Functional Currency, Exchange Gains & Losses and Foreign Monetary Assets and Liabilities

Mr. Arth, an accountant at Peace Ltd, was narrating challenges a Phase II company has in terms of foreign currency transactions. The Company has global operations. As a result, there are transactions in multiple currencies such as INR, USD, GBP, AED, and SGD.

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Traditionally, he had been following AS 11 for accounting and translating transactions in foreign currencies to INR. He was well aware of two approaches under AS 11 – Integrated Foreign Operations (IFO) and Non-Integrated Foreign Operations (NIFO). In his recent conversation with auditors, he realised that his company has to comply Ind AS 21 from April 1, 2017.

Since Peace Ltd would have to adopt Ind AS for the financial year 2017-18, Mr. Arth decided to track down the changes between AS and Ind AS. While going through Ind AS 21, The Effects of Changes in Foreign Exchange Rates, Mr. Arth came across three terms:

  1. Presentation Currency,
  2. Functional Currency, and
  3. Foreign Currency

‘Presentation Currency’ and ‘Foreign Currency’ seemed familiar and similar to terms used in AS 11, but the concept of ‘Functional Currency’ was clearly a new concept.  So he referred definitions under Ind AS 21.

Ind AS 21 defines Presentation Currency as “the currency in which financial statements are presented”. This was similar to the concept of reporting currency under AS 11.

Foreign Currency is defined as “currency other than the functional currency”. However, AS 11 defined foreign currency as “currency other than reporting currency”.

So he sought to understand the Concept of functional currency.

Functional currency is defined as the currency of the primary economic environment in which the entity operates.

But, what is ‘primary economic environment’?

Ind AS 21 describes the primary economic environment as the one in which an entity primarily generates and expends cash.

Ind AS 21 also provides certain indicators for determining the functional currency of an entity.

Primary Indicators

  • Currency that influences sales price of goods and services
  • Currency of country whose competitive forces and regulatory environment determine sales prices of goods and services
  • Currency that influences costs for labour, material and other costs of providing goods and services

Secondary Indicators

  • Currency in which debt and equity instruments are issued
  • Currency in which receipts from operating activities are retained

Mr. Arth set out to apply these principles in the case of Peace Ltd.

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Peace Ltd was in the business of assembling machines. It had factories at 4 locations in India. While most of the components for the machines were procured domestically, one of the key components was customised and imported from a supplier in the UK. Machines assembled by Peace Ltd were sold in domestic as well as foreign markets.

  • Costs of components procured locally is incurred in INR
  • Cost of component imported from the UK is paid in GBP
  • Cost of labour, operating and administrative expenses is also incurred in INR
  • Receipts from sale of machines in domestic market are in INR
  • Receipts from sale of machines in foreign markets are in USD

In the case of Peace Ltd, the currency for each of the primary indicators is INR. Since most costs are incurred in INR, and there are receipts from the sale of machines in INR as well, the entity retained its earnings in INR. Therefore, the functional currency, for Peace Ltd is INR. As a result, USD and GBP are foreign currencies.

Peace Ltd was poised for business expansion. It planned to set up branch offices in Dubai and Singapore. Branch in Singapore will primarily import the machines assembled at factories in India. However, the operations in Dubai will be relatively extensive. Peace Ltd plans to set up a factory that assembles the machine parts procured from India and UK.

Mr. Arth wanted to check if such branches would have the same functional currency as Peace Ltd.

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Peace Ltd was poised for business expansion. It planned to set up branch offices in Dubai and Singapore. Branch in Singapore will primarily import the machines assembled at factories in India. However, the operations in Dubai will be relatively extensive. Peace Ltd plans to set up a factory that assembles the machine parts procured from India and UK.

Mr. Arth wanted to check if such branches would have the same functional currency as Peace Ltd.

Every individual entity has a functional currency of its own. The branches in Dubai and Singapore would be ‘foreign operations’ of Peace Ltd. When an entity has any kind of foreign operations, in the form of subsidiary, branch or associate, few more factors are to be considered in the determination of the functional currency.

Additional Factors

  • 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
  • Whether transactions with the reporting entity are a high or a low proportion of the foreign operation’s activities
  • 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
  • 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

In the case of a branch in Singapore, the activities are carried out merely as an extension of Peace Ltd.’s operations in India. The cash flows from this branch, will probably be available to be remitted to Peace Ltd (Indian entity). Thus, economic environment of Singapore branch is not isolated/ detached from the primary economic environment of Peace Ltd. Operations in India. Therefore, the functional currency of Peace Ltd together with its Singapore operations will be INR.

In the case of Dubai branch, however, factory set up entails incurring expenses and generating income substantially in local currency. The Dubai branch will have significant autonomy in terms of operations and cash flows as decisions to be taken in that branch are on the basis of primary economic environment that differs from the economic environment of that of its India operations. Therefore the functional currency for the Dubai branch will be AED, while that for Peace Ltd (India Operations) will be INR.

Mr. Arth wondered, how would Peace Ltd incorporate the financial position of Dubai branch, a foreign operation, in its financial statements?

Since Dubai branch would have a functional currency that is not the same as the functional currency of Peace Ltd (India Operations), the financial statements of Dubai branch need to be translated into INR before incorporating it in its own financial statements.

Entities, often deal in multiple currencies. However, while presenting the financial statements of the entity, it is important to harmonise all transactions into a single currency. Once an entity determines its functional currency, all other currencies that it transacts in are ‘foreign currencies’

On every reporting date, foreign exchange monetary items and foreign exchange non-monetary items will be translated to INR as follows:

  • Monetary items -> Translated at Closing Rate as at reporting date
  • Non-monetary items measured at historical cost -> Translated at exchange rate on date of transaction
  • Non-monetary items measured at fair value -> Translated at exchange rate on date of valuation

Note:

  • Monetary items: An entity has right to receive/ obligation to deliver a fixed/ determinable amount of currency units, for example, trade receivables, trade payables, cash dividends, employee benefits to be paid in cash
  • Contract to receive/ deliver entity’s own equity instruments/ variable amount of assets where the fair value of receipt/ delivery is determinable in currency units are also monetary items
  • Non-monetary items: No right to receive/ obligation to deliver a fixed/ determinable amount of currency units, for example prepaid expenses, goodwill, intangible assets, PPE

Translation of items are exchange rates that differ from the exchange rates at which the transactions were carried out, would lead to foreign exchange gains and losses. How would Peace Ltd recognise such foreign exchange differences?

  • Exchange difference on monetary items à Gain/ loss recognised in Profit or Loss, in the period in which they arise
  • Exchange difference on non-monetary items recognised in OCI à Gain/ loss recognised in OCI
  • Exchange difference on non-monetary items recognised in Profit or Loss à Gain/ loss recognised in Profit or Loss

Now you may be confused to read above two lines. We strongly recommend you to subscribe to our video sessions in which we have detailed explanation on exchange differences on Non-Monetary items need to be recognised in SOPL and OCI.

But what if Dubai branch of Peace Ltd wanted to voluntarily change its functional currency?

A functional currency is determined after considering the underlying transactions, events, and conditions. Therefore, a functional currency, once determined, cannot be changed unless there is a change in those underlying transactions, events, and conditions.

Mr. Arth realised that some of the underlying transactions, events, and conditions, and as a result, the functional currency may undergo a change. Examples of such circumstances could be:

  • Changes in group structure
  • Changes in business model
  • Raising funds by way of equity or debt, in another currency

If there is any change in functional currency, an entity should apply the translation procedures prospectively, i.e. from the date of the change in functional currency.

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Let us take a few more examples to understand how various factors impact the determination of functional currency.

Case I: Peace Ltd is a Company based in Italy. It has 3 subsidiaries Truce Ltd, Bliss Ltd and Serene Pte Ltd that are based in UK, India, and Singapore respectively. The functional currencies for each of the subsidiaries have been determined as follows:    

  • Truce Ltd: GBP
  •  Bliss Ltd: INR
  •  Serene Pte Ltd: SGD

Peace Ltd primary activity is to raise funds – by way of equity and loans – in Euros. These funds are then allocated to all three subsidiaries for their operating activities and business expansion. Profits from each of the subsidiaries, remitted to Peace Ltd, are also held in Euros by Peace Ltd.

In this case, the primary indicators are not relevant for determining the functional currency of Peace Ltd. Therefore, the management will have to rely on secondary indicators.

Peace Ltd raises funds in Euro. The earnings are also retained by Peace Ltd in Euros. Therefore, the functional currency for Peace Ltd is Euro.

Some of the points to be noted here are:

  • Even though Peace Ltd is an ultimate holding company, it does not share its functional currencies with any of its subsidiaries
  • The group as a whole, may not have a common functional currency
  • In absence of clear indicators, the management may have to rely on its own judgment for determination of functional and foreign currencies

Let us tweak the situation in Case I now.

Case II: In Case I above, if Peace Ltd had raised funds in GBP, what would be its functional currency?

In such case, management needs to once again analyse secondary indicators. If management believes that GBP is a function of currencies dealt with, GBP will be considered as a functional currency.

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Case III: Peace Ltd is an Indian company manufacturing laptops. It has a manufacturing facility based in China. The factory in China manufactures all the components, assembles it and ships the assembled products to India. Therefore, all the manufacturing costs are incurred and paid for in CNY. Peace Ltd pays for all the expenses incurred by the manufacturing facility. The sales price of laptops, in Indian as well as global market, is determined on basis of exchange CNY/ INR exchange rate. 

Does the manufacturing facility have a separate functional currency? What is the functional currency of Peace Ltd?

In this case, Peace Ltd is operating in two economic environments and has transactions in INR and CNY. Even though the manufacturing facility in China isn’t a separate legal entity, it is a ‘foreign operation’.

While determining functional currency of a foreign operation, an entity should check the additional indicators along with the primary indicators.

Analysis of primary indicators:

  • Currency that influences sales price of goods and services à CNY
  • Currency of country whose competitive forces and regulatory environment determine sales prices of goods and services à INR & CNY
  • Currency that influences costs for labour, material and other costs of providing goods and services à CNY

This indicates that CNY may be the functional currency of the manufacturing entity, which is a foreign operation.

An analysis of the additional indicators reflects that:

  • The activities of the manufacturing facility are carried out with a significant degree of autonomy
  • cash flows from the activities of the manufacturing facility directly affect the cash flows of Peace Ltd and funds may not be readily available for remittance to Peace Ltd

Therefore, the functional currency of the manufacturing facility in China is CNY.

In the case of Peace Ltd (Indian Head Office), its function is merely that of a Head office. Peace Ltd. (Indian Head Office) raises and retains funds in INR. Also, the regulatory and competitive environment of India determines the sales price of laptops. So Peace Ltd. (Indian Head Office) has a separate functional currency, INR.

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