Identifying functional currency for development-stage entities – a matter of judgment!, part one

A common question relating to identifying an entity’s functional currency under IFRS, on which one can find plenty of diversity in practice.

Many Canadian entities, particularly in the resource industries (and let’s assume for this purpose with Canadian dollar functional currencies), have exploration-stage foreign subsidiaries. At the current time, those subsidiaries are incurring the bulk of their costs in the foreign currency (say the South African rand), but they’re entirely dependent on the parent, with its Canadian dollar capital structure, to keep this going. Further, if they ever do enter commercial production, revenues may be received in another currency altogether (say the United States dollar). So how should their functional currency be assessed?

Applying the primary indicators of an entity’s functional currency in IAS 21.9, you might say the factors relating to sales prices simply aren’t applicable, and that you get the right answer by looking at the currency mainly influencing labour, material and other costs (the South African rand). However, it’s arguably too simple to conclude that only the sales-related indicators don’t apply. IAS 21.9(b) expresses the second factor as “the currency that mainly influences labour, material and other costs of providing goods or services.” If the entity isn’t currently providing goods or services – and if it’s in the development stage, it isn’t – then you might argue this factor doesn’t apply either.

In this case, the right answer might be indicated by looking at the factors that “may also provide evidence” of functional currency set out in IAS 21.10, and the “additional factors” set out in IAS 21.11 – in particular, perhaps, the currency in which funds from financing activities are generated, and the indicators pertaining to the relationship with the parent – leading in our example to the Canadian dollar. This argument seems supported by the following passage of the basis of conclusions to IAS 21:

  • “The Board also discussed whether a foreign operation that is integral to the reporting entity (as described in the previous version of IAS 21) could have a functional currency that is different from that of its ‘parent.’ The Board decided that the functional currencies will always be the same, because it would be contradictory for an integral foreign operation that ‘carries on business as if it were an extension of the reporting enterprise’s operations’ to operate in a primary economic environment different from its parent.”

The problem there is that this passage doesn’t so much illuminate the body of the standard, as the basis for conclusions material usually does, but flatly contradict it, providing no clear way forward. Perhaps one could choose to take a forward-looking approach to the issue, as CPA Canada’s IFRS Discussion Group did in discussing the issue:

  • “The Group also discussed whether to look at future-oriented factors when determining the functional currency. Some Group members observed that practice is mixed as guidance in IAS 21 is not explicit in this area. Future-oriented factors that may be relevant include:
  • the time horizon of when revenues are expected to be generated; and
  • the currency that the revenue is expected to be denominated in according to the business model of the entity when it becomes fully operational.
  • Considering the mining or oil and gas industries as examples, these factors are important because sometimes an entity in the start-up phase may have a business model to sell the assets once probable resources exist rather than to develop the property to achieve production. Other entities may have a business model that will generate revenue in a certain currency (for example, sell gold in U.S. dollars) that may be different from the currency of the expenditures in the start-up phase when the functional currency is being determined.
  • Some Group members pointed out that a related issue is determining when an entity would need to reassess its functional currency, and what the triggering event might be. Depending on how an entity interprets and applies the requirements in IAS 21, it could lead to a change in functional currency at a later stage, particularly with development stage entities.”

But let’s go back to the core definition of a functional currency – “the currency of the primary economic environment in which the entity operates.” It goes on to say this is “normally the one in which it primarily generates and expends cash.” But the key word there is normally, suggesting (to me anyway) that following the cash might not always provide the right answer here. If a development-stage entity is working towards producing a mineral, the price of which would ultimately be denominated in US dollars, then perhaps one can argue its primary economic environment is that of the US dollar, even if it currently has little or no activity in that currency. After all, as many entities can testify, if the US dollar denominated market price falls below a certain level, then the entire project may become uneconomic; if the price rises, it may become attractive again. What could be more fundamental than that? Following that logic, it might make sense to show the trend of exchange gains or losses from the US dollar perspective, because that’s exactly the perspective investors should have when they consider the entity’s prospects.

Coming at that a different way, if the entity chooses the South African rand based solely on its current expenditures, then as the IDG’s discussion indicates, it may well have to reassess its functional currency later on, if and when it enters production. But although entering production is obviously a change of circumstances in some literal sense, you might argue it isn’t a change of circumstances in a sense that should impact the primary perspective of users. After all, their investing prospects have always been linked to the US-dollar denominated mineral price. Entering production doesn’t change that – it confirms it. The functional currency surely ought in some sense to be aligned with the key risks that will shape the entity’s future, and these plainly aren’t necessarily merely a function of how it happens to be spending money at the present moment.

But there’s a counter-argument to that too. I’ll return to it next time…

The opinions expressed are solely those of the author

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