IFRS Cases

Case 11-4 Functional Currency Determination

2.1 Topic 830 is based on the proposition that the translation of the financial statements of a foreign subsidiary, branch, division, joint venture, or other investee should accomplish the following objectives: Provide information that is generally compatible with the expected economic effects of a rate change on a reporting entity's cash flows and equity; and Reflect in consolidated statements the financial results and relationships of the individual consolidated entities as measured in their functional currencies in conformity with U.S. generally accepted accounting principles (GAAP).

Translation Process
Translation Process 1. Adjusting the financial statements of any foreign entity to be consolidated, combined, or accounted for by the equity method to conform with U.S. GAAP; 2. Determining whether the foreign entity operates in a highly inflationary economy, in which case the parent or investor entity's currency is to be used as if it were the entity's functional currency; 3. Determining the functional currency of the foreign entity if it does not operate in a highly inflationary economy; 4. Remeasuring the financial statements of the foreign entity into its functional currency if its accounting records are not kept in that currency; and 5. Translating the financial statements of the foreign entity into U.S. dollars (USDs) by applying the current exchange rate.

Highly Inflationary Economies

In highly inflationary economies, financial statements that are expressed in nominal units of local currency and that report nonmonetary assets at historical cost are not meaningful. Accordingly, paragraph 830-10-45-11 requires that the parent entity's reporting currency (i.e., the USD in the case of a U.S. parent) be used as if it were the functional currency for all operations in highly inflationary economies.

Functional Currency-US GAAP

The key step in the process of translating the financial statements of a foreign branch, subsidiary, or other investee is determining its functional currency. This is the key step because the amounts in its financial statements must be measured using its functional currency. The functional currency of a foreign entity not operating in a highly inflationary economy is defined as the currency of the primary economic environment in which it operates; normally, that is the currency of the environment in which the entity primarily generates and expends cash.

Functional Currency Determination Under US GAAP

Paragraph 830-10-45-6 provides that: The functional currency (or currencies) of an entity is basically a matter of fact, but If the facts do not clearly identify an entity's functional currency, management must assess the economic facts and circumstances pertaining to the entity's operations in relation to the objectives of translation specified by Topic 830 and must use its judgment in deciding the weight to give to the various economic facts and circumstances.

Factors affecting functional currency determination: US GAAP Cash flows. Cash flows related to the foreign entity's individual assets and liabilities are primarily in the foreign currency and do not directly affect the parent entity's cash flows. Sales prices. Sales prices for the foreign entity's products are not primarily responsive on a short-term basis to changes in exchange rate but are determined more by local competition or local government regulation. Sales market. There is an active local sales market for the foreign entity's products, although there also might be significant amounts of exports. Expenses. Labor, materials, and other costs for the foreign entity's products or services are primarily local costs, even though there also might be imports from other countries. Financing. Financing is primarily denominated in foreign currency, and funds generated by the foreign entitys operations are sufficient to service existing and normally expected debt obligations. Intra-entity transactions and arrangements. There is a low volume of intra-entity transactions and there is not an extensive interrelationship between the operations of the foreign entity and the parent entity. However, the foreign entity's operations may rely on the parent's or affiliates' competitive advantages, such as patents and trademarks.

Remeasurement to Functional Currency: US GAAP

If a foreign entity's accounting records are not kept in its functional currency remeasurement into the functional currency is required. The objective of the remeasurement process is to produce the same results that would have been reported if the accounting records had been kept in the functional currency. Exchange adjustments arising in the remeasurement process are included in the determination of income. Therefore, if a U.S. parent entity concludes that the functional currency of one of its foreign subsidiaries whose records have been kept in the local currency is the USD or if a U.S. parent has a foreign subsidiary that operates in a highly inflationary economy, the remeasured dollar financial statements of the subsidiary will be prepared in substantially the same manner as its dollar-translated financial statements.

Remeasurement process-US GAAP

Paragraph 830-10-45-18 contains a listing common nonmonetary balance-sheet accounts and related income-statement accounts that must be remeasured using historical exchange rates. For balance-sheet accounts, the accounts are: Marketable securities carried at cost: Equity securities; and Debt securities not intended to be held until maturity. Inventories carried at cost; Prepaid expenses such as insurance, advertising, and rent; Property, plant, and equipment; Accumulated depreciation on property, plant, and equipment; Patents, trademarks, licenses, and formulas; Goodwill; Other intangible assets; Deferred charges and credits, except policy acquisition costs for life insurance companies; Deferred income; Common stock; and Preferred stock carried at issuance price. Revenues and expenses related to nonmonetary items, for example: 1. Cost of goods sold 2. Depreciation of property, plant, and equipment 3. Amortization of intangible items such as patents, licenses, and so forth 4. Amortization of deferred charges or credits except policy acquisition costs for life insurance entities.

Translation Process-US GAAP

When a foreign entity's accounting records are maintained in its functional currency, its financial statements must be translated by using the current exchange rate. When an entity's accounting records are not maintained in its functional currency, the elements of its financial statements must be remeasured and the remeasured amounts are required before translation into the reporting currency. All elements (e.g., assets, liabilities, revenues, expenses, gains, and losses) of financial statements must be translated by applying the current exchange rates as of the dates they are reported. Accordingly:
Assets and liabilities reported in the balance sheet must be translated at the current exchange rate as of the balance-sheet date; and Revenues, expenses, gains, and losses reported in the statement of income must be translated at the current exchange rates as of the date on which they are recognized.

Functional Currency IFRS

Meaning of functional currency is very similar. However, process of determination of the functional currency is somewhat different. In particular, rather than being an issue of fact as is under US GAAP, IAS 21 establishes a hierarchy of factors to determine the functional currency.

Para 9-12 IAS 21

The primary economic environment in which an entity operates is normally the one in which it primarily generates and expends cash. An entity considers the following factors in determining its functional currency: (a) the currency: (i) that mainly influences sales prices for goods and services (this will often be the currency in which sales prices for its goods and services are denominated and settled); and (ii) of the country whose competitive forces and regulations mainly determine the sales prices of its goods and services. (b) the currency that mainly influences labour, material and other costs of providing goods or services (this will often be the currency in which such costs are denominated and settled). 10 The following factors may also provide evidence of an entitys functional currency: (a) the currency in which funds from financing activities (ie issuing debt and equity instruments) are generated. (b) the currency in which receipts from operating activities are usually retained.

IAS 21 cont:
11(a) whether the activities of the foreign operation are carried out as an extension of the reporting entity, rather than being carried out with a significant degree of autonomy (b) whether transactions with the reporting entity are a high or a low proportion of the foreign operations activities. (c) 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. (d) whether cash flows from the activities of the foreign operation are sufficient to service existing and normally expected debt obligations without funds being made available by the reporting entity.

Conclusion: Part 1
Under IFRS, USD is a functional currency of Sparkle mainly because Most sales are denominated in US$ and the US$ competitive forces and regulations determine the sales prices of goods and services. Both of these factors are primary factors at the top of the hierarchy of IAS 21. There are mixed results in the remaining factors (Deloitte solution)

Conclusion: Part 1 (cont.)

because the functional currency indicators included in ASC 830-10-55-3 through 55-7 (e.g., cash flows, sales price, sales market, expenses, financing, and intercompany transactions and arrangements) are considered equally as opposed to the hierarchy of factors provided in paragraphs 9 12 of IAS 21 one could reasonably conclude that NGN is the functional currency of Sparkle (Deloitte solution)

Conclusion: Part 2
IFRS: Nothing changed, so USD is the functional currency US GAAP: USD is now functional currency, because now all of Sparkle cash flows are on behalf of Brighten.

Case 12.03 Provisions and Contingencies

A provision, as defined in paragraph 10 of IAS 37, Provisions, Contingent Liabilities and Contingent Assets, should only be recognized when three specific criteria have been met.
(1) an entity must have a present obligation and such obligation must result from a past event. The present obligation can be either a legal or constructive obligation, which are both defined in paragraph 10 of IAS 37. (2) an entity must conclude that it is probable that it will be required to settle the obligation and that such settlement will result in an outflow of resources embodying economic benefits. For purposes of this criterion, probable means more likely than not. (3) an entity must conclude that it can make a reasonable estimate of the obligations amount. If these three criteria are not all met (i.e., none, one, or two of the criteria are met), the entity should not recognize a provision.

Contingent Liability--IFRS
Contingent liabilities, as defined in paragraph 10 of IAS 37, are not recognized in the balance sheet. However, a contingent liability should be disclosed when an entity concludes that there is more than a remote possibility that the contingent liability will result in an outflow of resources embodying economic benefits (see the 20 Loss Contingencies - Disclosure Requirements Provisions and Contingent Liabilities section of this chapter).

Past Event--IFRS
Past Event A past event that leads to a present obligation is called an obligating event. For an event to be an obligating event, it is necessary that the entity has no realistic alternative to settling the obligation created by the event. This is the case only: (a) where the settlement of the obligation can be enforced by law; or (b) in the case of a constructive obligation, where the event (which may be an action of the entity) creates valid expectations in other parties that the entity will discharge the obligation.

Scenario 1
IFRS: Record a provision because it is virtually certain that the law obligating payment will be passed. US GAAP: No accrual because future laws are not used as a basis for recording liability. Here it is important to distinguish between the fact of law being in existence (virtually certain), but uncertainty whether it will be retroactive (hence no US GAAP accrual)

Scenario 2
IFRS: Yes, because constructive obligation occurs US GAAP: No, because voluntarily obligations by management do not lead to contingencies.

Scenario 3
IFRS: No, since it does not related to past event US GAAP: No, because no present obligation exists.

Scenario 4
IFRS: no, since no past obligation exists US GAAP: no, since no past obligation exists