International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards

by International GAAP 2019 (pdf)

  In practice, contracts can be more complex than suggested above and often give rise

  to situations where the purchaser can influence or control the crystallisation of the

  contingent payments, e.g. where the contingent payments are dependent on the

  purchaser’s future actions – such as those that take the form of production-based

  royalties. These complexities can raise broader questions about the nature of the

  obligations and, as in the case of royalty-based contingent payments, the appropriate

  accounting standard to apply initially, as well as how to account for subsequent

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  adjustments to any liability that may have been recognised. To date, these

  complexities and lack of clarity as to the appropriate accounting have led to various

  treatments, including:

  • the cost of the asset does not initially include any amount relating to the contingent

  element. Any subsequent payments made in relation to the contingent element are

  either adjusted against the cost of the asset (once paid) or recognised in profit or

  loss as incurred;

  • the cost of the asset includes an estimate of the contingent consideration at the

  date of purchase. Subsequent changes in the liability relating to the contingent

  consideration are then recognised in profit or loss; or

  • the cost of the asset includes an estimate of the contingent consideration at the

  date of purchase. Subsequent changes in the liability relating to the contingent

  consideration that do not reflect the passage of time are adjusted against the cost

  of the asset.

  The first approach (which is relatively common in the extractive industries) considers

  that the applicable standard is IAS 37, and applies the concepts of obligating events,

  probability, contingencies and not providing for future operations. This means that

  nothing relating to the contingent payment is recognised at the date of purchase. The

  second approach applies the methodology in IFRS 3, while the third is based on the

  principles of IFRIC 1.106

  Given this divergence in practice, this issue was referred to the Interpretations

  Committee in January 2011. The Committee and the IASB have discussed this issue for

  a number of years since this date. They had been attempting to clarify how the initial

  recognition and subsequent changes in relation to such contingent consideration should

  be recognised but did not conclude.

  In March 2016, the Interpretations Committee determined that this issue was too

  broad for it to address within the confines of existing IFRSs. The Interpretations

  Committee decided not to add this issue to its agenda and concluded that the IASB

  should address the accounting for variable payments comprehensively. In

  February 2018, the IASB decided that in the following few months, staff should aim to

  carry out work on ‘Variable and Contingent Consideration’ to assess how broad that

  research project should be. This research project is not yet active, but the IASB

  expects to start, or restart work before the next Agenda Consultation, which is

  expected to begin around 2021.

  Until the Interpretations Committee and/or IASB progress this issue and the matter is

  resolved, an entity must capitalise expenditure that meets the definition of an asset,

  although it may choose not to recognise these costs until incurred. For other variable

  costs, it has the option to either:

  (i) not capitalise on initial recognition and expense variable payments; or

  (ii) capitalise them at their fair value on initial recognition and recognise the changes

  in contingent consideration in profit or loss or as an asset if certain conditions

  are met.

  The accounting policy must be applied consistently.

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  For further information on this issue see Chapter 17 at 4.5, Chapter 18 at 4.1.9 and

  Chapter 41 at 3.8.

  8.4.2

  Accounting for land acquisitions

  Obtaining the legal rights to explore for, develop and produce minerals can be achieved

  in a number of ways, as outlined at 5 above. One of these ways is through the outright

  purchase of the minerals and the land on, or under, which the minerals are located. In

  undertaking such a transaction, it is not uncommon for an entity to pay an amount in

  excess of the intrinsic value of the land itself. In such a situation, an entity needs to

  ensure it appropriately allocates the purchase price between the fair value of the land

  and the fair value of the mineral or surface mining rights acquired. The amount allocated

  to land will be capitalised and not depreciated, whereas the amount allocated to the

  minerals or surface mining rights will form part of the total cost of mining assets and will

  ultimately be depreciated on a units of production basis over the economically

  recoverable reserves to which it relates.

  9 FUNCTIONAL

  CURRENCY

  9.1

  Determining functional currency

  Determining functional currency correctly is important because it will, for example,

  affect volatility of revenue and operating profit resulting from exchange rate

  movements, determine whether transactions can be hedged or not and influence the

  identification of embedded currency derivatives. The movements may give rise to

  temporary differences that affect profit or loss. [IAS 12.41]. While under IAS 21 – The

  Effects of Changes in Foreign Exchange Rates – an entity can select any presentation

  currency, it does not have a free choice in determining its functional currency. Choice

  of functional currency is discussed in detail in Chapter 15 at 4; below is a summary of

  the application of the requirements to the extractive industries.

  IAS 21 requires an entity to determine separately the functional currency of each entity

  within a consolidated group. There is no concept of the functional currency of the

  group, only a presentation currency. Therefore, the functional currency of an operating

  subsidiary may differ from that of the group’s parent and/or foreign sales company to

  which it sells its production. The factors taken into account in determining functional

  currency may differ for operating companies and for group entities that are financing or

  intermediate holding companies (see Chapter 15 at 4.2). IAS 21 requires an entity to

  consider the following factors in determining its functional currency:

  (a) 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);

  (b) the currency of the country whose competitive forces and regulations mainly

  determine the sales prices of its goods and services; and

  (c) 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). [IAS 21.9].

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  While the currency referred to under (a) above will often be the currency in which

  sales prices for its goods and services are denominated and settled, this is not always

  the case. The US dollar is used for many commodities as the contract or
settlement

  currency in transactions (e.g. iron ore, oil), but the pricing of transactions is often

  driven by factors completely unrelated to the US dollar or the US economy (e.g. it

  may be influenced more by demand from the local economy or other economies

  such as China).

  As the extractive industries are international, it is often difficult to determine the

  currency of the country whose competitive forces and regulations mainly determine the

  sales prices of its goods and services. Therefore, factor (b) above will often prove to be

  inconclusive when a particular product is produced in many different countries.

  It will generally be fairly straightforward to identify the currency that mainly

  influences an entity’s key inputs (i.e. factor (c) above). In developing countries an

  entity will often need to import a significant proportion of its key inputs (e.g. fuel,

  equipment and expatriate workers) and even local inputs in an economy with a high

  inflation rate will often be linked to the US dollar. In such a case, the local currency is

  less likely to be the main currency that influences an entity’s key inputs. In most

  developed countries, however, the inputs tend to be denominated in the local

  currency, although some inputs (e.g. major items of equipment) may be denominated

  in another currency. As the extractive industries are capital intensive, the cost of

  equipment often far exceeds the operating expenses incurred. Equipment is often

  purchased in US dollars.

  When the factors (a) to (c) above are mixed, as they often are in practice, and the

  functional currency is not obvious, management should use ‘its judgement to determine

  the functional currency that most faithfully represents the economic effects of the

  underlying transactions, events and conditions’. [IAS 21.12]. If the above factors are

  inconclusive then an entity should also consider the following secondary factors:

  • the currency in which funds from financing activities (i.e. issuing debt and equity

  instruments) are generated;

  • the currency in which receipts from operating activities are usually retained; and

  • the functional currency of the reporting entity that has the foreign operation as its

  subsidiary, branch, associate or joint venture. [IAS 21.10, 11].

  After considering both the primary and secondary factors the functional currency may

  not be obvious because, for example, revenue is denominated in US dollars while

  virtually all expenses are denominated in the local currency. In that situation

  management may conclude that revenue, while denominated in US dollars, is in fact

  influenced by a basket of currencies. It is therefore possible that companies operating

  in a similar environment can reach different conclusions about their functional

  currency. Even in developed countries there is a general bias towards the US dollar as

  the functional currency.

  Although local statutory and tax requirements should be ignored in determining the

  functional currency, there may be a requirement to keep two sets of accounting records

  when an entity concludes that its local currency is not its functional currency.

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  The extract below from Rio Tinto illustrates a typical currency translation accounting

  policy of a mining company.

  Extract 39.15: Rio Tinto plc (2017)

  Notes to the 2017 financial statements [extract]

  1 Principal accounting policies [extract]

  (d) Currency translation

  The functional currency for each entity in the Group, and for joint arrangements and associates, is the currency of the

  primary economic environment in which that entity operates. For many of these entities, this is the currency of the

  country in which they are located. Transactions denominated in other currencies are converted to the functional

  currency at the exchange rate ruling at the date of the transaction. Monetary assets and liabilities denominated in

  foreign currencies are retranslated at period-end exchange rates.

  The Group’s financial statements are presented in US dollars, as that presentation currency most reliably reflects the

  global business performance of the Group as a whole. On consolidation, income statement items for each entity are

  translated from the functional currency into US dollars at average rates of exchange, except for material one-off

  transactions, which are translated at the rate prevailing on the transaction date. Balance sheet items are translated into US dollars at period-end exchange rates.

  Exchange differences arising on the translation of the net assets of entities with functional currencies other than the

  US dollar are recognised directly in the currency translation reserve. These translation differences are shown in the

  statement of comprehensive income, with the exception of translation adjustments relating to Rio Tinto Limited’s

  share capital which are shown in the statement of changes in equity.

  Where an intragroup balance is, in substance, part of the Group’s net investment in an entity, exchange gains and

  losses on that balance are taken to the currency translation reserve.

  Except as noted above, or in note 1(p) relating to derivative contracts, all other exchange differences are charged or

  credited to the income statement in the year in which they arise.

  9.2

  Changes in functional currency

  IAS 21 requires management to use its judgement to determine the entity’s functional

  currency so that it most faithfully represents the economic effects of the underlying

  transactions, events and conditions that are relevant to the entity. Note that IAS 21

  requires the functional currency to be determined by reference to factors that exist

  during the reporting period. Therefore, an entity should ignore future developments

  in its business, no matter how likely those developments are. For example, even if an

  entity is convinced that in three years’ time it will have revenues that will be

  denominated in US dollars, this is not a factor to be considered in determining its

  functional currency today. This is particularly relevant for entities in the extractive

  industries given the nature of their operations. For example, a company may conclude

  that during the development phase of the project the local currency is its functional

  currency but that once production and sales commence the US dollar will become its

  functional currency. Alternatively, exposure to a particular currency may increase

  during a period.

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  This is illustrated in the extract below from Woodside Petroleum’s 2010 financial

  statements.

  Extract 39.16: Woodside Petroleum Ltd (2010)

  Overview

  CHIEF FINANCIAL OFFICER’S REPORT [extract]

  Funding our growth plans and sustaining superior shareholder returns [extract]

  US dollar functional currency implemented

  With approximately 90% of revenue and more than 90% of debt denominated in US dollars, Woodside’s directors

  adopted a US dollar functional currency and presentation currency for the purpose of all financial reporting, effective

  1 January 2010. This change provides shareholders with a more accurate reflection of the company’s underlying

  performance, while increasing comparability of our financial results with those of our industry peers.

  The
one-off impacts of this change are highlighted in the Notes to the Financial Report.

  Notes to and forming part of the Financial Report continued [extract]

  For the year ended 31 December 2010

  1. Summary of significant accounting policies (continued) [extract]

  (a) Basis of preparation (continued) [extract]

  Change in functional and presentation currency

  An entity’s functional currency is the currency of the primary economic environment in which the entity operates.

  Woodside Petroleum Ltd has experienced a period of sustained growth in US dollar revenue streams and in the period

  up to 31 December 2009 increased its US dollar debt levels significantly. Consequently, the company announced on

  22 March 2010 that the directors had determined that the functional currency of the company and all its subsidiaries

  is US dollars. The change in functional currency has been applied prospectively with effect from 1 January 2010 in

  accordance with the requirements of the Accounting Standards.

  Following the change in functional currency, Woodside Petroleum Ltd has elected to change its presentation currency

  from Australian dollars to US dollars. The directors believe that changing the presentation currency to US dollars

  will enhance comparability with its industry peer group, the majority of which report in US dollars. The change in

  presentation currency represents a voluntary change in accounting policy, which has been applied retrospectively.

  To give effect to the change in functional currency, the assets and liabilities of entities with an Australian dollar

  functional currency at 31 December 2009 were converted into US dollars at a fixed exchange rate on 1 January 2010

  of US$1:A$1.1193 and the contributed equity, reserves and retained earnings were converted at applicable historical

  rates. In order to derive US dollar comparatives (presentation currency), the Australian dollar functional currency

  assets and liabilities at 31 December 2009 were converted at the spot rate of US$1:A$1.1193 on the reporting date;

  revenue and expenses for the year ended 31 December 2009 were converted at the average exchange rate of

  US$1:A$1.261 for the reporting period, or at the exchange rates ruling at the date of the transaction to the extent

  practicable, and equity balances were converted at applicable historical rates.

  The above stated procedures resulted in a foreign currency translation reserve of US$594 million on 1 January 2009. Earnings per share for 2009 has also been restated in US dollars to reflect the change in the presentation currency (refer to Note 5).