The term foreign operation includes subsidiaries, associates, joint ventures or branches of a reporting entity, and which activities are based or conducted in a country or currency other than those of the reporting entity. IAS 21 requires an assessment to determine whether the foreign operation inherits the reporting entitys functional currency, or whether it has a functional currency in its own right. The following additional factors are considered when determining the functional currency, and whether its functional currency is the same as that of the reporting entity:
- Autonomy - Whether the operation is essentially an extension of the reporting entity.
- Proportion of transactions Whether the foreign operations transactions with the reporting entity constitute a high or low proportion of the operations activities.
- Proportion of cash flows Whether cash flows from the activities of the foreign operation directly affect the cash flows of the reporting entity and are readily available for remittance to it.
- Debt service Whether a foreign operations cashflow can service its debt obligations without funds being made available by the reporting entity.
As described above, an entitys functional currency reflects the underlying transactions, events and conditions that are relevant to it. Hence, once determined, the functional currency does not change unless there is a change in the underlying nature of the transactions and relevant conditions and events. For example, a change in the currency that mainly influences the sales prices of the goods and services following a relocation of a significant component of the entitys business may led to a change in an entitys functional currency.
The effect of a change in the functional currency is accounted for prospectively. Therefore, an entity translates all items into the new functional currency using the exchange rate at the date of change. The resulting translated amounts for non-monetary items are treated as their historical cost. Exchange differences arising from the translation of a foreign operation previously recognised in other comprehensive income are not reclassified from equity to profit and loss until the disposal of the operation.