Translation to the Presentation Currency from the Functional Currency

IAS 21, The Effect of Changes in Foreign Exchange Rates defines Presentation Currency as the currency in which the financial statements are presented. While the Functional Currency was defined as the currency of the primary economic environment in which the entity operates.

As stated in para.38 of IAS 21, an entity may present its financial statements in any currency. If the presentation currency differs from the entity’s functional currency, it translates its results and financial position into the presentation currency.

If the financial statements of the entity are not in the functional currency of a hyperinflationary economy, then the results and financial position shall be translated into a different presentation currency using the following procedures :

1. assets and liabilities for each statement of financial position presented (ie including comparatives) shall be translated at the closing rate at the date of the statement of financial position;
2. income and expenses for each statement of comprehensive income or separate income statement presented (ie including comparatives) shall be translated at exchange rates at the dates of the transactions; and
3. all resulting exchange differences shall be recognised in other comprehensive income.

The exchange differences as stated above which result from :

• translating income and expenses at the exchange rates at the dates of the transactions and assets and liabilities at the closing rate;
• translating the opening net assets at a closing rate that differs from the previous closing rate

Such exchange differences are not recognised in profit or loss because the changes in exchange rates have little or no direct effect on the present and future cash flows from operations. The cumulative amount of the exchange differences is presented in a separate component of equity until disposal of the foreign operation. When the exchange differences relate to a foreign operation that is consolidated but not wholly-owned, accumulated exchange differences arising from translation and attributable to non-controlling interest are allocated to, and recognised as part of non-controlling interests in the consolidated statement of financial position (para.41 of IAS 21).

Further, para. 42 of IAS 21 states that the results and financial position of an entity whose functional currency is the currency of a hyperinflationary economy shall be translated into a different presentation currency using the following procedures :

1. all amounts (ie assets, liabilities, equity items, income and expenses, including comparatives) shall be translated at the closing rate at the date of the most recent statement of financial position, except that
2. when amounts are translated into the currency of a non-hyperinflationary economy, comparative amounts shall be those that were presented as current year amounts in the relevant prior year financial statements (ie not adjusted for subsequent changes in the price level or subsequent changes in exchange rates).

When there is a change in an entity’s functional currency, the entity shall apply the translation procedures applicable to the new functional currency prospectively from the date of the change (para.35 of IAS 21) (Hrd).

Capitalisation of Exchange Differences, permissible or not ?

IAS 21, The Effect of Changes in Foreign Exchange Rates requires recognition of foreign exchange differences as income or expense in the period in which they arise.

Previously, there had been an allowed alternative treatment for certain losses incurred due to effects of exchange rate changes in foreign-denominated obligations associated with asset acquisition. This allowed alternative treatment resulted in capitalization of the loss.

Revised IAS 21 removes the limited option in the previous version of IAS 21 to capitalise exchange differences resulting from a severe devaluation or depreciation of a currency against which there is no means of hedging. Under IAS 21, such exchange differences are now recognised in profit or loss. Consequently, SIC-11, which outlined restricted circumstances in which such exchange differences may be capitalised, has been superseded since capitalisation of such exchange differences is no longer permitted in any circumstances (IAS 21 Paragraph IN10).

Following are further explanation to removed the previously allowed alternative treatment of capitalisation of exchange differences as stated in Basic for Conclusions on IAS 21 :

BC24 - The previous version of IAS 21 allowed a limited choice of accounting for exchange differences that arise ‘from a severe devaluation or depreciation of a currency against which there is no practical means of hedging and that effects liabilities which cannot be settled and which arise directly on the recent acquisition of an asset’. The benchmark treatment was to recognise such exchange differences in profit or loss. The allowed alternative was to recognise them as an asset.

BC25 – The Board noted that the allowed alternative (of recognition as an asset) was not in accordance with the Framework for the Preparation and Presentation of Financial Statements because exchange losses do not meet the definition of an asset. Moreover, recognition of exchange losses as an asset is neither allowed nor required by any liaison standard-setter, so its deletion would improve convergence. Finally, in many cases when the conditions for recognition as an asset are met, the asset would be restated in accordance with IAS 29 Financial Reporting in Hyperinflationary Economies. Thus, to the extent that an exchange loss reflects hyperinflation, this effect is taken into account by IAS 29. For all of these reasons, the Board removed the allowed alternative treatment and the related SIC Interpretation is superseded.

WATCH OUT!

According to IAS 23, Borrowing Costs, an entity shall capitalise borrowing costs that are directly attributable to the acquisition, construction or production of a qualifying asset as part of the cost of that asset. Borrowing costs may include exchange differences arising from foreign currency borrowings to the extent that they are regarded as an adjustment to interest costs.

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Considering an entity’s Functional Currency

When a reporting entity prepares financial statements, IAS 21, The Effects of Changes in Foreign Exchange Rates, requires each individual entity included in the reporting entity – whether it is a stand-alone entity, an entity with foreign operations (such as a parent) or a foreign operation (such as a subsidiary or branch) – to determine its functional currency and measure its results and financial position in that 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.

An entity considers the following factors in determining its functional currency :

1. the currency that mainly influences sales prices for goods and services (this will often be the currency in which sales prices for its goods and services are denominated and settled); and
2. the currency of the country whose competitive forces and regulations mainly determine the sales prices of its goods and services
3. the currency that mainly influences labor, material and other costs of providing goods or services (this will often be the currency in which such costs are denominated and settled
4. the currency in which funds from financing activities (ie issuing debt and equity instruments) are generated
5. the currency in which receipts from operating activities are usually retained

The first three items are generally considered to be the most influential in deciding the functional currency.

The entity’s functional currency reflects the underlying transactions, events, and conditions under which the entity conducts its business. Accordingly, once determined, the functional currency is not changed unless there is a change in those underlying transactions, events and conditions.

If the functional currency is the currency of a hyperinflationary economy, the entity’s financial statements are restated in accordance with IAS 29, Financial Reporting in Hyperinflationary Economies.

Where there is a change in the functional currency, it should be applied from the date of change. A change must be linked to a change in the nature of the underlying transactions. For example, a change in the major market may lead to a change in the currency that influences sales prices. The change is accounted for prospectively, not retrospectively (HRD).

The Objective and Scope of IAS 21

OBJECTIVES - The purpose of IAS 21, The Effects of Changes in Foreign Exchange Rates, is to set out how to account for transactions in foreign currencies and foreign operations. The Standard also shows how to translate financial statements into a presentation currency. The presentation currency is the currency in which the financial statements are presented. The key issues are the exchange rate(s) that should be used and where the effects of changes in exchange rates are reported in the financial statements.

SCOPE – As stated in paragraph 3 of IAS 21, the Standard shall be applied :

(a) in accounting for transactions and balances in foreign currencies, except for those derivative transactions and balances that are within the scope of IAS 39, Financial Instruments : Recognition and Measurement and IFRS 9, Financial Instruments;

(b) in translating the results and financial position of foreign operations that are included in the financial statements of the entity by consolidation, proportionate consolidation or the equity method; and

(c) in translating an entity’s results and financial position into a presentation currency.

Further, paragraph 4 of IAS 21 states that IFRS 9 and IAS 39 apply to many foreign currency derivatives and, accordingly, these are excluded from the scope of this Standard. However, those foreign currency derivatives that are not within the scope of IFRS 9 and IAS 39 (e.g., some foreign currency derivatives that are embedded in other contracts) are within the scope of this Standard.

In addition, this Standard applies when an entity translates amounts relating to derivatives from its functional currency to its presentation currency.

This Standard does not apply to hedge accounting for foreign currency items, including the hedging of a net investment in a foreign operation. IAS 39 applies to hedge accounting.

This Standard applies to the presentation of an entity’s financial statements in a foreign currency and sets out requirements for the resulting financial statements to be described as complying with IFRSs. For translations of financial information into a foreign currency that do not meet these requirements, this Standard specifies information to be disclosed.

This Standard does not apply to the presentation in a statement of cash flows of the 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 (Hrd).