IAS 21 Foreign Exchange Rates: Summary, Practice Questions & Decision Tree

An entity's functional currency is the one tied to the main market where it does business — the currency that shapes its real revenues and costs (IAS 21.9). The main indicators come from what actually drives the business: the currency that most affects the selling prices of its products and services (and the currency of the country whose market conditions and rules largely set those prices), and the currency that most affects the cost of labour, raw materials and other inputs needed to produce its goods and services (IAS 21.9). Supporting clues — the currency it borrows in and the currency it keeps its operating cash in — help when the main indicators point in different directions (IAS 21.10). For a foreign operation, also consider how independently it runs from the parent, how much it trades with the parent, and whether it generates enough cash to cover its own debts (IAS 21.11).

Presentation currency is simply the currency chosen for reporting the financial statements, and any currency may be chosen for that purpose (IAS 21.8, 38). The two are different ideas: functional currency follows from economic facts and changes only when those facts change, whereas presentation currency is a reporting choice — a Canadian group whose parent measures in CAD can present consolidated statements in USD if that is more useful to investors. Once the figures are measured in the functional currency, they are translated into the presentation currency using the mechanics in IAS 21.39.

Any deal that will be settled in a currency other than the functional currency counts as a foreign currency transaction — imports on credit, foreign-currency loans, or buying an asset priced in another currency are everyday examples (IAS 21.20). On first recognition it is booked in the functional currency at the spot rate on the transaction date (IAS 21.21).

For practicality, a rate close enough to the actual rate may be used — for example a weekly or monthly average applied to all transactions in that period — provided rates have not moved wildly. Where rates have shifted sharply, using an average for the period is inappropriate and the actual transaction-date rates must be applied (IAS 21.22).

The split that decides everything is monetary versus non-monetary. The test is whether the item represents a fixed money claim. Monetary items are cash balances and any claim or obligation that will be settled for a fixed or easily calculable sum — receivables, payables, loans and accrued cash-settled amounts all fall here (IAS 21.8, 16). Non-monetary items lack that fixed-money feature: inventory, property plant and equipment, intangibles, goodwill, prepayments for goods and services, and equity investments.

• Monetary balances — re-measured to the closing rate at every reporting date (IAS 21.23(a)).
• Non-monetary items held at historical cost — translated at the rate on the date of the transaction and never retranslated (IAS 21.23(b)).
• Non-monetary items held at fair value — translated at the rate on the date the fair value was measured (IAS 21.23(c)).

So inventory bought for a foreign currency amount is fixed in the functional currency at its purchase-date rate, even though the payable created by the same purchase moves every period end. That asymmetry is the single most examined point in IAS 21: one transaction, two different translation treatments.

When a monetary item is settled or retranslated at a rate different from the one used when it was first recorded, the resulting gain or loss hits profit or loss in that period (IAS 21.28). There is no deferral and no smoothing: a payable that becomes more expensive gives an immediate loss, and one that becomes cheaper an immediate gain.

The main exception concerns a monetary item that forms part of the reporting entity's net investment in a foreign operation — typically a long-term intragroup loan that is not expected to be settled in the near future. In the consolidated financial statements the exchange differences on that item are first recognised in OCI and kept in equity as a separate reserve, and only moved into profit or loss when the net investment is disposed of (IAS 21.32). Note that in the individual statements of the lender or borrower, the same difference still goes to profit or loss — the OCI treatment applies at the consolidated level.

Where a gain or loss on a non-monetary item is itself recognised in OCI — a revalued property under IAS 16, for example — any exchange component of that gain or loss follows it into OCI; where the gain or loss is in profit or loss, the exchange component is in profit or loss too (IAS 21.30).

Bringing a foreign operation into the group figures follows a three-step rule (IAS 21.39). Apply the closing rate at the reporting date to every asset and liability in the statement of financial position, including the comparative figures. Translate income and expenses using the rates that applied when each transaction happened — in practice an average rate for the period unless exchange rates moved sharply. All exchange differences from this process go to OCI and are kept in a separate equity reserve.

Two details catch people out. First, any goodwill from buying the foreign operation, and any fair value adjustments made to the reported values of that operation's assets and liabilities, are treated as belonging to that operation — so they are expressed in its functional currency and re-measured to the closing rate each period end, generating further OCI differences (IAS 21.47). Second, the OCI difference arises from two sources at once: the closing-rate versus average-rate mismatch on the current year's profit, and the movement in the closing rate applied to opening net assets.

Once the operation is disposed of, the accumulated exchange differences held in equity are moved into profit or loss alongside the disposal result (IAS 21.48). Disposal includes selling the operation, liquidating it, repaying the share capital, or abandoning all or part of it.

Partial disposals are treated by reference to control. When a subsidiary that includes a foreign operation is partially sold but control is kept, the relevant share of the cumulative exchange differences is moved to non-controlling interests — it does not go to profit or loss (IAS 21.48C). For any other partial disposal — for example reducing an interest in an associate or joint arrangement while keeping significant influence or joint control — the relevant share of the cumulative amount is moved into profit or loss (IAS 21.48A–48B).