Chapter 2: The functional currency approaches

Foreign currency transaction – definition A foreign currency transaction is a transaction that is denominated or requires settlement in a foreign currency. A foreign currency is a currency other than the functional currency of the entity. For example, an entity may: buy or sell goods or services at a price denominated in a foreign currency. borrow or lend funds such that the amounts payable or receivable are denominated in a foreign currency; and/or acquire or dispose of assets, or incur or settle liabilities, denominated in a foreign currency.

When an entity directly enters such transactions, it is exposed to the cash flow effects of changes in value of the foreign currency. An entity must convert foreign currency items into its functional currency to recognise those items in its accounting records.

Once recognised, exchange differences will arise when changes in exchange rates affect the carrying amounts.

Introduction

IAS 21 requires each individual entity to determine its functional currency and measure its results and financial position in that currency. In consolidated accounts, the functional currency is determined at the level of each entity within a group. It follows those different entities within a group could have different functional currencies. However, there is no such thing as a group functional currency.

The functional currency serves as the basis for determining whether the entity is engaging in foreign currency transactions. IAS 21 defines foreign currency as a currency other than the functional currency. Identifying the functional currency has a direct impact on which transactions are foreign currency transactions that give rise to exchange gains and losses and, thereby, on the reported results.

Determining the functional currency

IAS 21 provides guidance on how to determine an entity’s functional currency, because judgement might be required.

An entity’s functional currency is the currency of the primary economic environment in which the entity operates. The primary economic environment is normally the economic environment in which the entity primarily generates and expends cash. The functional currency is normally the currency of the country in which the entity is located. It might, however, be a different currency.

IAS 21 requires entities to consider primary and secondary indicators to determine functional currency. Primary indicators are closely linked to the primary economic environment in which the entity operates and are given more weight. Secondary indicators provide supporting evidence to determine an entity’s functional currency. Determining an entity’s functional currency depends on the facts and circumstances.

The following indicators need to be considered by an entity in determining its functional currency:

Primary indicators of functional currency

Indicators	Factors to be considered by the entity in determining the functional currency
Sales and cash inflows	1.      The currency that mainly influences sales prices for its goods and services. This will often be the currency in which sales prices for goods and services are denominated and settled. For example, where an entity primarily sells its products in a particular country and those products are also priced in the currency of that country, and revenues are collected primarily in that currency, the currency of that country is likely to be the functional currency. However, the standard gives greater emphasis to the currency of the economy that determines the pricing of transactions than the currency in which transactions are denominated. 2.      The currency of the country whose competitive forces and regulations mainly determine the sales prices of its goods and services. Where sales prices of the entity’s products are determined by local competition and local government regulations rather than worldwide competition or by international prices, the currency of the country of operation is likely to be the functional currency. For example, aircraft manufacturers often price aircraft in US dollars or in euros, but the legal and regulatory environment of the country in which the manufacturer is located might restrict the entity’s ability to pass hard currency costs (that is, dollars or euros) to its customers. Therefore, while the business is influenced by the hard currency, its ability to generate revenue is determined by the local environment, which might indicate that the currency of the country of the entity’s operations is the functional currency.
Expenses and cash outflows	The currency that mainly influences labour, material and other costs of providing goods and services. This is often the currency in which such costs are denominated and settled. For example, where labour, material and other operating costs are primarily sourced and incurred in a particular country, the currency of that country is likely to be the functional currency, even though there might also be imports from other countries.

Secondary indicators of functional currency Indicators

Indicators	Factors to be considered by the entity in determining the functional currency
Financing activities	The currency in which funds from financing activities (such as issuing debt and equity instruments) are generated. For example, where financing is raised in and serviced by funds primarily generated by the entity’s operations in a particular country, this might indicate, in the absence of other indicators to the contrary, that the currency of that country is the functional currency.
Retention of operating income	The currency in which receipts from operating activities are usually retained. This is the currency in which the entity maintains its working capital balance.

The primary and secondary indicators for determining the functional currency must be considered by all entities.

Additional indicators for foreign operations

If the entity is a foreign operation, four additional factors should be considered in determining the functional currency and whether it is the same as that of the reporting entity. These additional factors are shown in the table below.

They set out the conditions that point to whether the foreign operation’s functional currency is the same as, or different from, the reporting entity (the reporting entity, in this context, being the entity that has the foreign operation as its subsidiary, branch, associate or joint venture).

Indicators	Conditions pointing to functional currency being different from that of the reporting entity	Conditions pointing to functional currency being the same as that of the reporting entity
Degree of autonomy	Activities are carried out with a significant degree of autonomy. An example is when the operation accumulates cash and other monetary items, incurs expenses, generates income and arranges borrowings, all substantially in a currency other than that of the reporting entity.	No significant degree of autonomy – activities are carried out as an extension of the reporting entity. An example is when the foreign operation only sells goods imported from the reporting entity and remits the proceeds to it. It follows that such an entity (which would be considered an integral foreign operation in the previous version of IAS 21) must have the same currency as the reporting entity. This is because it would be contradictory for an integral foreign operation that “carries on business as if it were an extension of the reporting entity’s operations” to operate in a primary economic environment that is different from that of its parent.
Frequency of transactions with reporting entity	Few inter-company transactions with the reporting entity.	Frequent and extensive inter-company transactions with the reporting entity.
Foreign operation’s cash flows impact on reporting entity	Do not directly affect the reporting entity’s cash flows.	Directly affect the reporting entity’s cash flows and are readily available for remittance cash flows impact on reporting entity to the reporting entity.
Financing	Primarily in a currency other than that of the reporting entity and serviced by funds generated by the entity’s operation.	Significant financing from, or reliance on, the reporting entity to service existing and normally expected debt obligations.

When assessing its functional currency, how does an entity determine the relative importance of the various indicators in IAS 21? In assessing the indicators’ relative importance, management might find it useful to consider the following for each indicator: The significance of that indicator to the entity’s operation. For example, the currency of the entity’s debt might not be an important indicator if the entity is not financed by debt and is primarily self-financing through retained earnings. How clearly the indicator identifies a particular currency as the functional currency. For example, if the same entity purchases raw materials both from the UK and from continental Europe, the ‘expenses’ indicator might be inconclusive. In contrast, if the majority of sales occur in the host country at prices determined by local conditions, the ‘sales’ indicator might be regarded as the key determinant in concluding that the currency of the country of operation is the functional currency. After considering all the indicators, the functional currency might still not be obvious. The operation might be diverse, with cash flows, financing and transactions occurring in more than one currency. In these situations, judgement is required in determining the functional currency that most faithfully represents the economic effects of the underlying transactions, events and conditions. In exercising that judgement, management should give priority to the primary indicators before considering secondary indicators and additional factors.

Does IAS 21 give greater emphasis to the primary indicators? Yes, IAS 21 gives greater emphasis to the primary indicators, because these indicators are closely linked to the primary economic environment in which the entity operates. The currency of the economy in which the entity operates generally determines the pricing of transactions; this is considered to be more influential than the currency in which the transactions are denominated and settled. This is because transactions can be denominated and settled in any currency that management chooses; but the pricing of the transaction is normally done by reference to the economy of the country whose competitive forces and regulations affect the transaction, so the currency of that economy becomes the functional currency, by definition. In other words, the currency of the country whose economy drives the business, and which determines the gains and losses to be recognised in the financial statements, most faithfully reflects the economic effects of the underlying transactions, events and conditions. The standard’s requirement that the primary and secondary indicators be looked at as a hierarchy helps avoid practical difficulties in determining an entity’s functional currency. For example, if all the primary indicators, which should be considered together, identify a particular currency as the functional currency, there is no need to consider the secondary indicators. Secondary indicators serve to provide additional supporting evidence in determining an entity’s functional currency, where consideration of the primary indicators alone is not sufficient.

Are the additional indicators in IAS 21 relevant for assessing the functional currency of associates and joint ventures? Associates and joint ventures are likely to be autonomous from an individual investor, given the lack of control over the entity. The additional indicators in IAS 21 are not likely to be relevant.

Functional currency of an entity with transactions denominated in a stable currency A real estate entity operates in Russia. It owns several office buildings in Moscow and St Petersburg that are rented to Russian and foreign entities. All lease contracts are denominated in US dollars, but payments can be made in either US dollars or Russian roubles. However, almost all of the lease payments are settled in roubles. This has been the historical pattern of payment. On first analysis, the ‘sales and cash inflows’ indicator appears to produce a mixed response, because the currency that mainly influences the pricing of the lease contracts is US dollars, whereas the cash inflows are in roubles. Also, cash outflows (such as the principal operating costs, management of properties, insurance, taxes and staff costs) are likely to be incurred and settled in roubles, which would indicate that the functional currency is the Russian rouble. The lease payments are denominated in US dollars, but US dollars are not considered to be significant to the entity’s operation, because: (a) most of the collection is in roubles, which is subject to short-term changes in US dollar/rouble exchange rates; and (b) it is the local conditions and circumstances in Russia, not the US, that determine the rental yields of properties in Moscow and St Petersburg that mainly influence the pricing of the lease contracts, which are merely denominated in US dollars. It is, therefore, the currency of the Russian economy, rather than the currency in which the lease contracts are denominated, that most faithfully represents the economic effects of the real estate activity in Russia.

Functional currency of an entity with products normally traded in a non-local currency (such as oil) Entity A operates an oil refinery in Saudi Arabia. All of the entity’s income is denominated and settled in US dollars. The oil price is subject to the worldwide supply and demand, and crude oil is routinely traded in US dollars around the world. Around 45% of entity A’s cash costs are imports or expatriate salaries denominated in US dollars. T he remaining 55% of cash expenses are incurred in Saudi Arabia and denominated and settled in riyal. The crude oil sales prices are influenced by global demand and supply. Crude oil is globally traded in US dollars around the world. The revenue analysis points to US dollars. The cost analysis is mixed. Depreciation (or any other non-cash expenses) is not considered, because the primary economic environment is where the entity generates and expends cash. Operating cash expenses are influenced by the riyal (55%) and the US dollar (45%). Management is able to determine the functional currency of entity A as US dollars, because the revenue is clearly influenced by US dollars and expenses are mixed.

How does a holding entity whose only activity is to hold investments in subsidiaries determine its functional currency? The IFRS IC has considered the functional currency of an ultimate holding entity whose only activity is to hold investments in subsidiaries. In its March 2010 update, it noted that the primary indicators in IAS 21 should not be considered in isolation and that judgement is required when the functional currency is determined. In our view, the following applies: Ultimate holding entity A policy choice exists for an ultimate holding entity as to how to interpret IAS 21 in order to determine its functional currency. The ultimate holding entity might determine that it is acting as an extension of its subsidiaries and, therefore, has the same functional currency as those subsidiaries. Alternatively, the ultimate holding entity might consider all of the primary and secondary indicators and conclude that its functional currency is determined by the currency of its own dividend revenue, its own expenses and the currency of its own financing. Intermediate holding entity An intermediate holding entity that is not autonomous does not have a policy choice. Whether it is appropriate for such an entity to look up or down depends on the particular facts and circumstances and which entity or entities the intermediate holding company is acting as an extension of, as noted below: When considering the ‘autonomy’ indicator in IAS 21, a non-autonomous subsidiary or branch typically derives its functional currency from its parent: ‘the look-up approach’. This would also be the case for an intermediate holding company that acts as an extension of its parent. On the other hand, the ‘autonomy’ indicator might also point to the conclusion that the intermediate holding entity is acting as an extension of its subsidiary or group of subsidiaries and, therefore, has the same functional currency as its subsidiary or group of subsidiaries: ‘the look-down approach’.

Functional currency of an offshore ultimate holding entity A group of companies is organised as follows: Entity A is a reporting entity with three operating subsidiaries (entities B, C and D) that are incorporated in Russia. Management has concluded that the functional currency of each subsidiary should be roubles. Entity A is the holding entity and has been set up by institutional investors in Cyprus (a Eurozone country). Entity A has obtained equity and loan financing and has invested in Russian entities B, C and D. It pools cash from all group entities, invests excess cash and obtains external financing, according to the group’s needs. The financing is drawn in US dollars, and all of its monetary assets are denominated in US dollars. The entity retains cash in US dollars, its expenses that are not associated with financing are insignificant compared to the investments in the Russian investees or the funding costs, and it has no employees. The entity’s activities are carried out by employees of its operating subsidiaries. Its shares are denominated in US dollars and it pays dividends to its investors in US dollars. What is entity A’s functional currency? As stated, in our view there is an accounting policy choice for determining the functional currency of an ultimate holding entity, as follows: Option 1: The ultimate holding entity is viewed as having the same functional currency as its operating subsidiaries, so entity A’s functional currency is the Russian rouble. Management is required to use its judgement to determine the functional currency that most faithfully represents the economic effects of the underlying transactions, events and conditions. Entity A has no activity of its own. The currency that reflects the economic substance of the underlying economic events that affect the holding entity is the Russian rouble, because all of the holding entity’s subsidiaries operate in Russia and entity A’s primary source of income will be dividends obtained from the subsidiaries in Russia. Entity A’s ability to service debts and pay dividends to shareholders is dependent on the Russian economy. Although IAS 21 explicitly defines a foreign operation as a reporting entity’s subsidiary, branch, associate or joint venture, that paragraph can be applied by analogy, and it is appropriate to view an ultimate holding entity as an extension of its subsidiaries. Option 2: The ultimate holding entity’s functional currency is not viewed as being dependent on its foreign operations, so entity A’s functional currency is US dollars. Entity A has no sales or purchases, nor does it incur significant expenses other than in respect of its financing activities. The economic source of dividend revenues is not a key factor in determining the functional currency of a non-operating ultimate parent entity. The primary indicators in IAS 21 are not directly relevant. It is the currency denomination of the financing activities that drives the functional currency determination. The functional currency is determined based on the primary economic environment in which the entity generates and expends cash, consistent with the secondary indicators. All cash flows associated with financing and dividends are US dollars. IAS 21 explicitly defines a foreign operation as a reporting entity’s subsidiary, branch, associate or joint venture. While a foreign operation could be viewed as an extension of its parent, IAS 21 is not required to be applied, by analogy, to view an ultimate holding entity as an extension of its subsidiary; this is because the parent controls the subsidiary, and not vice versa.

Functional currency of an intermediate parent with some operating activities Parent (entity P) is a manufacturing business located in the UK, with sterling as the functional currency. Entity P invests US dollars in an intermediate parent (entity IP), which then invests in three separate US dollar operating subsidiaries (entities S1, S2 and S3). Entity IP undertakes no ‘operating’ activities of its own; however, it acts as the holding entity of the US subsidiaries, heading up the US group. It has a dedicated management team and staff that carry out the head office functions, including the US group’s payroll, cash management and preparation of a sub-consolidation package. The management team takes finance decisions related to the sub-group and controls the activities of the subgroup. Its management team reports monthly to entity P’s board on the results of the US group. Its key cash inflows are the dividends from its subsidiaries (which it remits up directly to entity P), and inter-company balances from its subsidiaries (that are used to settle both entity IP’s own administration costs and those costs incurred directly by entity IP on behalf of its subsidiaries, such as payroll costs, computer services and maintenance). All cash inflows and outflows are denominated in US dollars. Entity IP is a US-registered entity. Entity IP has operating activities, in that it provides local management services to its subsidiaries. It incurs local costs and then either recharges these to its subsidiaries or retains dividend income from its subsidiaries to pay for these costs. All the costs are incurred in US dollars and will be reimbursed in US dollars. Entity IP does not raise finance; consideration of the currency in which funds from financing activities are generated is not directly applicable. However, the funding of its costs through dividends and inter-company balances is in US dollars. The currency in which receipts from operating activities are usually retained indicates US dollars as the functional currency. Looking to the additional factors in IAS 21: Entity IP has a significant degree of autonomy: it has its own management team and staff; a budget for which it is responsible; and discretion over its head office functions. It has a number of transactions with parties outside the group. The cash flows of entity IP do not directly affect the parent; entity IP is not merely acting as a conduit. Consideration of IAS 21, which states “whether cash flows from activities of the foreign operation are sufficient to service existing and normally expected debt obligations without funds being made available by the reporting entity”, is not applicable.

Functional currency of an intermediate parent with no operating or financing activities of its own Parent (entity P) is a manufacturing business located in the UK, with sterling as the functional currency. P invests US dollars in an intermediate parent (entity IP), which then invests in a US-dollar operating subsidiary (entity S) on behalf of entity P. Entity IP is a shell entity that undertakes no operating or financing activities, because it only holds investments. Its key cash inflows are dividends from entity S, which it remits directly to entity P. Entity IP is a US-registered entity. Any investing activity that entity IP undertakes is not carried out as a separate stand-alone activity, but at the behest of its parent. It is not, therefore, relevant to consider the ‘sales and cash inflows’ indicator. The ‘expenses and cash outflows’ indicator might be relevant, as it is more likely than not that entity IP will incur some local costs. But that indicator, by itself, is not considered significant to entity IP’s operations, nor does it clearly identify US dollars as the functional currency. The secondary indicators do not clearly identify US dollars as the functional currency, because entity IP does not raise any finance from external local sources – any finance raised is primarily from its parent or from sterling sources. Nor does entity IP retain any funds for own use, which are all remitted to the parent. All of the additional factors also point to US dollars not being the currency that most faithfully represents entity IP’s activities of receiving dividend income from entity S in US dollars and remitting these to its parent. The primary, secondary and additional indicators are mixed, and so management should exercise judgement in determining the currency that most faithfully represents entity IP’s activities. One analysis might focus on the fact that entity IP is a ‘foreign operation’ in relation to its parent, entity P. Entity IP does not have autonomy, transacts frequently with its parent, does not retain cash, and relies on entity P for financing. It is, therefore, simply a device or a shell corporation for the holding of investments that could have been held by entity P itself. The functional currency of entity IP is the same as its parent: sterling. An alternative analysis might focus on the fact that entity IP’s results are dependent on the economic activities of its subsidiary, whose functional currency is US dollars. The ‘cash inflows’ indicator, therefore, suggests that US dollars are significant to its investing activity. The facts and circumstances indicate that entity IP is a shell intermediate holding entity that merely holds the investment and receives occasional dividends, passing them on to the parent. Entity IP does not have autonomy, because it was set up and operates at the behest of the parent, carrying out a function that the parent could equally carry out itself. Management’s conclusion is that sterling is entity IP’s functional currency.

Functional currency of an entity raising finance for the group in a foreign currency compared to the other entities in the group A French-listed parent has significant French, UK and US operating subsidiaries, but no Japanese operations. The French parent creates a new subsidiary, Newco SA, incorporated and resident in France. Newco issues equity capital of yen 1 billion to the French parent, receiving yen 1 billion of cash. Newco also raises yen 100 million of external financing and places the yen 1.1 billion total cash on deposit with a bank in Japan, earning 0.1% interest per annum. The cash will be reinvested in yen-denominated financial instruments, such as bonds and commercial paper. Newco has few members of staff who manage the entity’s investing activities. It incurs euro operational costs that are insignificant compared to the interest paid on its yen borrowing. Like any wholly owned subsidiary, the retained profits are under the parent’s control. Newco does not undertake any key operating activities on its own. Consideration of the currency that mainly influences sales and costs is not directly relevant. Newco incurs expenses in euros, but these are not significant enough to suggest that the euro is the functional currency. It is necessary to look at the secondary indicators. Newco raises finance by issuing its own equity instruments to the parent in a currency that is different from the parent, but the proceeds are invested in yen-denominated assets at the behest of the parent. The external funds raised through the issue of debt instruments are insignificant compared to the issue of equity shares to the parent. It is not clear whether the income generated from the investments is reinvested in other yen-denominated assets or whether it is wholly passed on to the parent. In any event, the decision to reinvest or distribute is under the parent’s control. Consideration of the other additional factors suggests that Newco is a ‘cash box’ type entity, with no independent management/activity. Newco is simply a conduit for the parent entity that could invest the yen directly. It might be that the only reason why the parent entity has invested the yen through Newco is in the hope that its exposure to changes in the euro/yen exchange rate is reported in other comprehensive income through the translation of its net investment in Newco, rather than in the income statement, which would be the case if the yen deposits were treated as belonging to the parent. The ‘autonomy’ indicator points to the euro as the functional currency, because Newco appears to be merely an extension of the activities of the parent. This would point to the functional currency being the same as that of its parent − the euro. This would be the answer if Newco carried out only the activities described. The investing activity could have been done by the parent rather than the subsidiary and, therefore, based on the additional indicators relevant to a foreign operation, the parent’s functional currency is the foreign entity’s functional currency.

Functional currency of separate treasury centres in different geographical areas A Swiss multi-national entity, with the Swiss franc as its functional currency, has operating subsidiaries in the US and Europe whose functional currencies are US dollars and euros respectively. It has established a treasury centre (TC) in each of these geographical regions. The activities of the two TCs are identical, in that each provides financial and risk management services to its relevant operating subsidiaries. All transactions (For example, management of liquid funds, borrowings and hedging activities) between a TC and its respective operating subsidiaries are carried out in either US dollars or euros. Each TC earns dividends and income from cash management activities in US dollars and euros respectively. Each TC charges a monthly fee for providing such financial services to its operating subsidiaries that is denominated in either US dollars or euros, depending on its area of operation. All operating costs − such as staff costs payable to treasury and financial management specialists and other administrative and running costs − are incurred and settled by each TC in US dollars or euros. The TCs’ short- and long-term financing are provided by the Swiss parent in the form of Swiss franc loans. The TCs do not retain any US dollars or euros generated from their operation for their own use. After meeting local expenses, management either uses US dollars or euros to settle the inter-entity payables to the operating subsidiaries, or it distributes any surplus to the parent as dividends. What is the functional currency of the US dollar Treasury Centre? This illustration addresses only the US dollar TC; however, the considerations for the euro TC are the same. The primary factors (currency that influences sales price and the costs of providing goods and services) are arguably irrelevant, because the TC does not have any third-party sales and purchases. However, the determination of the functional currency is an entity-by-entity question, and it is not relevant to whether an entity’s fee income comes from inside or outside the group. What is relevant is the nature of the fee income and the manner in which it is earned. In this example, the TC provides financial services to the US operating subsidiaries for which it charges a fee. The fees are invoiced and settled in US dollars. The TC also earns investment income in US dollars. Because the TC earns its revenue and income in US dollars, and the underlying US economy determines the pricing of the TC’s fee income to the US operating subsidiaries, the ‘sales and cash inflows’ indicator identifies US dollars as the functional currency of the TC. Since all administrative and local expenses are incurred and settled in US dollars, the ‘expenses and cash outflows’ indicator also provides strong evidence that US dollars is the TC’s functional currency. The primary economic environment in which the TC generates and expends cash is the US and, therefore, its functional currency is US dollars. The primary indicators are clear, so there is no need to consider the secondary indicators, even if these seem to provide evidence that the Swiss franc is the functional currency (For example, the TC’s short- and long-term financing is primarily in the form of Swiss franc loans from the parent).

Functional currency of a treasury centre that pools resources in the group A UK multi-national entity, with sterling as its functional currency, has set up a treasury centre (TC) in Switzerland. The TC borrows US dollars, euros and sterling in the euro-market, and lends the proceeds to its parent and other operating subsidiaries, with the loans denominated in the borrowing entity’s functional currency. As part of its cash management operations, it pools the liquid resources of the parent and the operational units, and invests them temporarily in the euro-market. It also manages foreign exchange and interest rate risks of operating units by executing derivative contracts with third parties and/or with operating units. The TC earns dividends and income from cash management activities in US dollars, euros and sterling. It charges a monthly fee for providing such financial services to its parent and operating subsidiaries that is denominated in the relevant entity’s functional currencies. All operating costs, such as staff costs payable to treasury and financial management specialists and other administrative and running costs, are incurred and settled in Swiss francs. The TC’s short- and long-term financing needs are provided by its parent in the form of sterling loans. The TC provides financial services to group companies for which it charges a fee. However, the fees are invoiced in the functional currencies of the group companies and settled in those currencies. This ensures that the risk of non-functional currency transaction gains and losses on all inter-company transactions with the TC are passed on from the operating units to the TC for centralised management and control. The TC also earns investment income in US dollars, euros and sterling. Because the TC earns its revenue and income in different currencies, the ‘sales and cash inflows’ indicator fails to identify a particular currency that is significant, in its own right, as the functional currency of the TC. Furthermore, there is no explicit or implicit evidence to suggest that the underlying Swiss economy determines the pricing of the TC’s fee income to the group companies. On the other hand, all administrative and local expenses are incurred and settled in Swiss francs, so the ‘expenses and cash outflows’ indicator provides strong evidence that the Swiss franc is the functional currency. Therefore, because the primary indicators are not sufficiently conclusive in identifying the functional currency, it is necessary to consider the secondary indicators. The secondary indicators provide evidence that sterling is the functional currency. This is because the TC does not raise any finance from external local sources, for meeting the cost of its operations in excess of its operating income, but relies on short- and long-term financing from its parent. Furthermore, the cash inflows from operations occur in various currencies and are used to meet local expenses, so the ‘retention of cash’ indicator is not significant in determining the TC’s functional currency. The additional factors also support sterling as the functional currency. For example, the ‘autonomy’ indicator suggests that the UK parent has set up the TC to achieve overall financial efficiency of its international operations through centralised control and effective management of cash and financial risk. The volume of inter-company transactions is large, due to the regular transfer of foreign currency cash balances from and to the parent. The TC’s cash flows, therefore, impact the parent’s cash flows on a regular basis. The ‘financing’ indicator also identifies sterling as the functional currency. This analysis suggests that the primary indicators do not provide conclusive evidence that Swiss francs (the currency of the country in which the TC operates) is its functional currency. However, the secondary indicators support sterling as the functional currency. Overall, the evidence is mixed. Management should exercise judgement in determining the currency that most faithfully represents the economic effects of the TC’s activities. There are a number of possible solutions. One indicator might be that the TC has been set up primarily as a conduit to undertake the treasury operations of the entire multi-national group headed by the UK parent. The currency of the country that most faithfully represents the TC’s operations is, therefore, the functional currency of the UK parent: sterling. Another factor to consider is whether any of the three major currencies (dollars, euros, sterling) is dominant. If no clear currency is suggested by the previous factors, and if the TC’s operating expenses are significant, the Swiss franc might be the TC’s functional currency.

Functional currency of a foreign subsidiary importing products from parent for local distribution A subsidiary located in Spain imports a product manufactured by its US parent at a price denominated in US dollars. The product is sold throughout Spain at prices denominated in euros, which are determined primarily by competition with similar locally produced products. All selling and operating expenses are incurred locally and paid in euros. The operation’s long-term financing is primarily in the form of US dollar loans from the parent. The distribution of profits is under the parent’s control. The ‘sales and cash inflows’ indicator suggests that the foreign subsidiary’s functional currency is the euro, as that is the currency in which the sales prices are denominated and settled. Furthermore, the sales prices for the foreign entity’s products do not respond, on a short-term basis, to changes in exchange rates, but are determined by local competition and local government regulation. This is a strong indicator that the functional currency is the euro. The ‘expenses and cash outflows’ indicator provides a mixed response. This is because cost of sales is primarily denominated and settled in US dollars, whereas local expenses, including selling expenses, are denominated and settled in euros. Given that a significant part of the expenses is settled in US dollars, this indicator does not provide conclusive evidence that the euro is the functional currency. The primary indicators produce a mixed response, although overall they favour the euro. It is, therefore, necessary to look at the secondary indicators. The secondary indicators provide supporting evidence that US dollars is the functional currency. This is because the foreign subsidiary’s long-term financing is primarily in the form of US dollar loans from the parent, and the subsidiary does not raise any finance from external local sources. Furthermore, the foreign subsidiary does not retain any euros generated from its operations for its own use. After meeting local expenses, management either uses the euros to settle the inter-company payables to the parent, or it distributes any surplus to the parent as dividends. If the ‘autonomy’ indicator suggests that the foreign subsidiary is simply acting as an agent for its US parent by selling parent-produced goods to customers in Spain, collecting the proceeds and remitting the same to the US parent, the functional currency would be US dollars. The volume of inter-company transactions is large, because the foreign subsidiary imports goods from its US parent and settles the proceeds on a regular basis. The subsidiary’s cash flows, therefore, regularly impact the parent’s cash flows. However, if the foreign subsidiary’s operations were carried out with a significant degree of autonomy (that is, local management has a significant degree of authority and responsibility, such as to borrow loans, invest excess cash, modify prices or grant discounts and hire and fire staff), the functional currency would be determined independently from the parent. Management would conclude that the functional currency is the euro, as the primary indicators of IAS 21 are overall in favour of the euro.

Functional currency of a structured entity Entity A is a US bank, with a US dollar functional currency. Entity A establishes a structured entity in a European country in order to invest in a European bond portfolio. Entity A has funded the structured entity with equity and inter-company debt denominated in euros. The structured entity uses the financing to purchase a portfolio of euro government bonds. There is no intention for the structured entity to perform any activities other than holding the bond portfolio. The directors are all employees of the US parent, and the structured entity has no active management of its own. The functional currency of the structured entity is US dollars, because the entity has no operations and does not provide any services. The primary indicators, therefore, do not apply. The ‘financing’ indicator supports the euro, because all financing is in euros. However, all the financing is inter-company, and entity A could denominate the financing in any currency it wanted. Considering the ‘autonomy’ indicator, it is clear that the structured entity is not autonomous. It is a shell entity, has no independent activities and no active management of its own.

Could an entity have different functional currencies for stand-alone accounts and for group reporting purposes? Entity A is an autonomous foreign operation of reporting entity Z. Entity A operates in a country where US dollars are frequently used, because the currency of the country in which entity A operates has been inflationary in the past. Entity A primarily operates in the local market and is requested to prepare statutory stand-alone financial statements in accordance with IFRS. Local regulations require entity A to use the local currency as the presentation currency for the statutory accounts. Management has determined that the local currency should be the functional currency for the stand-alone financial statements. Entity A is also required to prepare an IFRS reporting package for entity Z. Management believes that entity A should use US dollars as the functional currency for group reporting purposes, because US dollars are frequently used in the local economy and because the group presentation currency is US dollars. Could an entity have different functional currencies for stand-alone accounts and for group reporting purposes? No. An entity can have only one functional currency. The functional currency is the currency of the primary economic environment. This is the same for stand-alone financial statements and for group reporting purposes. Entity A should use the local currency as its functional currency for both statutory and group reporting purposes.

Functional currency after a group restructuring Entity X is the ultimate holding company of a complex multi-national group with numerous intermediate parent entities. As part of a group restructuring, intermediate parent entity A sold some of its subsidiaries to intermediate parent entity B. Should the functional currency of both intermediate parents, entity A and entity B, be re-assessed after the group restructuring? Yes. The functional currency of both intermediate parents should be re-assessed to determine whether the previous IAS 21 functional currency determination is impacted by the group restructuring. For example, if the subsidiaries that have been sold to entity B are substantial operating companies, and entity B has limited or no other activities, IAS 21 might require entity B to have the same functional currency as that of the newly acquired subsidiaries. On the other hand, entity B might be acting as an extension of entity X, in which case the functional currency will be the same as that of entity X, both before and after the group restructuring. The group restructuring, by itself, does not trigger a re-assessment of the functional currency of entity X, because nothing has changed as regards the primary economic environment in which that entity operates. The functional currency of entity X would have been previously determined by management, according to the policy choice, and entity X might or might not have independent activities. The existence or not of such activities does not determine whether an intermediate holding entity is an extension of its parent.

Entity with multiple operations

An entity might have multiple foreign operations. A foreign operation is an entity that is a subsidiary, associate, branch or joint arrangement whose activities are based or conducted in a country or currency other than that of the reporting entity. A legal entity might have more than one distinct and separable foreign operation, such as a division or a branch.

How does an entity assess whether an operation within a single legal entity (such as a division or branch) is a separate entity for the purposes of IAS 21? This is not specifically addressed in IAS 21. We believe that, in determining whether each operation could be considered a separate entity for the purposes of this standard, the definition of a ‘business’ under IFRS 3 could be useful.

Once the number of foreign operations has been determined, each foreign operation should determine its functional currency and measure its results and financial position in that currency before they can be included in the reporting entity when it prepares its financial statements. Once a reporting entity’s presentation currency is determined, the results and financial position of its foreign operations having different functional currencies will be included using the translation method.

It is possible for an entity to have two or more foreign operations in one country, and to determine different functional currencies for those entities. Management should determine, for each of these entities, the appropriate functional currency.

Accounting records not maintained in functional currency

If a foreign operation’s books or records are not maintained in its functional currency, management should remeasure into the functional currency before translating into the presentation currency of the reporting entity. The remeasurement into the functional currency should be carried out using the translation method set out in paragraph 49.19 onwards, and would produce the same amounts in the functional currency as would have occurred if all of the items had been recorded in the functional currency in the first place.

Change in functional currency

Once the functional currency of an entity is determined, it should be used consistently, unless significant changes in economic facts, events and conditions indicate that the functional currency has changed.

A change in functional currency should be accounted for prospectively from the date of change. Management should translate all items into the new functional currency, using the exchange rate at the date of change.

Because the change was brought about by changed circumstances, it does not represent a change in accounting policy and, therefore, a retrospective adjustment under IAS 8, ‘Accounting policies, changes in accounting estimates and errors’, is not appropriate.

As all assets and liabilities are translated using the exchange rate at the date of change, 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 recognised in other comprehensive income are not reclassified from equity to profit or loss until the disposal of the operation.

How are equity items translated to the new functional currency? There is no specific guidance in IAS 21 on how to translate equity items to the new functional currency if it changes, but we believe that it would be consistent with the treatment of assets and liabilities for these also to be translated using the exchange rate at the date of the change of functional currency. This means that no additional exchange differences arise on the date of the change.

If the change in functional currency is accompanied by a change in presentation currency; that is the new functional currency becomes the entity’s presentation currency, then it will be necessary to retranslate the comparatives and any stub period prior to the date of change of the functional currency into the new presentation currency.

Assets and liabilities are retranslated from opening to closing rates (closing rate being the rate at the date of change for the stub period). Performance statement items are translated at the historical rate at the date of the transactions (or average rate if this approximates to the actual rate).

Equity items are translated either at closing rate (being the rate at the date of change for the stub period) or the historical rate at the date of the transactions. Resulting differences between the opening and historical rates and the closing rates (being the rate at the date of change for the stub period) are recognised in CTA.

Entities should also consider presentation currency when there is a change in functional currency. A change in functional currency might be accompanied by a change in presentation currency, because many entities prefer to present financial statements in their functional currency. However, other entities might decide to continue presenting their financial statements in the same presentation currency.

Does a change in functional currency always give rise to a change in presentation currency? Not necessarily. An example of where the presentation currency might not change would be a stand-alone Irish entity that previously presented its financial statements in its euro functional currency and whose functional currency changes to US dollars. The entity is based in Ireland and has Irish shareholders. It does not wish to change its presentation currency, and so it continues to present its financial statements in euros. A second example would be where an entity is part of a group whose presentation currency does not change following the change in functional currency of a foreign operation. In such a case, the numbers in the entity’s own financial statements, for the period up to the change in functional currency, do not change in presentation currency terms. From the point that the functional currency changes, new foreign exchange differences will arise in the entity’s own financial statements when items expressed in the new functional currency are translated into the presentation currency.

Change in functional currency but not in presentation currency Assume that the Irish entity’s functional currency changes to US dollars on 1 January 20X8. The entity presented its financial statements for the year to 31 December 20X7 in euros. It will continue to present its 20X8 financial statements in euros. In its 20X8 financial statements, its 20X7 comparatives will be exactly as they were in the 20X7 financial statements. A US dollar loan, for example, will be translated into euros at the closing rate, with exchange differences between opening and closing rates recorded in the income statement. An item of property, plant and equipment (PPE) that was purchased in euros will be stated at its euro historical cost less depreciation. On 1 January 20X8, all financial statement items are translated into US dollars at the rate ruling at that date. In its 20X8 financial statements, no foreign exchange difference will arise on the US dollar loan in the entity’s 20X8 income statement, because it is now an item expressed in the entity’s functional currency. Any monetary items that are not denominated in US dollars will be translated at the closing rate, with exchange differences recorded in the income statement. Any items of PPE will have been re-translated into US dollars at 1 January 20X8, and these re-translated amounts become their US dollar historical cost and accumulated depreciation. The items of PPE are depreciated in US dollars throughout 20X8. For the 20X8 financial statements, the US dollar (functional currency) balance sheet amounts are translated into euros (presentation currency) at the closing rate, and income statement items are translated into euros at the actual or average rates for the period. Any exchange differences arising from opening to closing rates, and average to closing rates, are recorded in other comprehensive income. In the entity’s separate financial statements, cumulative translation adjustment (CTA) will be recognised in other comprehensive income and recorded in a separate component of equity. CTA is reclassified to profit or loss on disposal of a foreign operation. In the context of the entity’s separate financial statements where there is one functional currency and a different presentation currency, the ‘foreign operation’ is the entire business of the entity. CTA would, therefore, only ever be reclassified if the entire business of the entity were to be sold, leaving a shell.

When a subsidiary, changes its functional currency, is any cumulative translation adjustment previously recognised in consolidated financial statements recycled to profit or loss? No. Where financial statements of a foreign entity (such as a subsidiary) are translated into a different presentation currency, cumulative translation adjustment (CTA) will arise in the presentation currency consolidated financial statements. When the functional currency of that foreign entity changes, to one that might be the same as, or different from, the group’s presentation currency, any CTA previously recorded in equity remains in equity and is only recycled to profit or loss on disposal of the foreign entity.

Change in functional currency of a foreign branch: impact on a depreciated asset A UK entity has a branch in France, with a sterling functional currency. The UK entity presents its financial statements in sterling. A significant change in trading operations and circumstances occurred during the first quarter of the financial year ended 30 June 20X6. This meant that sterling no longer faithfully represented the underlying transactions, events and conditions of the foreign branch. UK management concluded that the euro should be the functional currency of its foreign operation, and that all transactions undertaken from the beginning of the financial year 30 June 20X6 (that is, from 1 July 20X5) should be recorded in euros. The financial statements of the foreign branch are re-translated into sterling from the date that its functional currency changed to euros, and cumulative translation adjustment (CTA) will arise from this point on the difference between opening net assets at the date of change versus closing rates, and profit or loss from the date of change at average to closing rates, where the UK entity presented (and continues to present) its financial statements in sterling. If the UK entity decided to change its presentation currency to euros for its 30 June 20X6 financial statements, it would need to go through the process described in order to present its sterling functional currency branch in euros for prior periods. This involves translating the assets and liabilities at the closing rate at 30 June 20X4, and translating the income statement at actual or average rates for the year to 30 June 20X5. Equity items should be translated at historical or closing rates, and retained earnings should be restated, if practicable to do so. CTA arises, as a result of the change in presentation currency, from translating the sterling branch into euros up to the date of change (30 June 20X5). From 1 July 20X5, no re-translation will be required in relation to the foreign branch, since it has the same functional currency as the UK entity’s presentation currency. The sterling to euro CTA that is calculated up to 30 June 20X5 will remain in equity until the branch is disposed of or is subject to partial disposal.

Date at which change in functional currency is recognised

A change in functional currency should be reported as of the date it is determined that there has been a change in the underlying events and circumstances relevant to the reporting entity that justifies a change in the functional currency. This could occur on any date during the year. For convenience, and as a practical matter, there is a practice of using a date at the beginning of the most recent period (annual or interim, as the case might be).

In accordance with IAS 21, when there is a change in an entity’s functional currency, the entity applies the translation procedures applicable to the new functional currency prospectively from the date of the change.

In other words, all items are translated into the new functional currency using the exchange rate at the date of the change. 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 recognised in other comprehensive income are not reclassified from equity to profit or loss until the disposal of the operation.

An entity should disclose when there has been a change in functional currency, and the reasons for the change

Change in functional currency: date of accounting for the change The foreign branch’s financial statements at 30 June 20X5, previously prepared in sterling, are translated to euros at the rate of exchange ruling at the date of change − in this situation, 1 July 20X5, which is the first day of the current financial year. All items in the balance sheet are translated at the rate of exchange ruling at 30 June 20X5, which approximates to the date of change. Retrospective application is not permitted, because the change in functional currency is accounted for prospectively.

Translation from a non-hyperinflationary functional currency into a hyperinflationary presentation currency – example Entity A is located in a jurisdiction with a hyperinflationary economy. Entity A has determined that its functional currency is the currency of a non-hyperinflationary economy. However, due to local regulations, Entity A must present its financial statements in its local currency (i.e., in the currency of a hyperinflationary economy). Because Entity A’s functional currency is not the currency of a hyperinflationary economy, Entity A is outside the scope of IAS 29. Accordingly, in order to translate its financial statements to the hyperinflationary presentation currency, Entity A must use the following method described in IAS 21: assets and liabilities for each statement of financial position should be translated at the closing rate of the date of that statement of financial position; income and expenses should be translated at the exchange rates at the dates of the relevant transactions; and all resulting exchange differences should be recognized in other comprehensive income.

Accumulated exchange differences related to a foreign operation at the date the foreign operation’s functional currency becomes that of a hyperinflationary economy Before a foreign operation becomes hyperinflationary, IAS 21 require an entity to: present in other comprehensive income (OCI) any exchange differences resulting from translating the results and financial position of that non-hyperinflationary foreign operation; and present in a separate component of equity the cumulative amount of those exchange differences (cumulative pre-hyperinflation exchange differences). IAS 21 further requires the entity to present the cumulative amount of exchange differences recognized in OCI in a separate component of equity “until disposal of the foreign operation”. IAS 21 require an entity to reclassify the cumulative amount of those exchange differences (or a proportionate share of that cumulative amount in the case of a partial disposal) from equity to profit or loss on disposal (or partial disposal) of a foreign operation (except as specified in IAS 21) when the gain or loss on disposal is recognized. The requirements in IAS 21 also apply if the foreign operation is hyperinflationary. Accordingly, the entity does not reclassify within equity the cumulative pre-hyperinflation exchange differences once the foreign operation becomes hyperinflationary. This conclusion was confirmed by the IFRS Interpretations Committee in the March 2020 IFRIC Update.