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.
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. Mr.
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.
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)
Point of difference:
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.
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.
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.
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.