The objective of IAS 21 is to prescribe: (1) how to include foreign currency transactions and foreign operations in the financial statements of an entity, and (2) how to translate financial statements into a presentation currency. The scope of IAS 21 applies to:
1. Accounting for transactions and balances in foreign currencies, except for those derivative transactions and balances that are within the scope of IFRS 9, Financial Instruments. However, those foreign currency derivatives that are not within the scope of IFRS 9 (e.g., some foreign currency derivatives that are embedded in other contracts), and the translation of amounts relating to derivatives from its functional currency to its presentation currency are within the scope of this standard;
2. Translating the financial position and financial results of foreign operations that are included in the financial statements of the reporting entity as a result of consolidation or the equity method; and
3. Translating an entity's financial statements into a presentation currency.
IAS 21 does not apply to the presentation, in the statement of cash flows, of cash flows arising from transactions in a foreign currency, or to the translation of cash flows of a foreign operation, which are within the scope of IAS 7, Statement of Cash Flows.
IAS 21 does not apply also to hedge accounting of foreign currency items, including the hedging of net investment in a foreign operation. These are covered under IFRS 9 and are dealt with in this chapter under the section “Hedging.”
Functional Currency
The concept of functional currency is key to understanding translation of foreign currency financial statements. Functional currency is defined as being the currency of the primary economic environment in which an entity operates. This is normally, but not necessarily, the currency in which that entity principally generates and expends cash.
In determining the relevant functional currency, an entity would give primary consideration to the following factors:
1. The currency that mainly influences sales prices for goods and services, as well as the currency of the country whose competitive forces and regulations mainly determine the sales prices of the entity's goods and services; and
2. The currency that primarily influences labour, material and other costs of providing those goods or services.
Note that the currency which influences selling prices is often that currency in which sales prices are denominated and settled, while the currency that most influences the various input costs is normally that in which input costs are denominated and settled. There are many situations in which input costs and output prices will be denominated in or influenced by differing currencies (e.g., an entity which manufactures all of its goods in Mexico, using locally sourced labour and materials, but sells all or most of its output in Europe in euro‐denominated transactions).
In addition to the foregoing, IAS 21 notes other factors which may provide additional evidence of an entity's functional currency. These may be deemed secondary considerations, and these are:
1. The currency in which funds from financing activities (i.e., from the issuance of debt and equity instruments) are generated; and 2. The currency in which receipts from operating activities are usually retained.
In making a determination of whether the functional currency of a foreign operation (e.g., a subsidiary, branch, associate or joint venture) is the same as that of the reporting entity (parent, investor, etc.), certain additional considerations may also be relevant. These include:
1. Whether the activities of the foreign operation are carried out as an extension of the reporting entity, rather than being executed more or less autonomously;
2. What proportion of the foreign operation's activities is comprised of transactions with the reporting entity;
3. Whether the foreign operation's cash flows directly impact upon the cash flows of the reporting entity, and are available for prompt remittance to the reporting entity; and
4. Whether the foreign operation is largely cash flow independent (i.e., if its own cash flows are sufficient to service its existing and reasonably anticipated debts without the injection of funds by the reporting entity).
Foreign operations are characterised as being adjuncts of the operations of the reporting entity when, for example, the foreign operation only serves to sell goods imported from the reporting entity and in turn remits all sales proceeds to the reporting entity. On the other hand, the foreign operation is seen as being essentially autonomous when it accumulates cash and other monetary items, incurs expenses, generates income and arranges borrowings, all done substantially in its local currency.
In practice, there are many gradations along the continuum between full autonomy and the state of being a mere adjunct to the reporting entity's operations. When there are mixed indications, and thus the identity of the functional currency is not obvious, judgement is required to make this determination. The selection of the functional currency should most faithfully represent the economic effects of the underlying transactions, events and conditions. According to IAS 21, however, priority attention is to be given to the identity of the currency (or currencies) that impact selling prices for outputs of goods and services, and inputs for labour and materials and other costs. The other factors noted above are to be referred to secondarily, when a clear conclusion is not apparent from considering the two primary factors.
Example—Determining functional currency
A US‐based company, Majordomo, Inc., has a major subsidiary located in the UK, John Bull Co., which produces and sells goods to customers almost exclusively in the EU. Transactions are effected primarily in euros both for sales and, to a lesser extent, for raw materials purchases. The functional currency is determined to be euros in this instance, given the facts noted. Transactions are to be measured in euros accordingly. For purposes of the John Bull Co.'s stand‐alone financial reporting, euro‐based financial data will be translated into pounds sterling, using the translation rules set forth in IAS 21. For consolidation of the UK subsidiary into the financial statements of parent entity Majordomo, Inc., translation into US dollars will be required, again using the procedures defined in the standard.
In some cases, the determination of functional currency can be complex and time‐consuming. The process is difficult especially if the foreign operation acts as an investment company or holding company within a group and has few external transactions. Management must document the approach followed in the determination of the functional currency for each entity within a group—particularly when factors are mixed and
judgement is required.
Once determined, an entity's functional currency will rarely be altered. However, since the entity's functional currency is expected to reflect its most significant underlying transactions, events and conditions, there obviously can be a change in functional currency if there are fundamental changes in those circumstances. For example, if the entity's manufacturing and sales operations are relocated to another country, and inputs are thereafter sourced from that new location, this may justify changing the functional currency for that operation. When there is a change in an entity's functional currency, the entity should apply the translation procedures applicable to the new functional currency prospectively from the date of the change.
If the functional currency is the currency of a hyperinflationary economy, as that term is defined under IAS 29, Financial Reporting in
Hyperinflationary Economies, the entity's financial statements are restated in accordance with the provisions of that standard. IAS 21 stresses that an entity cannot avert such restatement by employing tactics such as adopting an alternate functional currency, such as that of its parent entity.
There are currently very few such economies in the world, but this situation of course may change in the future. There are also instances that have been noted where economies have experienced severe hyperinflation and have been unable to restate their financial statements in terms of the procedures required by IAS 29 due to the unavailability of reliable information on restatement factors. The difficulties experienced by reporters in such jurisdictions have been addressed by the IASB, in that IFRS 1, First‐time Adoption of International Financial Reporting Standards, was amended and now permits the readoption of IFRS by such entities through the application of exceptions and exemptions provided for in this standard.
Monetary and Non ‐ Monetary Items
For purposes of applying IAS 21, it is important to understand the distinction between monetary and non‐monetary items. Monetary items are those granting or imposing “a right to receive, or an obligation to deliver, a fixed or determinable number of units of currency.” In contrast, non‐ monetary items are those exhibiting “the absence of a right to receive, or an obligation to deliver, a fixed or determinable number of units of currency.” Examples of monetary items include accounts and notes receivable; pensions and other employee benefits to be paid in cash;
provisions that are to be settled in cash; and cash dividends that are properly recognised as a liability. Examples of non‐monetary items include inventories; amounts prepaid for goods and services (e.g., prepaid insurance); property, plant and equipment; goodwill; other intangible assets;
and provisions that are to be settled by the delivery of a non‐monetary asset.
FOREIGN CURRENCY TRANSACTIONS
Foreign currency transactions are those denominated in, or requiring settlement in, a foreign currency. These can include such common transactions as those arising from:
1. The purchase or sale of goods or services in transactions where the price is denominated in a foreign currency;
2. The borrowing or lending of funds, where the amounts owed or to be received are denominated in a foreign currency; or
3. Other routine activities such as the acquisition or disposal of assets, or the incurring or settlement of liabilities, if denominated in a foreign currency.
Under the provisions of IAS 21, foreign currency transactions are to be initially recorded in the functional currency by applying to the foreign currency‐denominated amounts the spot exchange rate between the functional currency and the foreign currency at the date of the transaction.
However, when there are numerous, relatively homogeneous transactions over the course of the reporting period (e.g., year), it is acceptable, and much more practical, to apply an appropriate average exchange rate provided such an average would approximate the spot rates applicable. In the simplest scenario, the simple numerical average (i.e., the midpoint between the beginning and ending exchange rates) could be used. Care must be exercised to ensure that such a simplistic approach is actually meaningful, however.
If exchange rate movements do not occur smoothly throughout the reporting period, or if rates move alternately up and down over the reporting interval, rather than monotonically up or down, then a more carefully constructed, weighted‐average exchange rate should be used. Also, if transactions occur in other than a smooth pattern over the period—as might be the case for products characterised by seasonal sales—then a weighted‐average exchange rate might be needed if exchange rates have moved materially over the course of the reporting period. For example, if the bulk of revenues is generated in the fourth quarter, the annual average exchange rate would probably not result in an accurately translated statement of comprehensive income.
IFRIC 22, Foreign Currency Transactions and Advance Consideration, was issued by the IASB in December 2016. This interpretation was issued to clarify how to determine the transaction date in situations where an advance payment was made or received in a foreign currency and a non‐monetary asset/liability was raised (as the case may be) before initial recognition of the related asset/expense or income in IAS 21.
The IFRIC clarified that the transaction date (and thus the spot rate) to be used in recognising the asset/expense or income on derecognition of the advance payment or receipt (non‐monetary asset/liability) is the date on which the entity initially recognised the non‐monetary assets/liability arising from the advance payment or receipt.
This IFRIC does not apply when the related asset/expense or income is measured on initial recognition at fair value or at the fair value of the consideration paid or received at a date other than the initial recognition of the non‐monetary asset/liability arising from the advanced consideration (for example, the IFRIC refers to the measurement of goodwill as described in IFRS 3). Additionally, it is not required that the interpretation is applied to income taxes and insurance contracts (including reinsurance contracts) issued or reinsurance contracts held by the entity.
Example—Continuing need to translate foreign currency denominated events
Continuing the preceding example, the UK‐based subsidiary, John Bull Co., which produces and sells goods to customers almost exclusively in the EU, also had sizeable sales to a Swiss company, denominated in Swiss francs. These occurred primarily in the fourth quarter of the year, when the Swiss franc‐euro exchange rate was atypically strong. In converting these sales to the functional currency (euros), the average exchange rate in the fourth quarter was deemed to be most relevant.
Subsequent to the date of the underlying transaction, there may be a continuing need to translate the foreign currency‐denominated event into the entity's functional currency. For example, a purchase or sale transaction may have given rise to an account payable or an account receivable, which remains unsettled at the next financial reporting date (e.g., the following month‐end). According to IAS 21, at each end of the reporting period the foreign currency monetary items (such as payables and receivables) are to be translated using the closing rate (i.e., the exchange rate at the date of the statement of financial position).
Example—Exchange differences
If John Bull Co. (from the preceding examples) acquires receivables denominated in a foreign currency, Swiss francs (CHF), in 202X, these are translated into the functional currency, euros, at the date of the transaction. If the CHF‐denominated receivables are still outstanding at year end, the company will translate those (ignoring any allowance for uncollectables) into euros at the year‐end exchange rate. If these remain outstanding at the end of 202X+1 (again ignoring collectability concerns), these will be translated into euros using the year end 202X+1 exchange rate.
To the extent that exchange rates have changed since the transaction occurred (which will likely happen), exchange differences will have to be recognised by the reporting entity, since the amount due to or from a vendor or customer, denominated in a foreign currency, is now more or less valuable than when the transaction occurred.
Example—Non ‐ monetary items
Assume now that John Bull Co. acquired the above‐noted receivables denominated in Swiss francs in mid‐202X, when the exchange rate of the Swiss franc versus the euro was CHF 1 = €.65. At year end 202X, the rate is CHF 1 = €.61, and by year end 20XX+1, the euro has further strengthened to CHF 1 = €.58. Assume that John Bull acquired CHF 10,000 of receivables in mid‐202X, and all remain outstanding at year end 202X+1. (Again, for purposes of this example only, ignore collectability concerns.)
At the date of initial recognition, John Bull records accounts receivable denominated in CHF in the euro equivalent value of €6,500, since the euro is the functional currency. At year end 202X these receivables are the equivalent of only €6,100, and as a result a loss of €400, which must be recognised in the company's 202X profit and loss statement. In effect, by holding CHF‐denominated receivables while the Swiss franc declined in value against the euro, John Bull suffered a loss. The Swiss franc further weakens over 202X+1, so that by year end 202X+1 the CHF 10,000 of receivables will be worth only €5,800, for a further loss of €300 in 202X+1, which again is to be recognised currently in John Bull's profit and loss statement.
Non‐monetary items (such as property purchased for the company's foreign operation), on the other hand, are to be translated at historical exchange rates. The actual historical exchange rate to be used, however, depends on whether the non‐monetary item is being reported on the historical cost basis, or on a revalued basis, in those instances where the latter method of reporting is permitted under IFRS. If the non‐monetary items are measured in terms of historical cost in a foreign currency, then these are to be translated by using the exchange rate at the actual historical date of the transaction. If the item has been restated to a fair value measurement, then it must be translated into the functional currency by applying the exchange rate at the date when the fair value was determined.
Example—Historical cost accounting employed by reporting entity
Assume that John Bull Co. acquired machinery from a Swiss manufacturer, in a transaction denominated in Swiss francs in 202X, when the CHF–euro exchange rate was CHF 1 = €.65. The price paid was CHF 250,000. For purposes of this example, ignore depreciation. At the transaction date, John Bull Co. records the machinery at €162,500. This same amount will be presented in the year end 202X and 202X+1 statements of financial position. The change in exchange rates subsequent to the transaction date will not be considered, since machinery is a non‐monetary asset.
Example—Revaluation accounting employed by reporting entity
Assume again that John Bull Co. acquired machinery from a Swiss manufacturer, in a transaction denominated in Swiss francs in 202X, when the CHF–euro exchange rate was CHF 1 = €.65. The price paid was CHF 250,000. For purposes of this example, ignore depreciation. At year end 202X, John Bull Co. elects to use the allowed alternative method of accounting under IAS 16, and determines that the fair value of the machinery is CHF 285,000. In the entity's year end statement of financial position, this is reported at the euro equivalent of the revalued amount, using the exchange rate at the revaluation date, or €173,850 (= CHF 285,000 × €.61). This same amount will appear in the 202X+1 statement of financial position (assuming no further revaluation is undertaken post‐202X).
If a non‐monetary asset was acquired in a foreign currency transaction by incurring debt which is to be repaid in the foreign currency (e.g., when a building for the foreign operation was financed locally by commercial debt), subsequent to the actual transaction date the translation of the asset and the related debt will be at differing exchange rates (unless rates remain unchanged, which is not likely to happen). The result will be either a gain or a loss, which reflects the fact that a non‐monetary asset was purchased but the burden of the related obligation for future payment will vary as the exchange rates fluctuate over time, until the debt is ultimately settled—in other words, the reporting entity has assumed exchange rate risk.
On the other hand, if the debt were obtained in the reporting (parent) entity's home country or were otherwise denominated in the buyer's functional currency, there would be no exchange rate risk and no subsequent gain or loss resulting from such an exposure.
Example—Other situations
Assume now that John Bull Co. acquired machinery from a Swiss manufacturer, in a transaction denominated in Swiss francs in 202X, when the CHF–euro exchange rate was CHF 1 = €.65. The price paid was CHF 250,000. For purposes of this example, ignore depreciation. At the transaction date, John Bull Co. records the machinery at €162,500. This same amount will be presented in the year end 202X and 202X+1 statements of financial position. The change in exchange rates subsequent to the transaction date will not be considered, since machinery is a non‐monetary asset.
However, the purchase of the machinery was effected by signing a five‐year note, payable in Swiss francs. Assume for simplicity the note is not subject to amortisation (i.e., due in full at maturity). The note is recorded, at transaction date, as a liability of €162,500. However, at year‐end 202X, since the euro has strengthened, the obligation is the equivalent of €152,500. As a result, an exchange gain of €10,000 is reported in profit or loss in the current period.
At year‐end 202X+1, this obligation has the euro‐equivalent value of €145,000, and thus a further gain of €7,500 is recognised by John Bull Co.
for financial reporting purposes.
Had the machinery been acquired for a euro‐denominated obligation of €162,500, this valuation would remain in the financial statements until ultimately retired. In this case, the Swiss machinery manufacturer, not the British customer (whose functional currency is the euro), accepted exchange rate risk, and John Bull Co. will report no gain or loss arising from exchange differences.
Other complications can arise when accounting for transactions executed in a foreign currency. IAS 21 identifies circumstances where the