Some time ago I was a part of an audit team auditing the financial statements of a medium-sized manufacturing company.
When we received the trial balance of that client, we spotted something strange:
There were loads of transactions in a foreign currency and resulting impact of constant conversion to the local currency on profit or loss was huge.
In the past years, the company was simply buying materials from its parent, made semi-finished products locally and then sold these semi-finished products to another company in the group.
Apparently, the group was simply using the local company as a production factory due to lower labor cost.
All was fine – both purchases and sales were made to companies in EUR in the past.
However, the main and only customer of our client changed during the period due to some group structure changes.
As a result of that change, our client was making purchases of raw materials in EUR, but 100% of its sales were made in GBP because the new customer insisted on GBP pricing.
Hmmm, that smells like a change in the functional currency.
And yes, it was.
But, it does not need to be something you should worry about.
In this article I would like to show you how to deal with the change in your functional currency and I will also try to address a few practical questions related to such a change.
Please note that here we are dealing with the currencies of non-hyperinflationary economy.
Functional vs. presentation currency
Before we even start with the explanation, I need to remind you that there is a BIG difference between the functional and the presentation currency:
- Functional currency is the currency of the primary economic environment in which you operate.
Your functional currency is NOT a matter of your choice, but the matter of your economic environment.
You should determine it by the careful assessment of factors like the primary currency in which you make sales, cost of sales, etc.
In fact, it is the functional currency in which you keep your accounting records and book the transactions.
- Presentation currency is the currency in which you present your financial statements.
The presentation currency is any currency that you choose.
This summary contains nice illustrative explanation of the practical difference between the two.
When to make a change in functional currency
First of all, you have to assess your primary economic environment to find out your functional currency.
In other words, you need to assess the economic effects of the underlying transactions, events and conditions relevant for you.
In this podcast episode I outline what and how to assess it.
However, sometimes these underlying transactions, events or conditions change and in this case, your functional currency changes, too.
Just as in my story from the beginning of this article: our client, the manufacturing company, changed its sole customer and was forced to sell its products in GBP rather than EUR.
Since the sales were the primary factor determining the functional currency in this case (as purchases and labor cost were all in different currencies and in a lower number of transactions), our client had to account for the change in functional currency.
Now, when to make a change precisely?
It should be on the specific date when the circumstances change.
In our example, the company knew exactly when they stopped selling in EUR and started to sell in GBP – so that was the date.
However, sometimes it happens that the change is not immediate. It could happen gradually over some period of time.
In this case, you need to apply your judgment and determine the appropriate date of change.
One small piece of advice: I would do it on the first day of your reporting period (if you don’t want to be your own enemy).
So, if your reporting period starts on January 1, do it on January 1.
Why?
Well, because it will be easier for you to translate all the balances to your presentation currency at the beginning of the reporting period (you will deal with translation from one functional currency, not two different functional currencies during the same period).
How to change functional currency
The standard IAS 21 requires applying all the procedures related to the change in functional currency prospectively from the date of change.
No restatement of previous period.
You simply need to translate all items of assets and liabilities into the new functional currency using the exchange rate at the date of change.
For non-monetary items, this amount will be the item’s new historical cost. It means that you are NOT going to update the recalculation at the year-end with the closing rate.
For example, let’s say your functional currency was EUR.
You decided to change your functional currency to USD on 1 January 2019 when the exchange rate was 1,145 USD/EUR.
In your balance sheet, there’s a property, plant and equipment (PPE) with the cost of EUR 10 000 as at 1 January 2019.
After the change in functional currency, the cost will be 11 450 USD and this is the new historical cost of PPE (no further currency revaluation in functional currency).
And, this will be the new historical cost event if you bought the same property in USD.
How to present comparatives when the functional currency changes
So, if you change your functional currency and you always present your financial statements in the same currency as your functional currency, then we are facing two changes in fact:
- The change in functional currency itself – as I explained above, you need to make this change prospectively without any restatement of previous periods.
- The change in presentation currency – the change in presentation currency is treated as a change in accounting policy and is to be applied retrospectively.
Imagine you presented in EUR last year. Your new functional currency is USD and you plan to present your financial statements in USD.
Thus you need to translate your comparative financial statements in EUR to USD using the appropriate exchange rates applicable for the comparative reporting period.
Now, if you decide to present in EUR despite your new functional currency is USD, then you will use IAS 21 rules for translating amounts in your functional currency to presentation currency as described here and here.
I better explain it with an example.
Example: Change in functional and presentation currency
ABC changed its functional currency on 1 January 20X2 from EUR to USD and decided to present its financial statements for the year ended 31 December 20X2 in new functional currency USD.
The financial statements for the year ended 31 December 20X1 were presented in EUR (previous functional currency).
Show how ABC needs to make a change in functional currency and how to present comparative amounts in the financial statements for the year ended 31 December 20X2.
ABC’s financial statements as at 31 December 20X1 in EUR are as follows:
The exchange rates USD/EUR are as follows:
- 31 December 20X0: 1,05
- 31 December 20X1: 1,17 (same as 1 January 20X2)
- Average 20X1: 1,08
- At the issuance of share capital: 1,21
Let’s deal with this situation step by step.
Change in functional currency
As the first thing, ABC should change its functional currency at the date of change – 1 January 20X2.
Therefore, ABC needs to recalculate all assets and liabilities to USD using the rate at the date of change – 1 January 20X2.
How about equity items like share capital and retained earnings?
Article 37 of IAS 21 says it clearly: you should apply the exchange rate at the date of the change to all items (hence including equity) and this amount will become their historical cost.
In fact, the change in functional currency is NOT the change in accounting policy and therefore the retrospective restatement, i.e. measuring share capital in new functional currency before that change (using the rate at its issuance) would NOT faithfully represent share capital at the time of making a change.
Yet still there is a sort of controversy here and I’ve even seen measurement of share capital and other equity items using the transaction date rate instead of the rate at the date of change.
Well, it is simply not under IAS 21.
Here’s the link to the financial statements of a company who changed its functional currency in 2016 from NOK to EUR. You can see this process real life.
The following table shows the recalculation:
| Item | EUR | Which rate? | Rate applied | USD |
| Non-current assets | 160 000 | 1 Jan 20X2 | 1,17 | 187 000 |
| Current assets | 130 000 | 1 Jan 20X2 | 1,17 | 152 000 |
| Share capital | -100 000 | 1 Jan 20X2 | 1,17 | -117 000 |
| Retained earnings | -20 000 | 1 Jan 20X2 | 1,17 | -23 400 |
| Long-term debt | -150 000 | 1 Jan 20X2 | 1,17 | -175 500 |
| Current liabilities | -20 000 | 1 Jan 20X2 | 1,17 | -23 400 |
| Total | 0 | 0 |
Thus here’s the statement of financial position of ABC at 1 January 20X2:
During 20X2, all the transactions will be recorded in the new functional currency – USD and at the end of 20X2, ABC will need to:
- Recalculate all monetary assets and liabilities denominated in currencies other than USD to USD using the closing exchange rate;
- Keep non-monetary items at their historical rate;
- Recalculate all items of income and expenses in currencies other than USD to USD using the exchange rate at the date of transaction.
Change in presentation currency
As I have already mentioned above, the change in presentation currency is a change in accounting policy and it is applied retrospectively.
At the end of 20X2, ABC’s new presentation currency USD is the same as its functional currency, so there is no need to recalculate anything.
However, for comparative financial statements, it is necessary to restate the amounts in EUR using the same exchange rates as if ABC had always presented its financial statements in USD.
More specifically:
- All assets and liabilities will be translated to USD using the closing rate at 31 December 20X1,
- All items of profit or loss will be translated to USD using the rates at the dates of transactions (we will use the average rate for 20X1 as acceptable approximation),
- All equity items will be translated with their historical rates.
Please note that within retained earnings, we only have the amount of EUR 20 000 – the same as profit for the year 20X1.
I made it intentionally simple, because now you need to recalculate full retained earnings with the average rate for 20X1 – the same rate that you would use for recalculating your income and expenses.
In practice, when there are more components of retained earnings, you need to keep track and show each component at its appropriate rate (e.g. profit of 20X0 at the average rate of 20X0, etc.).
Here’s our recalculation:
| Item | EUR | Which rate? | Rate applied | USD |
| Non-current assets | 160 000 | 31 Dec 20X1 | 1,17 | 187 000 |
| Current assets | 130 000 | 31 Dec 20X1 | 1,17 | 152 000 |
| Share capital | -100 000 | Date of issuance | 1,21 | -121 000 |
| Retained earnings | -20 000 | Average of 20X1 | 1,08 | -21 600 |
| Long-term debt | -150 000 | 31 Dec 20X1 | 1,17 | -175 500 |
| Current liabilities | -20 000 | 31 Dec 20X1 | 1,17 | -23 400 |
| Total | 0 | -2 200 |
As you can see, we have a difference in USD balance amounting to USD 2 200.
This is simply a component of equity called “exchange reserve” or “currency translation difference”.
But, here’s one small inconsistency:
The share capital in your comparatives is translated using the historical rate and the same share capital is translated in your current reporting period using the rate at the date of change.
Well, the difference between these two of EUR 4 000 is a part of total cumulative exchange reserve of USD 2 200 and it will be reported in the statement of changes in equity as “the effect of change in functional currency”.
The same applies for the difference in retained earnings of EUR 1 800.
Your statement of changes in equity would look something like:
| Description | Share capital | Retained earnings | Exchange reserve | Total |
| 31 Dec 20X1 | -121 000 | -21 600 | 2 200 | -140 400 |
| Effect of change in functional currency | 4 000 | -1 800 | -2 200 | 0 |
| 1 January 20X2 | -117 000 | -23 400 | 0 | -140 400 |
I am completely persuaded that there will be some questions or doubts related to this example.
No wonder.
There is not much practice since the change in functional currency is not that frequent, but I will try to help if I can.
Thank you!