IAS
21 requires each entity - whether a standalone entity, an entity with foreign operations
or a foreign operation – to determining its functional currency.
IAS21 defines the functional currency of an
entity as the currency of the primary economic environment in which it
operates.
This
is the environment in which an entity primarily generates and expends cash. In
determining an entity’s functional currency the following primary factors should
be considered:
ü
The
currency that primarily influences sales prices (usually the currency in which
prices are denominated and settled).
ü
The
currency of the country whose competition and regulations primarily influence
sales prices.
ü
The
currency that primarily influences labor and other costs of goods sold (usually
the currency in which prices are denominated and settled).
Less
critical deciding factors are the currency in which an entity retains receipts
from its operations, and the currency in which debt and equity instruments are
issued.
The
determination of the functional currency is not a matter of choice. It is based on actual facts and management
judgement. The methodology for the
determination of the functional currency under
U. S. GAAP and IFRS is not same.
IFRS uses the hierarchy of factors, with more emphasis on pricing factors.
However, U.S. GAAP bases its decision on cash flows. Under most circumstances,
the functional currency determination both under IFRS and U.S. GAAP should
provide similar results. However, on
transition to IFRS, all the entities are once again required to evaluate the
the functional currency of all of its foreign operations under IFRS an document
its results.
When
determining the functional currency of an entity’s foreign operation, factors
for consideration includes:
§
Autonomy.
Whether the operation is essentially an extension of the reporting entity, or
it can operate with a significant degree of autonomy. The functional currency
is the reporting entity’s in the first case, and the local currency in the
later.
§
Proportion
of transactions. Whether the foreign operation’s transactions with the
reporting entity constitute a high or low proportion of the operation’s
activities. The functional currency is the reporting entity’s in the first
case, and the local currency in the later.
§
Proportion
of cash flows. Whether cash flows from the foreign operation directly affect
the cash flows of the reporting entity, and are available for remittance. The
functional currency is the reporting entity’s if so, and the local currency if
not.
§
Debt
service. Whether a foreign operation’s cash flows can service its debt
obligations without funds transfers from the reporting entity. The functional
currency is the reporting entity’s if funds transfers are needed, and the local
currency if not.
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