International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards
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• Each entity – whether a stand-alone entity, an entity with foreign operations (such
as a parent) or a foreign operation (such as a subsidiary or branch) – determines its
functional currency. [IAS 21.17]. This is discussed at 4 below.
In the case of group financial statements, it should be emphasised that there is not
a ‘group’ functional currency; each entity included within the group financial
statements, be it the parent, or a subsidiary, associate, joint arrangement or branch,
has its own functional currency.
• Where an entity enters into a transaction denominated in a currency other than its
functional currency, it translates those foreign currency items into its functional
currency and reports the effects of such translation in accordance with the
provisions of IAS 21 discussed at 5 below. [IAS 21.17].
• The results and financial position of any individual entity within the reporting entity
whose functional currency differs from the presentation currency are translated in
accordance with the provisions of IAS 21 discussed at 6 below. [IAS 21.18].
Since IAS 21 permits the presentation currency of a reporting entity to be any
currency (or currencies), this translation process will also apply to the parent’s
figures if its functional currency is different from the presentation currency.
The standard also permits a stand-alone entity preparing financial statements or
an entity preparing separate financial statements in accordance with IAS 27 –
Separate Financial Statements – to present its financial statements in any currency
(or currencies). If the entity’s presentation currency differs from its functional
currency, its results and financial position are also translated into the presentation
currency in accordance with this process. [IAS 21.19].
4
DETERMINATION OF AN ENTITY’S FUNCTIONAL
CURRENCY
4.1 General
Functional currency is defined as the currency of ‘the primary economic environment
in which the entity operates’ (see 2.3 above). This will normally be the one in which it
primarily generates and expends cash. [IAS 21.9].
IAS 21 sets out a number of factors or indicators that any entity should or may need to
consider in determining its functional currency. When the factors or indicators are
mixed and the functional currency is not obvious, management should use its judgement
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to determine the functional currency that most faithfully represents the economic
effects of the underlying transactions, events and conditions. As part of this approach,
management should give priority to the primary indicators before considering the other
indicators, which are designed to provide additional supporting evidence to determine
an entity’s functional currency. [IAS 21.12].
The primary factors that IAS 21 requires an entity to consider in determining its
functional currency are as follows: [IAS 21.9]
(a) the
currency:
(i) 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
(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 labour, material and other costs of providing
goods or services (this will often be the currency in which such costs are
denominated and settled).
Where the functional currency of the entity is not obvious from the above, the following
factors may also provide evidence of an entity’s functional currency: [IAS 21.10]
(a) the currency in which funds from financing activities (i.e. issuing debt and equity
instruments) are generated; and
(b) the currency in which receipts from operating activities are usually retained.
An operation that is ‘integral’ to its parent, i.e. it carries on business as if it were an
extension of the parent’s operations, will always have the same functional currency as
the parent. (In this context, the term parent is drawn broadly and is the entity that has
the foreign operation as its subsidiary, branch, associate or joint arrangement).
[IAS 21.BC6]. Therefore the following additional factors are also considered in determining
the functional currency of a foreign operation, particularly whether its functional
currency is the same as that of the reporting entity: [IAS 21.11]
(a) whether the activities of the foreign operation are carried out as an extension of the
reporting entity, rather than being carried out with a significant degree of autonomy.
An example of the former is when the foreign operation only sells goods imported
from the reporting entity and remits the proceeds to it. An example of the latter is
when 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; and
(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.
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Although the standard says that these factors ‘are’ considered in determining the
functional currency of a foreign operation, this contradicts the requirement in the
standard that management gives priority to the primary indicators before
considering the other indicators. If it is obvious from the primary indicators what
the entity’s functional currency is, then there is no need to consider any of the
other factors.
Example 15.1: Factors to be considered when determining the functional
currency
A French entity (Parent A) has a US subsidiary (Subsidiary B) that produces and sells knitwear in the United States.
It is clear from the primary factors in IAS 21 that Subsidiary B’s functional currency is the US dollar, because
the US dollar mainly influences sales prices for goods, labour, material and other costs of providing goods,
and the competitive forces and regulations that mainly determine the sales prices of the goods are located in
the United States.
However, suppose Subsidiary B is financed by an inter-company loan denominated in euros granted from
Parent A and the cash flows generated by Subsidiary B are transferred to Parent A on a regular basis. Should
these additional factors be taken into account in determining the functional currency of Subsidiary B?
In our view, they should not. These additional factors only have to be considered when it is not obvious from
the primary factors what Subsidiary B’s functional currency is.
However, in practice, there are occasions when the functional currency is not completely clear from the
primary factors and it will often be necessary to consider the other indicators. For example, if Subsidiary B
was not producing the
knitwear itself, but purchasing it from sources outside of the US (such that its operating
costs were not predominantly in US dollars) this would mean that it was no longer obvious based on the
primary factors that its functional currency was the US dollar and the additional factors would be taken into
account in determining Subsidiary B’s functional currency.
Since an entity’s functional currency reflects the underlying transactions, events and
conditions that are relevant to it, once it is determined, IAS 21 requires that the
functional currency is not changed unless there is a change in those underlying
transactions, events and conditions. [IAS 21.13]. The implication of this is that
management of an entity cannot decree what the functional currency is – it is a
matter of fact, albeit subjectively determined fact based on management’s judgement
of all the circumstances.
4.2
Intermediate holding companies or finance subsidiaries
For many entities the determination of functional currency may be relatively
straightforward. However, for some entities, particularly entities within a group, this
may not be the case. One particular difficulty is the determination of the functional
currency of an intermediate holding company or finance subsidiary within an
international group.
Example 15.2: Functional currency of intermediate holding companies or
finance subsidiaries
An international group is headquartered in the UK. The UK parent entity has a functional currency of pound
sterling, which is also the group’s presentation currency. The group has three international sub-operations,
structured as follows:
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UK Parent
£ functional
US Mid Co
German Mid Co
Australian Mid Co
Multiple US Subs
Multiple German Subs
Multiple Australian Subs
(all US$ functional)
(all € functional)
(all Aus$ functional)
What is the functional currency of the three Mid Cos?
There are a variety of factors to be considered for intermediate holding companies or finance subsidiaries
when deciding on the appropriate functional currency. Therefore, there will not be a single analysis applicable
to all such entities.
IAS 21 defines a ‘foreign operation’ as ‘an entity that is a subsidiary...the activities of which are based or
conducted in a country or currency other than those of the reporting entity’ (see 2.3 above). This definition
would seem to suggest that a foreign operation must have its own ‘activities’.
Also, paragraph 9 of the standard states that the functional currency is ‘the currency of the primary economic
environment in which the entity operates’. However, under paragraph 9 this is determined by reference to the
currency that mainly influences sales prices and the operation’s costs, and is therefore not directly relevant to
intermediate holding companies or finance subsidiaries (see 4.1 above). Paragraphs 10 and 11 set out a
number of factors to consider in determining the functional currency of a foreign operation. The theme
running through these factors is the extent to which the activities and cash flows of the foreign operation are
independent of those of the reporting entity.
In the case of an intermediate holding company or finance subsidiary, the acid-test question to consider is
whether it is an extension of the parent and performing the functions of the parent – i.e. whether its role is
simply to hold the investment in, or provide finance to, the foreign operation on behalf of the parent company
or whether its functions are essentially an extension of a local operation (e.g. performing selling, payroll or
similar activities for that operation) or indeed it is undertaking activities on its own account.
This means that subsidiaries that do nothing but hold investments or borrow money on behalf of the parent
will normally have the functional currency of the parent. The borrowings of such companies are frequently
guaranteed by the parent, which is itself likely to be a relevant factor. In other words, on whose credit is the
lender relying? If the lender is looking to the ultimate parent, then the functional currency is likely to be that
of the ultimate parent. However, if the lender is looking to the sub-group, then the functional currency of the
companies in the sub-group will be relevant. Accordingly, any analysis that such a company has a functional
currency other than that of the parent will require careful consideration of the features of the entity which
give rise to that conclusion. Complex situations are likely to require the application of careful management
judgement as indicated by the standard.
As for other entities within a group, each entity should be reviewed for its particular
circumstances against the indicators and factors set out in the standard. This review
requires management to use its judgement in determining the functional currency that
most faithfully represents the economic effects of the underlying transactions, events
and conditions applicable to that entity.
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4.3
Investment holding companies
A similar, but subtly different, issue arises in situations where a group comprises an
investment holding company incorporated in one jurisdiction and a number of
operating subsidiaries which operate in a different jurisdiction and have the local
currency as their functional currency. The question is how to determine the functional
currency of the investment holding company which is often little more than a ‘shell’
with few transactions of its own.
This issue is common for parent companies established in Hong Kong (where the Hong
Kong dollar is the local currency) that have subsidiaries operating in Mainland China
(where Renminbi is the local currency), although very similar situations arise in other
jurisdictions. Often the investment holding company will be listed in Hong Kong, incur
some expenses, e.g. directors’ remuneration, limited staff costs and office rental
payments, in Hong Kong dollars and raise capital (shares and borrowings) in Hong Kong
dollars. Furthermore, dividends from subsidiaries will either be received in Hong Kong
dollars or be converted into Hong Kong dollars on receipt.
In 2010, the IFRS Interpretations Committee was asked to consider this issue and the
staff identified two broad approaches being used in practice, namely:
• the parent uses the currency of its local environment, i.e. the one in which its
operating expenses are denominated, it receives dividends from its subsidiaries
and it raises funding; and
• the parent uses the currency of the local environment of its subsidiaries as its
functional currency as this is the environment which drives the dividend income it
receives, which is its primary source of revenue, i.e. the parent is seen as an
extension of its subsidiaries.
The Interpretations Committee chose not to take the issue onto its agenda because any
guidance it could provide would be in the nature of application guidance and simply
emphasised that judgement needed to be applied.2 In practice the judgement will often
be based on whether the holding company’s operations are co
nsidered sufficiently
substantive to enable it to have a different functional currency from its subsidiaries.
4.4
Branches and divisions
IAS 21 uses the term ‘branch’ to describe an operation within a legal entity that may
have a different functional currency from the entity itself. However, it contains no
definition of that term, nor any further guidance on what arrangements should be
regarded as a branch.
Many countries’ governments have established legal and regulatory regimes that apply
when a foreign entity establishes a place of business (often called a branch) in that
country. Where an entity has operations that are subject to such a regime, it will
normally be appropriate to regard them as a branch and evaluate whether those
operations have their own functional currency. In this context, the indicators in
paragraph 11 of the standard used to assess whether an entity has a functional currency
that is different from its parent (see 4.1 above) will be particularly relevant.
An entity may also have an operation, e.g. a division, that operates in a different
currency environment to the rest of the entity but which is not subject to an overseas
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branch regime. If that operation represents a sufficiently autonomous business unit it
may be appropriate to view it as a branch and evaluate whether it has a functional
currency that is different to the rest of the legal entity. However, in our experience, this
situation will not be a common occurrence.
4.5
Documentation of judgements made
Since the determination of an entity’s functional currency is critical to the translation
process under IAS 21, we believe that an entity should clearly document its decision
about its functional currency, setting out the factors taken into account in making that
determination, particularly where it is not obvious from the primary factors set out in
paragraph 9 of the standard. We recommend that the ultimate parent entity of a group
should do this for each entity within the group and agree that determination with the
local management of those entities, particularly where those entities are presenting
financial statements in accordance with IFRS. Although the determination of functional
currency is a judgemental issue, it would be expected that within the group the same