Foreign operations – Ind AS 21

Executive summary of Foreign Operations

Let us see how the functional currency is determined for a foreign operation.  So what are the factors to be considered in determining the functional currency of a foreign operation? 

Basically, there are four factors to be considered. Let us see those factors one by one.

The first factor to be considered is the degree of autonomy.  The question that needs to be asked is whether the foreign operation is conducted as an extension of the reporting entity. Are the activities in such foreign operation carried out without significant autonomy? If the answer is ‘No’, then the local currency would be the functional currency of such foreign operation. However, if the answer is ‘Yes’, then the reporting entity’s currency would be the functional currency of the foreign operation. 

The second factor to be considered is the transactions of the foreign operation with the reporting entity.  The question that needs to be asked is – Is the percentage and frequency of transaction with the reporting entity significant?  If the answer is ‘Yes’, then the reporting entity’s currency would be the functional currency of the foreign operation.  If the answer is ‘No’, then the local currency would be the functional currency of such foreign operation.

The third factor to be considered is the effect of cash flows. The question that should be asked is – Does the cash flow of foreign operation affect the cash flows of the reporting entity.  If the answer is ‘No’, then the local currency would be the functional currency of the foreign operation. If the answer is ‘Yes’, then the reporting entity’s currency would be the functional currency of such foreign operation. 

The fourth factor to be considered is about financial and debt servicing. The question that should be asked is whether the cash flows of foreign operations is sufficient to service its own debt? If the answer is ‘Yes’, then the reporting entity’s currency would be the functional currency of such foreign operation. If the answer is ‘No’, then the local currency would be the functional currency of the foreign operation.

If the indicators are mixed, the management should use its discretion to determine the functional currency of the foreign operation. 

A change in the functional currency is not generally permitted

It is changed only when there is a change in underlying factors.

What is foreign operation?

• A foreign operation is an entity which could either be a subsidiary, associate, joint venture or a branch of the reporting entity
• The activities of the foreign operation are conducted in a country or currency other than that of the reporting entity

Factors for foreign operation

• Following four factors are to be considered for determining functional currency of foreign operations:
• Degree of autonomy
• Percentage and frequency of transaction with the reporting entity
• Effect of cash flows on the reporting entity
• Financing and debt servicing

Degree of autonomy

• If the activities of the foreign operations can be regarded as an extension of the reporting entity, then the reporting entity’s currency would be the functional currency of the foreign operation
• In this case, the activities of the foreign operations are carried out without significant autonomy
• However, if the foreign operation is carried out with significant autonomy, then the local currency of the foreign operations would be its functional currency e.g., where the foreign operation accumulates cash and increases expenses or generates income in local currency, the local currency would be its functional currency

Example:  Indicator – Degree of autonomy

            Sungsam Limited is an Indian company making laptops.  It has a subsidiary in Korea, known as Sungsam Corporation.   The Indian entity sells some of the laptops to Korean subsidiary.  The Korean subsidiary is the authorised dealer of Sungsam Limited for Asia.  The Korean subsidiary has no other activity than selling these laptops.  What should be the functional currency Sungsam Corporation, Korea? 

1. Korean Currency: 

Ans: Incorrect.   The Korean company does not have any activity other than selling the laptops received from its parent company.  It could be concluded that the foreign subsidiary is an extension of the Indian company.  The functional currency of Sungsam Corporation should be INR which is the functional currency of Sungsam Limited, India.  The Korean currency is not the functional currency of the Korean subsidiary.

• INR:

Ans: Correct.  The Korean company does not have any activity other than selling the laptops received from its parent company.  It could be concluded that the foreign subsidiary is an extension of the Indian company.  The functional currency of Sungsam Corporation should be INR which is the functional currency of Sungsam Limited, India.  The Korean currency is not the functional currency of the Korean subsidiary.

Percentage and frequency of transaction

• Transactions with the reporting entity are considered in this factor.  If the transactions of the foreign operations form a high percentage of its overall activities, then the currency of the reporting entity will become the functional currency of the foreign operation
• On the other hand, if the percentage and frequency of transaction with the reporting entity are not significant and can be considered as meagre, then the local currency of the foreign operation would be its functional currency

Indicator – Percentage and frequency of transaction

            Aerobridge Limited has a subsidiary, Aerobridge Dubai Corporation in Dubai, manufacturing aeronautical components.  Aerobridge Dubai sells its entire production to Aerobridge Limited, India.  Determine the functional currency of Aerobridge Dubai Corporation.  The functional currency of Aerobridge Limited is INR. 

1. INR.

Ans: Correct.  When we consider the total percentage of transactions Aerobridge Dubai Corporation Dubai has with the parent company viz., Aerobridge Limited, it is found that it forms a very significant percentage of transaction.  Hence the functional currency of Aerobridge Limited will be the functional currency of Aerobridge Dubai Corporation.

• UAE Dhiram:

Ans: Incorrect. When we consider the total percentage of transactions Aerobridge Dubai Corporation Dubai has with the parent company viz., Aerobridge Limited, it is found that it forms a very significant percentage of transaction.  Hence the functional currency of Aerobridge Limited will be the functional currency of Aerobridge Dubai Corporation.

Effect of cash flows

• Foreign operations generate cash flows which should be analysed to find out if such cash flows directly affect the cash flows of the reporting entity
• It should also be analysed if such cash flows are available for remittance to the reporting entity and if these conditions are satisfied, then the currency of the reporting entity would be the functional currency of the foreign operation as well
• However, if the cash flows do not impact the cash flows of the reporting entity, then the local currency of the foreign operation would be deemed to be its functional currency

Indicator – effect of cash flows

            Ananda Software Limited is having a subsidiary located in Paris.  Ananda Software Limited exports a substantial portion of its software through its Paris subsidiary.  Since substantial portion of its exports is through the Paris subsidiary, Ananda Software Limited depends upon remittance from Paris so as to run its software development activities in India.  Paris subsidiary is in a position to remit the software proceeds to India on a regular basis.  Determine the functional currency of the Paris subsidiary.  

1. EUR:

Ans: Incorrect. The functional currency of Ananda Software Limited viz., INR is also the functional currency of its Paris subsidiary as the cash flows from the Paris operations are substantial and directly affects the cash flows of Ananda Software Limited.

• INR:

Ans:  Correct. The functional currency of Ananda Software Limited viz., INR is also the functional currency of its Paris subsidiary as the cash flows from the Paris operations are substantial and directly affects the cash flows of Ananda Software Limited.

Financing and debit servicing

• Where the cash flows of the foreign operation are insufficient to service its own debt obligations, without looking for any assistance from the reporting entity, then the currency of the reporting entity would be the functional currency of the foreign operation
• However, if the financing and servicing of the debt obligation is made from the surplus available in such foreign operation, then the local currency would be the functional currency of the foreign operation

Indicator – Financing and debit servicing

Prima Facie Limited started a subsidiary in New York known as Ipso Facto Inc.  Ipso Facto Inc. borrowed USD 500,000 from Bank of New York and is yet to start its operations.  Ipso Facto Inc. depends on Prima Facie Limited for both repayment of the sales and service loan.  Determine the functional currency of the Ipso Facto Inc. 

1. USD:Incorrect.  The functional currency of Ipso Facto Inc. is INR which is the functional currency of Prima Facie Limited, as the subsidiary does not have enough cash flows to repay the loan as well as interest on such loan.

• INR. Correct. The functional currency of Ipso Facto Inc. is INR which is the functional currency of Prima Facie Limited, as the subsidiary does not have enough cash flows to repay the loan as well as interest on such loan.

Mixed indicators

• When the indicators mentioned above are mixed, then the management should use its judgement to determine the functional currency that most effectively represents the economic effects of the underlying transactions, events and conditions
• As mentioned above, the primary indicators are considered  first before the additional indicators are considered which are provided mainly to give effect of supporting evidence to determine an entity’s functional currency

Change in functional currency.

• Functional currency is not changed unless there is a change in underlying transactions, events and conditions, so as to alter the economic changes

When does the entity change its functional currency?

• Functional currency is changed whenever the entity feels like changing.

Ans: Incorrect. Functional currency is not changed unless there is a change in underlying transactions, events and conditions so as to alter the economic changes.

• Functional currency is not changed unless there is a change in underlying transactions, events and conditions so as to alter the economic changes.

Ans: Correct. Functional currency is not changed unless there is a change in underlying transactions, events and conditions so as to alter the economic changes.

Restatement of financial statements.

• If the functional currency is the currency of a hyperinflationary economy, the entity’s financial statements are restated in accordance with Ind AS 29, Financial Reporting in Hyperinflationary Economies

An entity cannot avoid restatement in accordance with Ind AS 29 by, for example, adopting as its functional currency a currency other than the functional currency determined in accordance with this Standard (such as the functional currency of its parent).

Ind AS Accounting Standards