More thoughts on functional currency under IFRS – development-stage entities

by John Hughes

In my last post on some of the issues relating to functional currency under IFRS, I skipped over a question that’s come up a few times 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 if and when they ever attain production, it’s clear most of their sales will be denominated in another currency altogether (say US dollars). On the basis that the subsidiary’s anticipated (or at least intended) primary economic environment will ultimately be the US dollar, could the US dollar appropriately be regarded as its functional currency at the current time?

The plainest reading of IAS 21 would likely say it can’t be. Applying the primary indicators 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). Alternatively, depending on the circumstances, the additional factors in IAS 21.11 may lead to identifying the functional currency as the Canadian dollar (if, for example, the foreign subsidiary is unable to service its obligations without receiving funds from the Canadian parent). In either of these scenarios, the functional currency may well change once the entity becomes an active producer and starts to generate US dollar-denominated revenues.

I think that’s a reasonable enough analysis but I’m not sure it’s necessarily the only one. 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 it’s just as reasonable to conclude this factor doesn’t apply either. In this case, the right answer might be indicated by looking at the currency in which funds from financing activities are generated, or at the additional factors pertaining to the relationship with the parent. But on a careful reading, those other factors are also arguably largely moot in the context of a development stage entity.

Let’s go back then 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, indicating 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 I think it’s plausible to 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 makes 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 noted it may well have to apply a change of functional currency later on, if and when it enters production. But although entering production is obviously a change of circumstances in some literal sense, I doubt it’s 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.

On the other hand, one could perhaps extend this line of thinking into macro-economic hyperspace, to say, well, even if the price of our intended product will be denominated in US dollars, the currency that will mainly influence it in the long run is the Chinese yen, because the price ultimately rises or falls with the outlook for demand from China. Ultimately, maybe the core principle driving the notion of functional currency just isn’t as clear as it could be. But that’s no reason just to approach it as a set of rules!

The opinions expressed are solely those of the author.