Functional
Currency under IFRS and its Implementation
By
Sanjay Chauhan
This article covers the ‘Functional Currency’ aspect differentiating with
‘Presentation Currency’ as laid in Ind AS 21 i.e. IAS 21, which is totally new
concept when India converges to IFRS.
Introduction
India has laid down the convergence plan of ‘Indian Accounting
Standards’ (AS) with ‘International Financial Reporting Standards’ i.e. IFRS in
a phased manner. The first phase implementation was expected to begin from April 1, 2011 but due to practical challenges, the implementation is
delayed. Veerappa Moily in a recent interview expressed his views by saying
that even if tax issues are not addressed, the Ministry will go ahead with IFRS
convergence.
ICAI, as part of
convergence approach, has come out with 35 Ind AS which are same as IFRS except for the carve outs. Ministry of
Corporate Affairs (MCA) has notified 35 Ind ASs on February 25, 2011.
Amongst these
standards, there is one standard that has the potential to entirely turn the Indian
financial statements Topsy Turvy and that is IAS 21 i.e. Ind AS 21.
Currency for
accounting and presentation
While all Indian
entities prepare their books of accounts in Indian Rupees, we have never
thought on preparing our books in any other currency. While there may be some
who did wish of using currency other than Indian Rupee (INR) on account of huge
foreign exchange exposures but did not have any guidance or literature to
support them. The spot will now be addressed in “Ind AS 21 - The Effects
of Changes in Foreign Exchange Rates”
Once India starts converging to Ind AS, we will have this standard on
effects of exchange fluctuations, which has considered the aspect of huge
volatility and exposures to operations due foreign currency (i.e. other than
INR). It requires the managements of the companies to adopt a suitable currency
for maintaining their accounts. Since the entities may vary their exposures to
currency in different years, the standard has mandated the assessment of such
book keeping currency every year.
If any other
currency say US $ is considered as the currency that influences the primary
economic environment, managements will have to prepare themselves to consider
INR as foreign currency exposure and mark to market all INR monetary assets and
liability at each balance sheet date.
Ind AS 21 – ‘The Effects of Changes in Foreign Exchange Rates’
is a standard that brings a new dimension to the financial statements prepared
in India. Now, the book keeping currency i.e. Functional currency
will no more be optional or default INR, it will be governed by specific
principles as laid down under the standard and can be different than the
presentation currency.
Functional
Currency:
Let us appreciate
the governing principles of functional currency under Ind AS 21:
“Functional
currency is the currency of the primary economic environment in which the
entity operates.” (para 7)
“The primary
economic environment in which an entity operates is normally the one in which
it primarily generates and expends cash. An entity considers the following
factors 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.
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).” (para 8)
Ind AS 21 defines
the Functional Currency and differentiates with the Presentation Currency. The
primary factor that drives the choice of currency is primarily influenced by
stream of revenue and operating costs. Additional factors that the standard
requires to examine are the currency of loan obligations.
“Many reporting
entities comprise a number of individual entities (e.g. A group is made up of a
parent and one or more subsidiaries). Various types of entities, whether
members of a group or otherwise, may have investments in associates or joint
ventures. They may also have branches. It is necessary for the results and
financial position of each individual entity included in the reporting entity
to be translated into the currency in which the reporting entity presents its
financial statements. This Standard permits the presentation currency of a
reporting entity to be any currency (or currencies). The results and financial
position of any individual entity within the reporting entity whose functional
currency differs from the presentation currency are translated in accordance
with paragraphs 38–50.” (para 10)
Under existing AS
11 definitions, foreign currency is a currency other than reporting currency,
and reporting currency is the currency used for reporting financial statements.
The rules of translating the subsidiary accounts into reporting currency as
remain similar under Ind AS 21, which prescribes using closing rate for Balance
sheet items and transaction rate or average rate for income statement items
(para 38-50)
Under Indian
GAAP, a currency used for preparing as well as reporting .i.e.
presenting financial statements to regulatory authorities, lenders, investors,
etc is foreign currency is no other than INR. There is no idea of
differentiating the currency to report financial statements (presentation
currency) and currency in which books of accounts are to be maintained (functional
currency).
Functional
Currency: Industry perspective
Under Indian GAAP
there is no concept of functional currency identification. It however has
reference to ‘Reporting Currency’, which is expected to be the same currency of
the country in which it is domiciled.
The definition of
functional currency in Ind AS will encompass all the Companies whose primary
economic environment is not the Indian economy.
The impact of
this standard will be more evident on Commodity
market linked companies engaged
in mining, refining, and trading products, whose primary revenue is governed by
International Commodity prices prevailing on London
Metal Exchange in US Dollars. Another Industry attracted by the
implementation of Ind AS will be Business
Process Outsourcing
Companies and Software Companies whose
primary revenue is again governed in terms of Dollars
and Euros.Oil and Gas companies are also prone to get
functional currency assessment and application in India since the Oil prices
are quoted in US $ per barrel globally.
It will also be
impacting the bullion
companies that are
listed on Indian stock exchanges and others that are planning to list soon on
Indian and international bourses. The revenues of these companies are always
traded in US $ in India
and internationally.
Domestic prices
for sales within India, of these companies though is in INR, but are arrived at
by first considering the respective International prices in US$ and then making
certain adjustments such as duty differentials, domestic market premium,
freight differentials, competitive discounts, etc which in industry terms is
called as ‘Shadow Gap’ pricing.
It will
depend on each company to apply its own judgment and access all the criteria of
primary environment and other additional factors that influence the choice of
its functional currency.
Challenges on
adoption of functional currency other than INR in India:
1. If the
accounting records of these Indian Companies are to be prepared under Ind AS
then the financial statements will altogether give a different picture. Since
currency fluctuation on say US $ may now sit in transaction amounts and change company’s
profitability.
2. Change in mindset and budgets required.
3. Will lead to difficulty in decision
making processes by Indian Managements specifically in assessing its foreign
exchange exposure which so far was on currencies other than INR.
4. Continuing a parallel accounting system
for Income Tax submission since Direct tax Code does not provide for similar
changes.
5. Updation / modification to respective ERP
solutions.
6. Accounting for Deferred tax and
unwanted volatility in income statement.
Indian Industry
including Managements, Lenders, Investors, Analysts of financial statements
will have to prepare for seeing a currency different than INR as accounting
currency in annual financial statements. Many companies internationally have
adopted this standard which aligned their accounting currency i.e. functional
currency in line with their respective primary economic environments.
In International
market most of the transactions happen in US dollars and India is now a part of
a global economic platform and thus is very much influenced by US $ in its
financial statements. The impact is more evident in industries that are
primarily dependent on US $ and whose profitability is affected by any change
in US $: INR exchange rate such as Mining & Metals, Oil & Gas, Software
exports and Business Processing Operations among others.
In determining
the functional currency, the entity will have to manage various challenges
including the change in mindset and ERP solutions. It is worth to note that
accounting software giants such as SAP has a functionality to address the dual
currency accounting which can take care of both Tax reporting using INR as
functional currency and IFRS reporting using any other currency.
Change in
functional currency
“When there is a change
in an entity’s functional currency, the entity shall apply the translation
procedures applicable to the new functional currency prospectively from the
date of the change”
Thus the entity
will have to assess the criteria for driving primary economic every year and
apply the accounting impacts for such change prospectively. Here the country’s
policies also would influence the decision such as restrictions on holding
foreign currency and INR being the only legal tender in India.
The entity will
also have to explain as to why it considers such change in its functional
currency, in notes to financial statements.
Presentation
currency
Here Ind AS 21
allows the entity to present its financial statements in any currency and does
not restrict any one currency. However, considering the Indian requirements for
ROC filing, tax submission, Stock exchange filings, etc the presentation
currency will be preferred to be INR.
INR as the
presentation currency in Indian market will also be preferred currency for
reporting to facilitate easy comparability with its peer group. This can
be achieved by either following the rules of translation (using average rate
for P&L and closing rate of balance sheet) which will give rise to
translation reserve or convenient translation using a single rate for all the
items on balance sheet and income statement.
International
Precedence
In order to
relate to the new concept, we hereby study some international companies who
have gone through the change in functional currency. Following relevant
excerpts are for reference:
“StatoilHydro
(OSE:STL; NYSE:STO) changed the company structure as per 1 January 2009. The parent company, StatoilHydro ASA, and two
subsidiaries, consequently changed their functional currencies to USD from the
same date.
The accounts for
these companies are therefore now recorded in USD, while the presentation
currency for the Group remains NOK. The changes in functional currencies have no cash impact.
The companies
changing functional currency will no longer have currency exchange effects,
deriving from USD denominated monetary assets and liabilities, related to the
“Net financial items”. Conversely, monetary assets and liabilities, denominated
in other currencies than USD, may now generate such currency effects.”
Radiance
Electronics Limited, Singapore
“Certain
subsidiaries of the Group have changed their functional currency from SGD and
RMB to USD in FY2008A. Revenue for these subsidiaries is mainly denominated in
USD while purchases are mostly made in USD. Administrative expenses are
denominated based on their country of domicile and are mainly in SGD and RMB.
While the factors
used to determine its functional currencies are mixed, the Company is of the
opinion that USD best reflects the economic substance of the underlying
transactions and circumstances relevant to the foregoing subsidiaries.
Accordingly, the subsidiaries adopt USD as its functional currency with effect
from the current financial year ended 31 December 2008. This change shall be applied retrospectively to the prior
years.
The Company and
the Group continues to present its financial statements in SGD consistent with
prior years.”
Internationally
it was easier for Companies to adopt a change in currency of accounting since
these are fully convertible economies i.e. they can operate bank accounts in
foreign currency. Thus
the change in mindset was comparatively easier, however the common challenge
was again ERP which had to be equipped with dual currency reporting for tax
purposes.
Forward
Path
It will be a
challenging journey for Indian corporates who will adopt Converged IFRS ie
“Ind AS” and will have to definitely consider the implications of these
standards on its accounting and reporting requirements.
Companies will
also have to consider the Enterprise Resource Planning (ERP) solutions to make
them equipped with dual currency accounting and reporting considering the Indian
Tax authorities will require INR as book keeping currency.
Thus till now we
considered INR for recording and viewed dollar as foreign currency but now the
users of financial statements will have to be prepared to see Indian Profit
& Loss account under US $ and exchange fluctuation impact on profitability
on INR balances.
This standard on
functional currency might be considered as welcome move for some and tedious
requirement for others. We will have to wait and see the real implementation.
Article Courtesy (mail from) : Ajay Aggarwal
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