With the ever increasing globalization, many companies around the world are expanding their reach to multiple countries. The geographical boundaries are no longer a limitation to run the business. This results in extensive foreign currency exposure to multinational companies around the world.
Mainly, an entity may carry on foreign activities in two ways.
1) It may have transactions in foreign currencies (eg: Export/import of goods and services)
2) it may have foreign operations (Foreign subsidiary, associates, branch etc.)
IAS 21 provides instructions regarding how to include the foreign currency transactions and foreign operations in the financial statements of an entity and also how to translate these financial into a presentation currency.
One of the primary requirements for an entity to comply with IAS 21 is to identify its functional currency. Functional currency is the currency of the primary economic environment in which the entity operates. ‘The primary economic environment in which an entity operates’ is normally the one in which it mainly generates and expends it’s cash.
Sometimes it might require significant judgement on the management’s part to determine the functional currency of an entity. Hence we have made a humble attempt to jot down the steps which can help in determination of the functional currency of an entity.
Indicators to determine the functional currency of an entity per IAS 21:
An entity considers the following factors in determining its functional currency:
1. Primary Indicators :
(a) The currency:
(i) in which sales prices for its goods and services are denominated and settled.
(ii) Of the country whose competitive forces and regulations mainly determine the sales prices of its goods and services.
(b) The currency that mainly influences labor, material and other costs of providing goods or services (i.e. the currency of an entity’s cost of sales & other expenses)
2. These factors may also provide evidence (secondary indicators) of an entity’s functional currency :
(a) The currency in which funds from financing activities (receipts of debt funds, equity etc.) are generated.
(b) The currency in which receipts from operating activities are usually retained.
3. The following additional factors are considered in determining the functional currency of a foreign operation, and whether its functional currency is the same as that of the reporting entity (i.e the parent entity) :
(a) whether the activities of the foreign operation are :
(i) carried out as an extension of the reporting entity, (eg: the foreign operation only sells goods imported from the reporting entity and remits the proceeds to it.)
(ii) they are being carried out with a significant degree of Independence. (eg : the operation accumulates cash and other monetary items, incurs expenses, generates income and arranges borrowings, all substantially in its local currency.)
(b) whether transactions with the reporting entity are a high or a low proportion of the foreign operation’s activities.
(c) whether cash flows from the activities of the foreign operation directly affect the cash flows of the reporting entity and are readily available for remittance to it.
(d) whether cash flows from the activities of the foreign operation are sufficient to service existing and normally expected debt obligations without funds being made available by the reporting entity.
If the above indicators are mixed & functional currency is not obvious, management must use its judgement to determine the functional currency that most faithfully represents the economic effects of the underlying transactions, events and conditions.
While taking this decision, the management should give priority to the primary indicators in paragraph 1 before considering the indicators in paragraph 2 and 3 as the later ones are designed to provide additional supporting evidence to determine an entity’s functional currency.
Can the functional currency of an entity be changed?
An entity’s functional currency reflects the underlying transactions, events and conditions that are relevant to it. Accordingly, once determined, the functional currency is not changed unless there is a change in those underlying transactions, events and conditions.
What if the functional currency is the currency of a hyper inflationary economy?
If the functional currency is the currency of a hyper inflationary economy, the entity’s financial are restated in accordance with “IAS 29 Financial Reporting in Hyper inflationary Economies”. An entity cannot avoid restatement in accordance with IAS 29 by, for example, adopting as its functional currency a currency other than the functional currency determined in accordance with this Standard (such as the functional currency of its parent).
The determination of functional currency is one of the vital steps for entities dealing in foreign currency transactions. Appropriate determination of functional currency is required for the financial statements to portray a true & fair view of its state of affairs. However this exercise can sometimes be a difficult task & requires appropriate judgement to be made by the management.