Determining functional currency

Nik Hanes’ question, relating to my posting “Can you still accounting in foreign currency", touches on some important points regarding how one determines functional currency under the rules set out in IAS 21.

IAS 21 BC9 states that the indicators in paragraph 9 of the standard are the primary indicators for determining the functional currency and that paragraphs 10 and 11 are secondary. It explains that this is because the indicators in paragraphs 10 and 11 are not linked to the primary economic environment in which the entity operates but provide supporting evidence to determine an entity's functional currency.

The primary paragraph 9 indicators relate to the pricing of sales and expenses. For trading operations these factors are highly relevant, hence the comment in BC9. However, for entities that do not undertake any key operating activities on their own, such as 'UK Finco' in the above article, the indicators in the text of paragraph 9 are largely irrelevant. Accordingly, the generally accepted view is that  those situations it is therefore necessary to turn to the secondary indicators in paragraphs 10 and 11.

Paragraph 10 refers to the currency of funds from financing activities and working capital. UK Finco has euro denominated equity and a euro-denominated loan, which would imply a euro functional currency. 

However, paragraph 11 then considers whether the functional currency of the foreign operation (UK Finco, in our example) may be the same as that of the reporting entity (i.e. UK Parent) because the activities of the foreign operation are carried out as an extension of the reporting entity, rather than with a significant degree of autonomy. The use of the phrase 'reporting entity' is rather misleading in this context. Usually it would be taken to mean the foreign operation whose functional currency we are trying to ascertain. However paragraph 11 explains that in this case, it refers to the parent or other investor in the foreign operation, where the foreign operation is the subsidiary company whose functional currency we are trying to determine.

In our example, UK Finco is established solely as an extension of its parent, 'UK Parent', to on-lend funds from its parent to another group company. UK Finco has no independent management or activity of its own and all of its transactions are intra-group. Given this, the significance of the paragraph 11 factors carries greater weight than the factors in paragraph 10. This leads to the conclusion that UK Finco has the same functional currency as its parent, i.e. sterling.