Functional currency

A key issue for developing mining companies reporting under IFRS is correctly determining their functional currency. This is defined by IAS 21 as ‘the currency of the primary economic environment in
which the entity operates’. An incorrect functional currency can result in significant misstatement in the financial statements.

Unlike presentation currency (which is a matter of choice), a company’s functional currency should be a matter of fact. There are several factors that need to be considered in determining the most appropriate currency.

The currency that most influences sales prices, often that in which revenue is denominated, is usually the most significant driver of functional currency, but for exploration or early stage developers, there may be no revenue as yet. So how else to determine functional currency?

This would involve considering the currency in which labour, material  and expenses are incurred. Thereafter, other factors may provide evidence of an entity’s functional currency including the currency in which borrowings are denominated, and the currency in which cash is held.

The relative importance of these factors changes during the development cycle of the company. At the exploration or development stage, it is likely that the functional currency could be the local currency of the jurisdiction in which the project is situated, with expenses including salaries, fuel and electricity.

Once the project comes into production and starts to generate revenue, there will be a period of transition as income grows to become the largest influence. Management will need to determine a transition point, which may be reaching a certain stage in commissioning or production level. At this stage, the currency affecting revenue, often the US Dollar, may take over.

A change in functional currency is a significant accounting judgement and management will need to justify in the financial statements the point at which the functional currency changed. The translation procedures should be applied prospectively from the date of change. All items are translated to the functional currency at the rate prevailing at the date of change. For non-monetary items, this becomes their historic cost.

The impact of an incorrect functional currency may result in a misstatement to foreign exchange differences being recognised in the statement of comprehensive income and may present an inaccurate view of the company’s financial performance.

From a UK perspective for example, a company’s functional currency is also important from a tax point of view. Broadly, a company’s tax computations must be prepared in sterling, based on accounts prepared in the company’s functional currency. Therefore if a company prepares its accounts using an incorrect functional currency its tax computations will be incorrect and, in order to prepare correct tax computations, it will be necessary to prepare revised accounts using the correct functional currency for each relevant year, which could cause difficulties in practice.

Depending on the circumstances, the determination of the company’s functional currency could significantly affect the exchange differences recognised through profit and loss. As a general rule, any exchange gains and losses will be taxable or allowable and therefore that determination can also have a significant effect on the company’s tax position.

For further detail on how to consider the functional currency, and the impact of a change please contact us.