Arthur et al. Q10.3 Determination of functional currency (Section 10.5)
The functional currency is defined in AASB 121.08 as “the currency of the primary economic environment in which the entity operates”. AASB 121.09 explains that “the primary economic environment in which the entity operates” is the environment in which the entity primarily generates and expends cash. AASB 121.09 identifies primary indicators that must be considered when determining an entity’s functional currency. When the primary indicators do not provide clear guidance for determining an entity’s functional currency, the secondary indicators in AASB 121.10 and AASB 121.11 should be referred to for additional guidance.
Based upon the information available in the question, the functional currency of CI Ltd is AUD, based upon the following indicators:
1 The selling price of goods sold by CI Ltd is determined by the prices at which the goods are expected to be sold by in Australia, less a small profit margin (i.e., Australian market conditions). Furthermore, the selling price of goods sold by CI Ltd is denominated in AUD (AASB 121.9(a));
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2 CI Ltd’s sole activity is to purchase goods from Chinese manufacturers on behalf of its parent entity, , and sell those goods to . The operations of CI Ltd are carried out as an extension of the activities of (AASB 121.11(a)); and
3 Transactions with represent a high proportion of CI Ltd’s activities (AASB 121.11(b)).
The currency that mainly influences CI Ltd’s cost of providing goods is Chinese Yuan (CNY), as CI Ltd purchases goods manufactured in China. Chinese labour, material and other costs mainly influence the cost of the manufactured goods purchased by CI Ltd (AASB 121.9(b)). However, if the manufactured goods are sold internationally, the markups and selling prices will be determined by international market conditions (foreign demand) as well as Chinese costs (supply factors).
The currency that influences the operating costs of CI Ltd is the Cayman dollar (KYD), as CI Ltd pays operating costs such as accounting and taxation in KYD. However, these operating costs would be a low proportion of CI Ltd’s total cost of providing goods.
Additional information that would be relevant to determining the functional currency of CI Ltd includes:
1 The currency in which CI Ltd obtains funds from financing activities (AASB 121.10(a));
2 The currency in which CI Ltd retains funds from operating activities (AASB 121.10(b));
3 Whether cash flows from CI Ltd’s activities directly affect the cash flows of and are readily available for remittance to (e.g., CI Ltd paying dividends or providing loans to [AASB 121.11(c)]); and
4 Whether the cash flows from CI Ltd’s activities are sufficient to service CI Ltd’s debt obligations (AASB 121.11(d)).
Arthur et al. Q10.5 Importance of the choice of functional currency (Sections 10.3 and 10.10)
(a) Effect of choice of functional currency on reported profits of subsidiary
The choice of functional currency of the subsidiary will affect the reported profits of the subsidiary, because transactions and account balances which are not denominated in that currency will need to be translated into the functional currency. Income and expense transactions that are not denominated in the functional currency will need to be translated into the functional currency using the exchange rates at the date of the transactions (or an average rate for the period if there are multiple transactions of a similar kind [AASB 121.21–121.23]). The foreign exchange gains and losses resulting from translating foreign currency monetary item balances into the functional currency are included in the reported profit of the subsidiary (AASB 121.28). Foreign exchange gains and losses resulting from translating foreign currency non-monetary items, which were restated to fair value into the functional currency, are included in the other comprehensive income of the subsidiary (AASB 121.30).
Alternatively, if a different currency was chosen to be the functional currency, a different set of transactions and account balances, which are not denominated in that currency will need to be translated into the functional currency. Compared to the first situation, some transactions and account balances denominated in the new functional currency, which were previously translated, now do not need to be translated, and therefore are not affected by exchange rate movements. However, other transactions and account balances denominated in the old functional currency, which were not previously translated, now do need to be translated, and therefore are affected by exchange rate movements. Therefore, choosing a different functional currency will affect the reported profits of the subsidiary.
(b) Effect of choice of functional currency on consolidated profits
The choice of functional currency of the subsidiary will also affect the consolidated profit of the group. If the currency chosen to be the functional currency of the subsidiary differs from the presentation currency for the consolidated financial report, the financial statements of the subsidiary will need to be translated from the functional currency of the subsidiary to the presentation currency of the group. Income and expense items, including any foreign exchange gains and losses included in the reported profit of the subsidiary, are translated into the presentation currency using the historic exchange rates applying at the date of the transactions giving rise to the income or expense (AASB 121.39(b)) (or if there are multiple transactions of a similar kind, the average exchange rate for the period can be used to translate the entire income or expense account balance (AASB 121.40)).
Therefore, the translated foreign exchange gains and losses included in the reported profit of the subsidiary will also be included in the consolidated profit. Where the foreign exchange gains and losses included in the subsidiary’s reported profit relate to intragroup transactions with the parent entity or other subsidiaries in the group, the amount of translated foreign exchange gains and losses included in consolidated profit is subject to consolidation eliminations and adjustments. Similarly, translated
foreign exchange gains and losses included in the other comprehensive income of the subsidiary will be included in the consolidated other comprehensive income, subject to consolidation eliminations and adjustments. Furthermore, the translation gain or loss arising upon translating the functional currency financial statements of the subsidiary into the presentation currency of the group is included in consolidated other comprehensive income (AASB 121.39(c) (and taken directly to a foreign currency translation reserve; AASB 121.41).
If a different currency was chosen to be the functional currency of the subsidiary (and also different from the presentation currency of the group), as explained in the answer to part (a), a different amount of foreign exchange gains and losses would be included in the subsidiary’s reported profit, and other comprehensive income. Therefore, the translated amount of these foreign exchange gains and losses included in consolidated profit and consolidated other comprehensive income (subject to consolidation eliminations and adjustments) will also differ. Furthermore, the amount of the translation gain or loss arising upon translating the functional currency financial statements of the subsidiary into the presentation currency of the group, included in consolidated other comprehensive income will also differ.
Alternatively, if the currency chosen to be the functional currency of the subsidiary is the same as the presentation currency for the consolidated financial report, the financial statements of the subsidiary will not need to be translated from the functional currency of the subsidiary to the presentation currency of the group. The foreign exchange gains and losses included in the subsidiary’s reported profit and other comprehensive income are directly included in consolidated profit and other comprehensive income, subject to consolidation eliminations and adjustments. Where the functional currency of the subsidiary is the same as the presentation currency for the consolidated financial report, there will not be any translation gain or loss included in consolidated other comprehensive income.
(c) Effect of choice of functional currency on consolidated cash flows
The choice of functional currency of the subsidiary will not affect the consolidated cash flows of the group. Cash flows of the group, which are denominated in a currency other than the presentation currency of the group, are translated into the presentation currency using the historical exchange rates at the date the cash flow occurs (AASB 121.21 and AASB 107.25) (or an average rate for the period if there are multiple cash flows of a similar kind as an approximation to using the historical exchange rates at the date of each cash transaction [AASB 107.27]). The relevant exchange rate for a group where the presentation currency is, say, AUD is the exchange rate for exchanging AUD with the currency in which the cash flow is denominated, regardless of the functional currency of the subsidiary. The amounts of translated cash flows will not vary with the choice of functional currency, because historical exchange rates are used to translate all cash flows.
Arthur et al. Q10.9 Economic and accounting measures of exchange gains (Section 10.9)
Where the financial statements of a foreign operation are translated from the functional currency of the foreign operation into the presentation currency using the current rate method, a foreign currency translation gain will arise where the functional currency appreciates and the net assets of the foreign operation are positive. The opening net assets translated at the closing exchange rate at the end of the period is a greater amount (expressed in terms of the presentation currency of the entity) than the opening net assets translated using the opening exchange rate at the beginning of the period. This foreign exchange gain will be adjusted for the effect of changes in net assets (including changes attributable to total comprehensive income for the period and dividends).
Assume that the functional currency of the foreign operation is the local currency of the country where the foreign operation is located. The appreciation of the local currency could lead to adverse economic consequences for investors in the foreign operation if the goods produced by the foreign operation compete with goods produced by entities located in other countries (e.g., motor vehicles). The foreign operation’s cost of producing the goods in local currency terms may be unchanged, but the appreciation of the local currency results in competing imported goods becoming cheaper. If the foreign operation exports some of the goods it produces to other countries, the appreciation of the local currency results in the exported goods becoming more expensive compared to the goods produced in those other countries. The foreign operation may need to reduce its selling prices to remain competitive, which would result in lower profits (or increased losses), and reduce the value of the foreign operation. Therefore, an appreciation of the local (functional) currency can result in a foreign currency translation gain, but adverse economic consequences for investors in the foreign operation.
If the functional (local) currency of the foreign operation differs from the presentation currency, an appreciation of the functional currency, where the net assets of the foreign operation are positive, can result in a foreign exchange translation gain, but adverse economic consequences for investors in the foreign operation in the form of reduced profits, and reduced value of their investment. Alternatively, if the functional currency of the foreign operation is the same as the presentation currency, there will not be any foreign currency translation gain or loss, but there still can be adverse economic consequences for investors in the foreign operation, if there is an appreciation of the local currency of the country where the foreign operation is located.
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