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

Continuing with some complexities of identifying an entity’s functional currency under IFRS

We concluded last time by considering a Canadian mining entity that identities the South African rand as the functional currency of an exploration-stage foreign subsidiary, based solely on its current expenditures. As the discussion of CPA Canada’s IFRS Discussion Group indicates, it may well have to reassess its functional currency later on, if and when it enters production. But I suggested last time that 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.

One complexity though is that the argument I made there may misrepresent the significance of the US dollar to the entity. In one of its Viewpoints series on applying IFRSs in the mining industry, CPA Canada says this:

  • “In the mining industry, sales prices for metals are often denominated and settled in USD; however, the USD may only be acting as a currency of convenience (i.e., it may not in fact influence sales prices) and, as a result, sales prices may fluctuate in response to changes in the USD exchange rate.
  • For example, a Canadian mining entity may sell its production of gold to the Royal Canadian Mint in USD. Although the USD is often the currency in which sales prices for gold are denominated and settled, this does not necessarily mean that the USD is the currency that mainly influences sales prices for gold because the sales prices for gold are determined in global markets.
  • For many of the commodities sold by mining entities, it will be difficult to identify a single country whose competitive forces and regulations mainly determine the sales prices because of the global nature of the mining industry.”

The Alberta Securities Commission provided an example of this in the recent Corporate Finance Disclosure Report I discussed here. The report addresses a case in which an entity “with a material foreign operating subsidiary changed the functional currency of the foreign entity effective January 1, 2014…Currency X was the functional currency of ForeignSub up to December 31, 2013, at which time it was changed to the United States Dollar (USD).” The example goes on:

  • “Although the note disclosure and the (issuer’s) response indicated that the change in functional currency corresponded to the significant acquisition in Country X completed by the (issuer) in December of 2013, the (issuer) had material operations, including significant revenues, from its pre-existing Country X properties. As such, there was uncertainty as to whether there was actually a change in the underlying transactions, events and conditions that are relevant to the ForeignSub, and as to the timing of any such change.
  • The (issuer’s) analysis supporting USD as the new functional currency stated that the indicators in paragraph 9 of IAS 21 were mixed. However, the main factors included:
  •    the benchmark price for oil and natural gas was set in USD;
  •    the revenues were invoiced in USD;
  •    most of the operating costs were transacted and invoiced in Country X currency;
  •    most of the capital costs were regularly transacted and invoiced in USD; and
  •    settlement of all invoices was in Country X currency.
  • This analysis focused on the currency in which the sales and costs were denominated, but not necessarily the primary economic environment in which the entity operated and the currency that mainly influenced the sales prices or the labour, material and other costs.
  • The fact that revenues are invoiced in USD does not necessarily indicate that this currency influences these sales prices. Specifically, prior to 2015, the Country X government would override the global market by regulating domestic pricing; as such, the influence on sales prices would be more weighted on the Country X area rather than the US. We did note that starting in 2015, the domestic pricing for Country X is more directly tied to the US.”

Still, the ASC doesn’t say it actively disagreed with the approach the issuer took, only that it “requested increased disclosure of the key judgements relating to the determination of ForeignSub’s functional currency in the (issuer’s) future disclosure, taking into account the factors that support the primary as well as the secondary factors considered.” It’s hard to know where to turn for any more definitive guidance. What if (for the sake of argument) one could demonstrate that the phrase “determined in global markets” as used in CPA Canada’s second paragraph above essentially means determined in China. Could it follow that the functional currency is the Chinese yen, even if the entity will never use that currency directly? No one’s likely to use such an argument, but frankly, I’ve heard worse rationales for accounting treatments.

Where does all of this leave us? Well, the Accounting Standards Board “discussed the issue at its November 2015 meeting and directed the staff to undertake further limited research on the issue to find out whether there is diversity in practice, particularly among Canadian development-stage entities.” Subsequently, in March 2016, it “directed the staff to determine next steps.” So maybe that’ll get somewhere eventually. Until then, we end up where we so often do, with (as CPA Canada put it) a matter of judgment, based on an assessment of the specific facts and circumstances relevant to each entity. Where else!

The opinions expressed are solely those of the author.

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