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Section 30 – Foreign Currency Translation
Scope
It is likely that entities transact business with customers and suppliers who are invoiced/invoice in a currency which is not the entity’s functional currency. It is also likely that entity’s have subsidiaries and investment in country’s outside of the parent company’s home country. Section 30 deals with such issues including:
- how to determine an entities functional currency;
- the retranslation of foreign currencies into an entities functional currency;
- the retranslation of foreign operations into the consolidated financial statements; and
- providing detailed rules on the rate to use when retranslating these foreign currencies; and
- retranslating foreign currencies/operations into a presentational currency.
Functional currency
Extract from FRS102: Section 30.2 -30.5
30.2 Each entity shall identify its functional currency. An entity’s functional currency is the currency of the primary economic environment in which the entity operates.
30.3 The primary economic environment in which an entity operates is normally the one in which it primarily generates and expends cash. Therefore, the following are the most important factors an entity considers in determining its functional currency:
(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; and
(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).
30.4 The following factors may also provide evidence of an entity’s functional currency:
(a) the currency in which funds from financing activities (issuing debt and equity instruments) are generated; and
(b) the currency in which receipts from operating activities are usually retained.
30.5 The following additional factors are considered in determining the functional currency of a foreign operation, and whether its functional currency is the same as that of the reporting entity (the reporting entity, in this context, being the entity that has the foreign operation as its subsidiary, branch, associate or joint venture):
(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.
(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
OmniPro comment
A key starting point with regard to defining what currency is a foreign currency for an entity is the assessment of the entity’s functional currency. Any currency which is not the entity’s functional currency is then a foreign currency, under which the rules of Section 30 are followed.
It is clear that every entity has its own functional currency including group companies so every entity should review its own circumstances to determine its functional currency. Section 30.3 above identifies the primary indicators of an entity’s functional currency and Section 30.4 above provides secondary indicators. Other factors which are considered are provided in Section 30.5 above.
In determining a functional currency more weight is given to the primary indicators, before considering the secondary and other evidence which are purely provided to give supporting evidence to determine an entity’s functional currency.
The steps involved in determining a functional currency in order of priority are:
1) Review the primary indicators to provide evidence of the functional currency
– Determine the currency of the primary sales and cash inflows – this will often be the currency in which the sales prices for its goods and services are denominated and settled. Questions to ask include:
– What currency are the principal sales invoices raised in?
– What currency are sales contracts determined in?
– What currency are cash receipts in?
– Determine the currency of primary purchases and cash outflows – this will often be the currency in which the costs are denominated and settled. Questions to ask include:
– What currency are the principal expenses incurred in?
When reviewing the above indicators, an entity assesses what currency the majority of the costs and sales are denominated in.
If there is still doubt from reviewing the above primary factors an entity should then move to the secondary factors to see if this can provide further support.
2) Secondary indicators merely provide supporting evidence in determining a functional currency. The questions to ask are:
– What is the currency in which the entity is financed (financing activities) i.e. the currency in which debt is raised and equity is obtained.
– Where financing is raised in and serviced by funds primarily generated by the entity’s local operation, this could indicate that the local currency is the functional currency.
– What currency is the operating income retained or is it retained? Indicators of this would be the local currency in which the entity maintains its excess working capital balance.
If there is still doubt from reviewing the above secondary factors an entity should then move to step 3 where relevant to see if this can provide further support.
3) Where an entity is a subsidiary, associate, joint venture or branch then if steps 1 and 2 do not provide conclusive evidence, the entities should review:
– The degree of autonomy the entity has from its parent
Indicators of significant autonomy and therefore indicating that the entity has a different functional currency to the parent include:
– Ability to enter into its own contracts
– Ability to negotiate its own finance
– Ability to determine how it invests excess cash
– Not merely an entity that sells goods on behalf of its parent and then transfers cash to the parent.
– Frequency of transactions with reporting entity
– Indicators that the entity has a different functional currency to its parent include: Frequent intercompany transactions and trading dealings with the parent company.
– Cash flow impact on reporting entity (parent company) Indicators that there is little impact on the cash flows of the parent:
– No significant cash flow impact as the foreign entity can hold its own cash in its local currency and determine what to invest this in. It does not have to remit funds regularly.
– Financing. Indicators that the entity has a different functional currency to its parent include:
– Financing being obtained in the local currency and serviced by funds generated in the foreign operation. Little or no financing provided by the parent.
Appendix I of FRS 102 defines a foreign operation as ‘an entity that is a subsidiary, associate, joint venture or branch of a reporting entity, the activities of which are based or conducted in a country or currency other than those of the reporting entity’.
For some entities it will be very easy to determine a functional currency however for others it may not be. Judgement will be required. More weight should be put on the primary indicators.
Each entity’s circumstances must be looked at in isolation, it cannot be reviewed from a group perspective.
Examples
Example 1: Intermediary holding company
UK Parent A is a UK company with a functional currency as CU. It has a 100% subsidiary called Intermediate Co which in turn owns 100% of a trading subsidiary Company B whose functional currency is FC.
The Intermediate Co merely holds the investment in Company B and obtains FC borrowings from the bank to make this investment. The borrowings are guaranteed by Parent UK Co.
In this instance what is the functional currency of Intermediate Co?
Applying the guidance in Section 30.3 to 30.5 as follows:
Primary indicators:
- currency in which costs or income is derived – As Intermediate Co does not generate revenue and only incurs minimal expenses, this indicator is not that relevant.
Secondary indicators:
- Operating activities – this is not relevant as the company does not generate any cash flows it merely holds the investment
- Financing activities – Intermediate Co has obtained FC borrowings to make the acquisition, however this is only a secondary indictor and section 30.5 has to be reviewed for foreign operations.
Factors specific to foreign operations:
- Degree of autonomy – Section 30.5(a) states that where the activities of the foreign operation is an extension of the reporting entity and has very little autonomy, then the foreign entity is likely to have the functional currency of its parent. – In this example, as Intermediate Co has merely been put in funds through UK Parent A (by parent A providing finance by way of guarantee to the bank) and it has akin made an investment into a subsidiary on UK Parent Co’s behalf, this would indicate that the functional currency of the parent is that of the UK Parent Co i.e. FC.
- Frequency of transaction with parent – All transactions are with the parent thereby indicating it should take the functional currency of the parent.
- Cash flow impact on reporting entity – not that relevant
- Financing – Parent Co has provided the funds therefore this suggest it is an extension of the Parent Co.
Based on the facts and circumstances outlined Intermediate Co’s functional currency should be CU and not FC.
Example 2: Intermediate holding Company
If we take example 1 and this time assume that no bank borrowings was obtained and instead UK Parent Co provided the loan finance or equity finance. In this case the same determination would be obtained i.e. the functional currency of Intermediate Co is CU.
Example 3: Intermediate holding Company
If we take example 1 and in this case the money to fund the investment in Company B is obtained from a sister company. In this case the functional currency of the Intermediate Co would likely be the functional currency of the sister company.
Example 4: Functional currency
Company A is a trading company resident in France. Company A predominately sells its goods in FC with 30% of sales being made in CU. The company’s principal costs are wages and stock purchases. These are all paid in FC.
Based on the primary indicators, the functional currency of Company A is CU. The secondary indicators do not need to be reviewed as it is clear from the primary indicators.
Example 5: Functional currency
Company A is a trading company resident in France. Company A predominately sells its goods in FC with 30% of sales being made in CU. The company’s principal costs are wages and stock purchases. These are mainly denominated and settled in CU.
The company is financed through FC borrowings.
In this case the primary indicators do not give conclusive evidence so therefore one must move to the secondary indicators. The secondary indicators are financing activities and from review of same we can see that this is carried out in FC.
On this basis it would appear the functional currency is FC.
The functional currency should remain the same and cannot change unless there is a change in the business operations.
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