Subsidiary Translations- Functional Currency Method in a Nutshell

 

Hi all!

 

Today we are going to explore Functional Currency Method in IAS 21. This method aims to accurately reflect the economic effects of an entity’s transactions, assets, and liabilities in the currency that most significantly affects its business performance.

Key Points:

Monetary Items: Translated using the closing rate at the reporting date.

Non-Monetary Items: Measured at historical rates, i.e., the transaction rate on the date of the transaction.

Income & Expenses: Measured at transaction rates or an average rate if hyperinflation is absent.

Differences from Presentation Currency Method:

Net Assets: Opening balances are translated at prescribed rates, and the FX difference is not measured using the closing rate.

Retained Earnings and Reserves: Translated for current year balances by finding the difference between total assets minus total equity & liabilities, without using the closing rate.

FX Gains/Losses: Unlike Presentation Currency method where FX gains/losses taken to OCI, it is taken to Profit & Loss statement in this method.

Here are a few well-known examples of how companies might have different functional currencies based on their operations:

1. Toyota Motor Corporation (Japan) - Likely uses the Japanese Yen (JPY) as its functional currency, reflecting its primary economic environment.
2. Apple Inc. (United States) - Uses the US Dollar (USD) as its functional currency, as its primary operations and significant transactions occur in the US.
3. BP plc (United Kingdom) - Likely uses the US Dollar (USD) as its functional currency, given that most of its oil transactions are conducted in USD, even though it is headquartered in the UK.
4. Nestlé S.A. (Switzerland) - Uses the Swiss Franc (CHF) as its functional currency, reflecting its operations and transactions primarily based in Switzerland.
5. Volkswagen Group (Germany) - Likely uses the Euro (EUR) as its functional currency, consistent with its location and the primary economic environment.

Let’s dive into the practical steps with a pragmatic approach:

View/Download Excel example here

1.       Translate Opening Non-Monetary Items: Calculate the sum of Property, Plant, and Equipment (PPE), Inventory, and other non-monetary assets.

2.       Subtract non-monetary liabilities, which can be found by subtracting net assets from the above sum.

3.       Determine Opening Retained Earnings: Use the balancing method as demonstrated in the video to find the opening retained earnings in Net Assets Opening Balance translation section.

4.       Translate Current Year Retained Earnings and Reserves: Carry forward the opening translated retained earnings & other reserves balance to this section.

5.       Use the Profit After Tax (PAT) and closing balances of retained earnings from the Statement of Profit or Loss and Other Comprehensive Income (SPLOCI) and the Statement of Changes in Equity (SOCIE) and make adjustments for Dividends and other adjustments when there is a need.

6.       Carry forward other reserves Current balances into this part.

7.       Calculate FX Gain or Loss: Determine the foreign exchange gain or loss.

8.       Include this in the restated financial statement to arrive at the nominal profit or loss for the year.

There is a crucial point to remember! In both the Presentation Currency Method (PCM) and the Functional Currency Method (FCM), the opening net assets and current year balances are translated, but the closing balances are not.

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