to review critically and exercise professional judgement and scepticism to ensure that the assessment made by management is appropriate and in accordance with IAS 21 principles.

How does IAS 21 address changes in functional currency over time

Changes in functional currency are addressed in IAS 21 through specific guidelines that dictate how entities should manage such transitions. The standard emphasizes that once an entity has determined its functional currency, it should only change it when there is a significant alteration in the underlying transactions and relevant economic conditions.

Accounting for Changes in Functional Currency

When a change in functional currency occurs, IAS 21 mandates that the entity must apply all procedures related to the change prospectively from the date of change. This means that prior financial statements are not restated to reflect the new functional currency. Instead, all assets and liabilities are translated into the new functional currency using the exchange rate at the date of the change. For non-monetary items, the translated amounts are treated as their historical cost, and there is no further revaluation in subsequent periods.

Implications of Change

The implications of changing the functional currency can be significant. For instance, if a company shifts its functional currency from one currency to another, it must ensure that all its financial reporting reflects this change accurately from the point of transition onward. The exchange differences that arise from the translation of a foreign operation are recognized in other comprehensive income and are not reclassified to profit or loss until the disposal of the operation. This ensures that the financial statements remain consistent and comparable over time, despite the change in currency.

Factors Influencing Change

The decision to change functional currency is influenced by various factors, primarily related to the economic environment in which the entity operates. These include:

• Sales Price Influences: The currency that predominantly affects the sales prices of goods and services.
• Cost Influences: The currency that mainly influences labor, materials, and other costs associated with providing goods or services.
• Regulatory Environment: The currency of the country whose competitive forces and regulations primarily determine the sales prices.

A change in any of these factors can trigger a reassessment of the functional currency. For example, if a company relocates a significant portion of its operations to a different country, the currency that influences its operations may also change, necessitating a change in functional currency.

What are the implications of changing the functional currency on financial statements

Changing the functional currency has significant implications on an entity’s financial statements under IAS 21 The Effects of Changes in Foreign Exchange Rates:

Prospective Application

A change in functional currency is accounted for prospectively from the date of change. Previously issued financial statements are not restated for the change.

Translation of Assets and Liabilities

All assets and liabilities are translated into the new functional currency using the exchange rate at the date of change. For non-monetary items, the translated amounts are treated as their historical cost going forward.

Equity Translation Differences

Exchange differences arising from the translation of a foreign operation previously recognized in other comprehensive income are not reclassified from equity to profit and loss until the disposal of the operation.

Significant Changes in Economic Facts and Circumstances

A change in functional currency is only justified when there are significant changes in economic facts and circumstances that clearly indicate the functional currency has changed. Such changes are expected to be rare.

Factors Indicating Change

Factors that may indicate a change in functional currency include:

• Change in the currency that mainly influences sales prices
• Change in the competitive forces and regulations that determine sales prices
• Change in the currency that mainly influences labor, material and other costs

How does changing the functional currency impact financial ratios

Changing the functional currency can significantly impact an entity’s financial ratios, which are crucial for assessing its financial health and performance. Here are the key implications:

1. Impact on Profitability Ratios

When the functional currency changes, the translation of revenues and expenses may differ based on the exchange rates at the time of transactions. This can lead to fluctuations in profitability ratios such as:

• Gross Profit Margin: If the new functional currency strengthens against the previous one, it may reduce the reported revenue when translated back into the presentation currency, affecting the gross profit margin.
• Net Profit Margin: Similar effects can occur with net income, as changes in exchange rates may alter the reported expenses and revenues, impacting the net profit margin.

2. Effect on Liquidity Ratios

Liquidity ratios, such as the current ratio and quick ratio, may be affected by the revaluation of monetary assets and liabilities. For instance:

• Current Ratio: If monetary assets are translated at a less favorable exchange rate, this could reduce the total current assets, thereby lowering the current ratio.
• Quick Ratio: A similar effect can occur for the quick ratio, as changes in cash and cash equivalents due to currency translation can impact this measure of liquidity.

3. Changes in Leverage Ratios

Leverage ratios, including the debt-to-equity ratio, may also be impacted:

• Debt-to-Equity Ratio: If liabilities denominated in a foreign currency increase in value relative to equity due to a change in functional currency, this could result in a higher debt-to-equity ratio, indicating increased financial risk.

4. Valuation Ratios

Valuation ratios such as the price-to-earnings (P/E) ratio can be influenced by changes in reported earnings resulting from currency translation:

• P/E Ratio: If earnings per share (EPS) decline due to unfavorable currency translation effects, the P/E ratio may increase, potentially signaling that the stock is overvalued.

5. Cumulative Translation Adjustments (CTA)

The cumulative translation adjustment account captures the effects of currency translation on equity. Changes in the functional currency may lead to adjustments in the CTA, which can affect the equity section of the balance sheet:

• Equity Ratios: Changes in the CTA can alter total equity, impacting ratios such as return on equity (ROE) and return on assets (ROA).

What are the effects of changing functional currency on leverage ratios

Changing the functional currency can have significant effects on leverage ratios, which are critical indicators of a company’s financial health and risk profile. Here are the key implications:

1. Debt Valuation Changes

When a company changes its functional currency, the valuation of its debt can be affected, particularly if the debt is denominated in a foreign currency.

• Appreciation of Functional Currency: If the new functional currency appreciates against the currency in which the debt is denominated, the value of foreign currency debt decreases when translated into the new functional currency. This can lead to an increase in the company’s net worth, allowing it to borrow more and potentially increasing its leverage ratio.
• Depreciation of Functional Currency: Conversely, if the functional currency depreciates, the value of foreign currency debt increases, negatively impacting the balance sheet. This can lead to a decrease in leverage, as the company may need to de-lever to maintain financial stability.

2. Impact on Debt-to-Equity Ratio

The debt-to-equity ratio is a key leverage ratio that indicates the proportion of debt used to finance the company relative to its equity.

• Increased Debt-to-Equity Ratio: Following a functional currency appreciation, if the company’s foreign currency debt decreases in value, the equity base may increase due to the favorable translation effects. This can lead to a higher debt-to-equity ratio, indicating increased leverage.
• Decreased Debt-to-Equity Ratio: If the functional currency depreciates, the increase in debt value can lead to a lower equity base, resulting in a higher debt-to-equity ratio, which signals increased financial risk.

3. Financial Flexibility and Borrowing Capacity

The ability to borrow can be influenced by changes in functional currency:

• Enhanced Borrowing Capacity: An appreciation of the functional currency may enhance a firm’s borrowing capacity, as lower debt values relative to equity can make the company more attractive to lenders.
• Reduced Borrowing Capacity: A depreciation may restrict borrowing capacity, as lenders may perceive the company as riskier due to increased debt levels relative to equity.

4. Asymmetric Effects of Currency Changes

Research indicates that the effects of currency fluctuations are asymmetric:

• Greater Impact of Depreciations: Generally, the negative effects of currency depreciations on leverage are more pronounced than the positive effects of appreciations. For instance, a significant depreciation can lead to a larger decrease in leverage compared to the increase in leverage from a similar appreciation, highlighting the financial frictions that may arise during adverse currency movements

Are there specific industries more affected by changes in functional currency

Certain industries are more susceptible to the effects of changes in functional currency due to their unique operational characteristics, exposure to foreign markets, and reliance on international transactions. Here are some key industries that may be particularly affected:

1. Export-Import Businesses

Companies engaged in export and import activities are directly impacted by changes in functional currency. Fluctuations in currency values can affect pricing, profit margins, and overall competitiveness in international markets. For instance, if a company exports goods and its functional currency appreciates, the translated revenue in the functional currency may decrease, impacting profitability.

2. Manufacturing and Supply Chain

Manufacturers that source materials from different countries or sell products internationally face significant risks related to currency fluctuations. A change in functional currency can alter the cost structure and pricing strategy, affecting production costs and profitability. For example, if a manufacturer shifts its functional currency to a stronger currency, the costs of imported materials may become more expensive when translated back into the new functional currency.

3. Financial Services

Financial institutions, including banks and investment firms, are heavily exposed to currency risk due to their global operations and foreign currency transactions. A change in functional currency can affect the valuation of assets and liabilities, impacting key financial ratios and overall financial stability. Additionally, the translation of foreign investments may lead to significant gains or losses, influencing reported earnings.

4. Energy and Natural Resources

Companies in the energy sector, particularly those involved in oil and gas, often operate in multiple countries with varying currencies. Changes in functional currency can significantly impact revenue and costs, especially if commodity prices are denominated in a different currency. For instance, if a company shifts its functional currency to a currency that depreciates against the dollar, its revenues from oil sales may decrease when converted back.

5. Technology and Software

Technology companies that operate globally or have substantial foreign operations may experience significant effects from changes in functional currency. These companies often have revenue streams in multiple currencies, and a change in functional currency can affect revenue recognition and profitability. For example, if a software company changes its functional currency to one that is weaker, it may see a reduction in revenue when translating foreign sales.

6. Tourism and Hospitality

The tourism and hospitality industry is also sensitive to changes in functional currency, particularly for businesses that rely on international travelers. A change in functional currency may affect pricing strategies, cost structures, and ultimately, profitability. For instance, if a hotel chain changes its functional currency to a stronger currency while its costs remain in a weaker currency, it may face challenges in maintaining competitive pricing.

How do changes in functional currency influence the accounting treatment of nonmonetary assets

Changes in functional currency influence the accounting treatment of nonmonetary assets significantly under IAS 21. Here are the key effects:

1. Remeasurement of Nonmonetary Assets

When an entity changes its functional currency, nonmonetary assets must be remeasured into the new functional currency using the exchange rate at the date the asset was originally acquired. This means that the historical cost of nonmonetary assets is translated to the new functional currency based on the exchange rate effective at the time of the asset’s inception, rather than the current exchange rate at the time of the change.

2. Translation into Reporting Currency

After remeasurement into the new functional currency, nonmonetary assets are then translated into the entity’s reporting currency using the current exchange rate. This two-step process ensures that the financial statements accurately reflect the value of these assets in the new currency environment.

3. Impact on Cumulative Translation Adjustment (CTA)

The difference between the historical carrying values of nonmonetary assets (based on the exchange rate at the time of acquisition) and their new translated values (using the current exchange rate) is recorded in the cumulative translation adjustment (CTA) account. This adjustment is recognized in equity and reflects the impact of currency translation on the value of nonmonetary assets.

4. No Restatement of Previous Periods

Importantly, the change in functional currency does not require restatement of prior financial statements. The new values for nonmonetary assets become the basis for future accounting, and previously recorded CTA balances are not reversed upon the change in functional currency. This means that the historical context of nonmonetary assets is preserved, and only the current financial statements reflect the new functional currency.

5. Future Implications for Nonmonetary Assets

Once the functional currency is changed, the new exchange rates will apply to future transactions involving nonmonetary assets. This can affect depreciation calculations, impairment assessments, and the overall valuation of assets on the balance sheet. The lower-of-cost-or-market analysis must also be performed in the new functional currency, which could impact asset valuations and financial ratios going forward

Examples

Example 1: Change in Functional Currency for a Manufacturing Company

Scenario:
A manufacturing company based in Brazil has its functional currency as the Brazilian Real (BRL). Due to a significant increase in sales to the European market, the company decides to change its functional currency to the Euro (EUR).Impact on Nonmonetary Assets:

• Remeasurement: The company will remeasure its nonmonetary assets (e.g., machinery, inventory) into EUR using the exchange rate at the time of acquisition. For instance, if a machine was purchased for 100,000 BRL when the exchange rate was 1 EUR = 5 BRL, the historical cost in EUR would be 20,000 EUR.
• Translation: After remeasurement, if the current exchange rate is 1 EUR = 6 BRL, the value of the machine would be re-evaluated in EUR, but its carrying amount would remain at 20,000 EUR unless impaired.
• Cumulative Translation Adjustment (CTA): Any differences arising from the translation of these assets will be recorded in the CTA, impacting the equity section of the balance sheet.

Example 2: Financial Services Firm with Foreign Operations

Scenario:
A financial services company operates in multiple countries and has its functional currency as the US Dollar (USD). It has a subsidiary in Japan whose functional currency is the Japanese Yen (JPY). The parent company decides to change its functional currency to JPY due to increased operations in Japan.Impact on Leverage Ratios:

• Debt Valuation: If the company has significant debt denominated in USD, changing the functional currency to JPY may lead to an increase in the reported value of liabilities if the JPY depreciates against the USD. For example, if the company has 1,000,000 USD in debt and the exchange rate changes from 100 JPY/USD to 110 JPY/USD, the translated debt would increase from 100,000,000 JPY to 110,000,000 JPY.
• Debt-to-Equity Ratio: The increase in liabilities due to currency translation would raise the debt-to-equity ratio, indicating higher leverage and potentially increasing the perceived financial risk of the company.

Example 3: Retail Company with International Sales

Scenario:
A retail company based in Canada sells products internationally, primarily in the US market. Its functional currency is Canadian Dollars (CAD). Due to a strategic shift, the company changes its functional currency to USD.Impact on Nonmonetary Assets:

• Inventory Valuation: The company must remeasure its inventory, which was originally valued at 500,000 CAD. If the exchange rate at the time of acquisition was 1 USD = 1.25 CAD, the historical cost in USD would be 400,000 USD.
• Future Transactions: After the change, any future inventory purchases will be recorded in USD, impacting the cost of goods sold and potentially affecting profit margins based on currency fluctuations.

Example 4: Technology Company with Global Operations

Scenario:
A technology company based in Australia has a functional currency of AUD but operates extensively in Europe and the US. The company decides to change its functional currency to EUR due to increased revenue from European customers.

Impact on Leverage Ratios:

• Increased Borrowing Capacity: If the functional currency change leads to a favorable translation of foreign revenues, the company may see an increase in its equity base. This could improve its debt-to-equity ratio if the value of its debt remains stable or decreases due to favorable currency movements.
• Financial Ratios: The overall impact on leverage ratios will depend on the exchange rates at the time of the functional currency change. If the EUR appreciates against the AUD, the company may appear less leveraged, enhancing its attractiveness to investors and creditors.

CONCLUSION:

Changing the functional currency under IAS 21 has significant implications for an entity’s financial statements. The transition is accounted for prospectively, meaning prior financial statements are not restated. All assets and liabilities are translated into the new currency using the exchange rate at the date of change, with non-monetary items treated as historical cost going forward.The decision to change functional currency should be based on significant changes in economic conditions, such as shifts in sales price influences or operational relocations.

This change can affect key financial ratios, including profitability, liquidity, and leverage ratios, which are crucial for assessing financial health. Industries such as export-import businesses, manufacturing, and financial services are particularly sensitive to these changes due to their reliance on foreign markets and currency fluctuations.Ultimately, careful consideration is essential before changing the functional currency, as it can have far-reaching effects on financial reporting and performance metrics.