Getting your functional currency right

IAS 21 The Effects of Changes in Foreign Exchange Rates requires each entity - whether a standalone 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. Foreign currency items are then translated into the functional currency. If the entity chooses a presentation currency different from its functional currency, transactions and balances are translated again, from the functional currency into the presentation currency.

Using an incorrect functional currency can have a significant impact on an entity’s reported results.

In group financial statements, the results and financial position of each individual entity must be translated from their functional currency into the group’s presentation currency.

What is the functional currency?

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

How does the functional currency hierarchy work?

The diagram below illustrates how the functional currency hierarchy operates. First, we consider the primary indicators, and if those are not conclusive, there are additional indicators.

The hierarchy explicitly gives more importance to paragraph 9 than paragraph 10 of IAS 21. If an entity’s revenues and costs associated with generating those revenues are impacted by, say, US dollar (USD) movements, this is more significant in determining the entity’s functional currency than its funding arrangements.

Example 1 – Functional currency of an individual entity (mining)

Company A is listed on the Australian Securities Exchange (ASX) and has a gold mine in South Africa.

The South African workforce is paid in South African Rands.

Capital equipment is purchased in US dollars.

Gold produced by the mine is sold in US dollars.

Company A is financed by loans in Australian dollars, incurs listing fees in Australian dollars and pays its directors in Australian dollars.

Analysis

Step one - Consider primary indicators

Primary indicators (IAS 21, paragraph 9)	Currency	Comments
The currency that mainly influences selling prices for goods and services	US dollars	The sale price of gold is denominated and settled in US dollars
The currency of the country whose competitive forces and regulations mainly determine the selling prices for goods and services	US dollars	Changes in metal prices often correlate with changes in the US dollar
The currency that mainly influences labour, material and other costs of providing goods and services	Labour costs paid in South African Rands Capital equipment paid in US dollars Listing fees and directors’ fees paid in Australian dollars	Capital equipment is likely to comprise the majority of the cost base of Company A (denominated in US dollars)

Based on its analysis of the primary indicators in IAS 21, paragraph 9, Company A concludes that its functional currency is the US dollar, and therefore, there is no need to assess the additional indicators in paragraph 10.

Example 2 – Functional currency of an individual entity (mining)

Company B is listed in Australia and has a gold mine in Tasmania. 

The workforce is paid in Australian dollars.

Capital equipment is purchased in US dollars, Euros and Australian dollars, with the majority being in US dollars.

The gold produced by the mine is sold in US dollars.

Company B is financed in Australian dollars, incurs listing fees in Australian dollars and pays its directors in Australian dollars. 

Analysis

Step one - Consider primary indicators

Primary indicators (IAS 21, paragraph 9)	Currency	Comments
The currency that mainly influences selling prices for goods and services	US dollars	The sales price of gold is denominated and settled in US dollars
The currency of the country whose competitive forces and regulations mainly determine the selling prices for goods and services	US dollars	Changes in metal prices often correlate with changes in the US dollar
The currency that mainly influences labour, material and other costs of providing goods and services	Labour costs paid in Australian dollars Capital equipment paid in US dollars, Euros and Australian dollars Listing fees and directors’ fees paid in Australian dollars	Capital equipment is likely to comprise the majority of the cost base of Company A (denominated in US dollars)

Although the costs incurred by Company B are denominated in various currencies, based on the primary indicator for goods and services, it concludes that its functional currency is the US dollar.

Example 3 – Functional currency of group entities (mining)

Parent Co is listed in Australia and has a gold mine in South Africa, which operates through Subsidiary Co.

Subsidiary Co pays its South African workforce in South African Rands, purchases capital equipment in US dollars and sells the gold produced in US dollars.

Parent Co is financed by loans in Australian dollars, incurs listing fees in Australian dollars, pays its directors in Australian dollars and pays dividends to its shareholders in Australian dollars. To date, Subsidiary Co has not declared or paid any dividends to Parent Co.

Analysis – Subsidiary Co

Step one - Consider primary indicators

Primary indicators (IAS 21, paragraph 9)	Currency	Comments
The currency that mainly influences selling prices for goods and services	US dollars	The sales price of the gold is denominated and settled in US dollars
The currency of the country whose competitive forces and regulations mainly determine the selling prices for goods and services	US dollars	Changes in metal prices often correlate with changes in the US dollar
The currency that mainly influences labour, material and other costs of providing goods and services	Labour costs paid in South African Rands Capital equipment paid in US dollars	Capital equipment is likely to comprise the majority of the cost base of Company A (denominated in US dollars)

Subsidiary Co concludes that its functional currency is the US dollar.

Analysis – Parent Co

Step one - Consider primary indicators

Primary indicators (IAS 21, paragraph 9)	Currency	Comments
The currency that mainly influences selling prices for goods and services	N/A	Parent Co does not generate revenue from providing goods and services. Its only source of income is dividend income from Subsidiary Co, for which it has received none to date.
The currency of the country whose competitive forces and regulations mainly determine the selling prices for goods and services	N/A	As above
The currency that mainly influences labour, material and other costs of providing goods and services	N/A	Parent Co does not provide any goods or services

Step two - Consider additional indicators

Additional indicators (IAS 21, paragraph 10)	Currency	Comments
The currency in which funds from financing activities are generated	Australian dollars	Funds raised on ASX and Australian loan funding
The currency in which receipts from operating activities are usually retained	Australian dollars	Dividends paid to shareholders are paid in Australian dollars

Considering the additional indicators, Parent Co concludes that its functional currency is Australian dollars.

Alternative view

Another acceptable view would be where Parent Co concludes that it has the same functional currency as Subsidiary Co because:

• Parent Co essentially has no activities of its own other than raising funds, incurring listing and directors’ fees, and ultimately paying dividends to shareholders
• Parent Co’s ability to service its debts and pay dividends to shareholders is dependent on the performance of Subsidiary Co’s gold mine, whose functional currency is US dollars
• Parent Co is acting as an extension of Subsidiary Co.

While paragraph 11 of IAS 21 provides additional factors to consider when determining the functional currency of a foreign operation (one of them being whether the activities of the foreign operation are carried out as an extension of its parent), the reverse does not necessarily apply. However, Parent Co may analogise to IAS 21, concluding that Parent Co is acting as an extension of Subsidiary Co, and that Parent Co’s functional currency is, therefore, US dollars.

Must the entity reassess the functional currency each year?

IAS 21 does not require an annual reassessment of the functional currency. The entity’s functional currency reflects the underlying transactions, events and conditions that are relevant to it. Once determined, the functional currency does not change unless there is a change in the underlying transactions, events and conditions, in which case it must be reassessed.

Businesses conducting exploration and evaluation (E&E) activities that progress to mining development and then production are examples of entities that may typically need to reassess their functional currency more frequently.

Example 4 – Functional currency of group entities (exploration)

Parent Co is listed in Australia and holds various mining tenements in South Africa, which operate through its Subsidiary Co and are still in the E&E phase.

Subsidiary Co pays salaries in Australian dollars, equipment for use on exploration activities is sourced in Australian dollars, and drilling contracts are negotiated and priced in Australian dollars. There is currently no revenue in Subsidiary Co because it is still in the E&E phase.

Parent Co is financed by loans in Australian dollars, incurs listing fees in Australian dollars and pays its directors in Australian dollars.

Analysis – Subsidiary Co

Step one - Consider primary indicators

Primary indicators (IAS 21, paragraph 9)	Currency	Comments
The currency that mainly influences selling prices for goods and services	N/A	Subsidiary Co does not generate revenue from providing goods and services
The currency of the country whose competitive forces and regulations mainly determine the selling prices for goods and services	N/A	As above
The currency that mainly influences labour, material and other costs of providing goods and services	Labour costs are paid in Australian dollars Capital equipment is paid in Australian dollars Drilling contracts priced in Australian dollars.	Although E&E activities do not result in Subsidiary Co providing goods and services, E&E expenses are influenced by the Australian dollar

Subsidiary Co concludes that its functional currency is Australian dollars.

Analysis – Parent Co

Step one - Consider primary indicators

Primary indicators (IAS 21, paragraph 9)	Currency	Comments
The currency that mainly influences selling prices for goods and services	N/A	Parent Co does not generate revenue from providing goods and services
The currency of the country whose competitive forces and regulations mainly determine the selling prices for goods and services	N/A	As above
The currency that mainly influences labour, material and other costs of providing goods and services	N/A	Parent Co does not provide any goods or services

Step two - Consider additional indicators

Additional indicators (IAS 21, paragraph 10)	Currency	Comments
The currency in which funds from financing activities are generated	Australian dollars	Funds raised on ASX and Australian loan funding
The currency in which receipts from operating activities are usually retained	N/A	Subsidiary Co is still in E&E phase, so no dividends are paid to Parent Co

Considering the additional indicators, Parent Co concludes that its functional currency is Australian dollars.

More information

Our webinar contains more information about accounting for the effects of changes in foreign exchange rates.

Need help?

Determining the functional currency of each group entity or foreign operation is a complex and involves significant judgement. Our team of IFRS & Corporate Reporting experts is here to help. Contact us now.