How to Apply and Audit Foreign Currency Translation Under IAS 21

Functional currency is not a choice: applying IAS 21.9 through IAS 21.12

IAS 21.8 defines functional currency as the currency of the primary economic environment in which the entity operates. This is a factual determination, not a policy election. The entity cannot choose its functional currency any more than it can choose its reporting period.

IAS 21.9 gives the primary indicators. The functional currency is the currency that mainly influences sales prices for goods and services, and the currency of the country whose competitive forces and regulations mainly determine those sales prices. These are the dominant indicators. If an entity invoices 90% of its revenue in EUR and sells into a market where EUR-denominated pricing is standard, the primary indicator points clearly to EUR regardless of what currency the entity’s parent uses.

IAS 21.10 adds a secondary layer: the currency that mainly influences labour, material, and other costs of providing goods and services. When an entity earns in EUR but sources 80% of its raw materials in USD (because the commodity is priced in USD globally), the secondary indicator creates a tension that requires judgment.

The standard doesn’t prescribe a weighting between primary and secondary indicators. Your working paper needs to document both, explain the tension, and conclude which currency represents the primary economic environment on balance.

When primary and secondary indicators point in different directions, IAS 21.12 lists additional factors to consider. These include the currency in which funds from financing activities are generated and the currency in which receipts from operating activities are usually retained. An entity that borrows in CHF, earns in EUR, pays suppliers in USD, and retains cash in EUR has a complex profile. The additional factors serve as tiebreakers, not substitutes for the primary analysis.

For groups with foreign operations, IAS 21.11 adds indicators for determining whether a foreign operation’s functional currency matches the parent’s. These include the degree of autonomy, the proportion of intercompany transactions, the currency of financing, and whether cash flows from the operation directly affect the parent’s cash flows. A subsidiary that operates independently in its local market, finances itself locally, and remits only dividends will almost certainly have the local currency as its functional currency. A subsidiary that functions as an extension of the parent (filling orders, using parent-funded working capital, remitting all cash daily) points toward the parent’s functional currency.

When functional currency changes: IAS 21.36 and the reassessment trigger

Many entities set their functional currency once and never revisit the determination. IAS 21.36 requires reassessment when there is a change in the underlying transactions, events, and conditions that determined the original functional currency.

A Dutch entity that signed its first major USD-denominated supply contract in 2023, shifting 60% of its cost base to USD, may need to reconsider whether EUR is still the functional currency. The trigger isn’t a specific percentage. It’s a genuine shift in the primary economic environment. Your working paper should document the primary and secondary indicators annually, even when the conclusion doesn’t change, because the evidence trail matters if a reviewer questions the determination in a later year.

When the functional currency does change, IAS 21.37 requires prospective application from the date of the change. The entity translates all items into the new functional currency using the exchange rate at the date of the change. For non-monetary items, the resulting translated amounts become their historical cost in the new functional currency. No retrospective restatement. No catch-up adjustment to retained earnings. The change is applied from the date forward.

The practical difficulty is identifying the exact date. A shift in economic environment rarely happens on a single day. If a client’s functional currency changes because its revenue mix shifted over the course of 2024, you need to agree on a date (typically the beginning of the period in which the change occurred) and document why that date was selected. This requires a conversation with the client, not a unilateral determination.

Transaction date rates, average rates, and what IAS 21.22 actually permits

IAS 21.21 requires foreign currency transactions to be recorded using the spot exchange rate at the date of the transaction. For a purchase invoice dated 15 March, you use the EUR/USD rate on 15 March. Not the month-end rate. Not the rate when the invoice was entered into the accounting system.

In practice, most mid-tier entities don’t apply daily spot rates to individual transactions. IAS 21.22 permits an average rate for a period as a practical expedient, provided exchange rates don’t fluctuate significantly during that period. The standard doesn’t define “significantly.” Your audit judgment needs to assess whether the client’s chosen averaging period (weekly, monthly, or quarterly) produces results that are materially different from applying actual transaction-date rates.

The test is straightforward. Take a sample of material transactions. Compare the rate the client applied (the period average) against the actual spot rate on the transaction date. If the differences are immaterial in aggregate, the average rate is acceptable.

If the currency pair experienced a sharp movement during the averaging period (the GBP/EUR rate moved 4% in a single week during a political event, for instance), the average rate for that period isn’t a reasonable approximation any longer. IAS 21.22 would require the entity to use actual rates for transactions during that volatile window. This isn’t a theoretical concern. Currency pairs involving GBP, TRY, and several Eastern European currencies have seen multiple intra-month moves exceeding 2% in recent years.

Document the test. Reviewers want to see that you considered whether the averaging period was appropriate, not just that you accepted the client’s standard practice. Include the source of the rates used (ECB reference rates are the standard source for EUR-based entities) and the materiality of any identified differences.

Closing rate for monetary items, historical rate for non-monetary items

IAS 21.23 sets the retranslation rules at each reporting date. Monetary items are retranslated at the closing rate. Non-monetary items measured at historical cost stay at the historical rate. Non-monetary items measured at fair value are translated at the rate on the date the fair value was determined.

The exchange differences arising from retranslating monetary items go to profit or loss under IAS 21.28. This means a EUR-functional entity holding a USD-denominated receivable recognises a gain or loss in profit or loss at every reporting date when the EUR/USD rate moves. Clients sometimes try to park these differences in equity or in a “translation reserve” at the individual entity level. IAS 21.28 doesn’t permit that. Translation reserves in equity are only for the translation of foreign operations under IAS 21.39.

One exception exists under IAS 21.32. Exchange differences on monetary items that form part of the reporting entity’s net investment in a foreign operation are recognised in other comprehensive income in the consolidated financial statements (and reclassified to profit or loss on disposal of the foreign operation). A common example: a parent lends EUR to its USD-functional subsidiary, and the loan is in substance part of the net investment because repayment is neither planned nor likely in the foreseeable future. The exchange difference on that intercompany loan goes to OCI in the consolidated accounts, not to profit or loss. In the parent’s separate financial statements, however, IAS 21.28 still applies and the difference goes to profit or loss. This dual treatment confuses entities that prepare both separate and consolidated statements.

The monetary versus non-monetary boundary: where errors cluster

IAS 21.16 defines monetary items as units of currency held and assets and liabilities to be received or paid in a fixed or determinable number of units of currency. Cash, trade receivables, trade payables, and loan balances are monetary. Inventory, property, plant and equipment, intangible assets, and equity investments are non-monetary.

Prepayments cause the most confusion. A prepayment for goods not yet received is non-monetary (it represents a right to receive goods, not cash). It stays at the historical rate. But an advance payment that will be refunded in cash if the goods aren’t delivered is monetary (it represents a right to receive cash). Your audit procedure needs to assess the substance of each material prepayment denominated in a foreign currency: does it convert to goods or to cash?

Deferred revenue creates the mirror-image question. A deposit received in USD for a future service delivery is non-monetary (it represents an obligation to deliver a service, not to pay cash). It stays at the historical rate. But a refundable deposit that the entity must return in cash if the service isn’t provided is monetary. The classification depends on the contractual terms, not the entity’s expectation of how the arrangement will settle.

Provisions can go either way. A warranty provision measured under IAS 37 is typically non-monetary because it represents an obligation to repair or replace goods, not to pay a fixed sum of cash. But a provision for a contractual penalty payable in a fixed foreign currency amount is monetary. The classification depends on the contractual terms, not the entity’s expectation of how the arrangement will settle.

Check each one individually.

Your working paper should include a schedule of all material foreign-currency-denominated assets and liabilities, with each item classified as monetary or non-monetary and the rate applied (closing or historical). If the entity’s ERP system applies a blanket closing rate retranslation to all foreign currency items, you’ve found an error: non-monetary items at historical cost are being retranslated when they shouldn’t be.

Translation of foreign operations under IAS 21.39

When a parent prepares consolidated financial statements, each foreign operation’s financial statements must be translated into the presentation currency. IAS 21.39 sets the method: assets and liabilities at the closing rate, income and expenses at the rates on the dates of the transactions (or an average rate as a practical approximation under IAS 21.40). The resulting exchange differences go to other comprehensive income and accumulate in a separate component of equity, commonly called the foreign currency translation reserve (FCTR).

The FCTR is a balancing figure. It arises because the balance sheet is translated at the closing rate while the income statement is translated at average rates (or transaction-date rates). When rates move during the year, these two translation bases produce a difference.

IAS 21.39(c) puts it in OCI.

The audit risk with foreign operations is completeness of the FCTR. If the consolidation model doesn’t isolate the translation adjustment as a separate line, it ends up buried in retained earnings or, worse, misallocated against goodwill. Confirm the consolidation spreadsheet calculates the FCTR explicitly. Verify that the FCTR balance rolls forward from the prior year opening balance, plus the current year translation difference, less any amounts reclassified to profit or loss on disposal of the foreign operation under IAS 21.48.

For groups with goodwill arising on acquisition of a foreign operation, IAS 21.47 requires that goodwill be treated as an asset of the foreign operation and translated at the closing rate. The resulting exchange difference goes to OCI as part of the FCTR. Many consolidation models treat goodwill as a parent-level asset and translate it at the historical rate from the acquisition date. That’s wrong. Verify the treatment of goodwill on acquisition of each foreign operation.

Similarly, fair value adjustments arising on acquisition (such as a fair value uplift to property) are treated as assets of the foreign operation and retranslated at the closing rate (IAS 21.47). If the consolidation model applies historical rates to these adjustments, the FCTR will be understated.

Disposal of a foreign operation and FCTR recycling under IAS 21.48

On disposal of a foreign operation, IAS 21.48 requires the cumulative FCTR balance relating to that operation to be reclassified from equity to profit or loss. This is a one-time recycling event that can materially affect the reported gain or loss on disposal.

Partial disposals that result in loss of control also trigger recycling (IAS 21.48A). Partial disposals that do not result in loss of control reattribute a proportionate share of the FCTR to non-controlling interests but do not recycle to profit or loss. The distinction matters for the gain or loss on disposal calculation and for the equity split between the parent and non-controlling interests going forward.

The practical audit issue is the accuracy of the cumulative FCTR. If the entity has held the foreign operation for fifteen years, the FCTR balance reflects every year’s translation difference since acquisition. If any prior year had an error in the FCTR calculation (wrong closing rate, goodwill translated at historical rate instead of closing rate, fair value adjustments not retranslated), that error carries through to the recycling amount on disposal.

Before signing off on a disposal year, request the full FCTR roll-forward from acquisition to disposal. Check at minimum the acquisition-year FCTR calculation, the most recent four years, and any year with a major rate movement. This is time-consuming but necessary. An incorrect FCTR recycling amount distorts the gain or loss on disposal, which is typically a material line item in the disposal year.

Worked example: Vandermeer Holding N.V. and its UK subsidiary

Vandermeer Holding N.V. is a Dutch investment holding company (functional and presentation currency: EUR) with €85M consolidated revenue. Vandermeer owns 100% of Ashworth Distribution Ltd, a UK-based logistics subsidiary with GBP functional currency. Ashworth’s revenues are GBP-denominated contracts with UK retailers. Ashworth finances itself through a GBP facility with Barclays. At 31 December 2024, Ashworth’s balance sheet shows total assets of £12.4M. The EUR/GBP closing rate at 31 December 2024 is 0.8620 (€1 = £0.8620). The average rate for 2024 is 0.8580. The opening rate at 1 January 2024 was 0.8690. The prior year FCTR balance attributable to Ashworth was €(142,000) (debit, meaning cumulative EUR strengthening against GBP).

Step 1: Confirm Ashworth’s functional currency (IAS 21.9 and IAS 21.11)

Ashworth’s revenue is GBP, its costs are GBP, it borrows in GBP, and it retains cash in GBP. All primary indicators in IAS 21.9 point to GBP. The IAS 21.11 autonomy indicators confirm Ashworth operates independently from the parent: local management, local financing, local customer base, dividend remittances only. Functional currency: GBP.

Step 2: Translate Ashworth’s balance sheet at the closing rate (IAS 21.39(a))

Total assets of £12.4M translate at the closing rate of 0.8620 = €14,385,150 (£12.4M / 0.8620). All assets and liabilities translate at this single rate. No historical rates apply to the consolidated balance sheet translation of the foreign operation (this is different from the individual entity retranslation rules in IAS 21.23).

Goodwill of £400,000 arising on Vandermeer’s acquisition of Ashworth also translates at the closing rate under IAS 21.47. At 31 December 2024: £400,000 / 0.8620 = €464,037. Confirm the consolidation model is not holding goodwill at the historical acquisition-date rate.

Step 3: Translate Ashworth’s income statement at the average rate (IAS 21.40)

Ashworth’s profit for the year of £1.1M translates at the average rate of 0.8580 = €1,281,585 (£1.1M / 0.8580). The engagement team reviewed monthly EUR/GBP rates during 2024 and identified no month where the rate deviated from the annual average by more than 1.5%. The average rate is a reasonable approximation of transaction-date rates for 2024.

Step 4: Calculate the current year FCTR movement

The FCTR movement for 2024 is a mechanical calculation. The difference arises because the opening net assets were translated at the 1 January rate (0.8690), the closing net assets at the 31 December rate (0.8620), and the profit for the year at the average rate (0.8580).

Assume Ashworth’s opening net assets were £10.8M. Opening net assets in EUR: £10.8M / 0.8690 = €12,428,078. Closing net assets of £11.9M (£10.8M + £1.1M profit) at closing rate: £11.9M / 0.8620 = €13,805,104. Profit translated at average rate: €1,281,585.

FCTR movement = €13,805,104 less €12,428,078 less €1,281,585 = €95,441 (credit, reflecting GBP strengthening against EUR during 2024). Updated FCTR balance: €(142,000) + €95,441 = €(46,559).

A reviewer sees the functional currency determination, the rates used with ECB sources, the translation calculations, and the FCTR roll-forward. Each element ties to a specific IAS 21 paragraph.

Practical checklist

1. Obtain the functional currency assessment and verify each IAS 21.9 indicator is documented with current-year evidence, not carried forward from inception without reassessment (IAS 21.36)
2. For entities using average rates, test a sample of material transactions to confirm the average rate approximates the actual transaction-date rates within an acceptable range, and document the volatility analysis (IAS 21.22)
3. Confirm all monetary items denominated in foreign currencies are retranslated at the closing rate, with exchange differences in profit or loss (IAS 21.23, IAS 21.28)
4. Verify non-monetary prepayments and deferred revenue are classified correctly (right to goods/services = non-monetary at historical rate; right to cash = monetary at closing rate)
5. For consolidated foreign operations, confirm the FCTR rolls forward correctly from opening balance through current year OCI to closing, and verify that goodwill and fair value adjustments on acquisition are translated at the closing rate (IAS 21.39, IAS 21.47)
6. Check whether any foreign operations were disposed of during the year, verify the cumulative FCTR was reclassified to profit or loss, and request the full FCTR roll-forward from acquisition for material disposals (IAS 21.48)

Common mistakes

• Carrying forward the functional currency determination from incorporation without reassessing when the entity’s economic environment has changed. IAS 21.36 requires reassessment when underlying conditions shift. The AFM has flagged this in group audits where subsidiaries changed their revenue mix significantly but the functional currency designation was never revisited.
• Applying the closing rate to non-monetary items at the individual entity level. IAS 21.23(b) requires non-monetary items at historical cost to remain at the transaction-date rate. This error inflates or deflates inventory and PP&E balances and creates phantom exchange gains or losses in profit or loss.

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Further reading and source references

• IAS 21, The Effects of Changes in Foreign Exchange Rates: the source standard governing functional currency determination, transaction translation, and foreign operation translation.
• IAS 29, Financial Reporting in Hyperinflationary Economies: applies when a foreign operation’s functional currency is the currency of a hyperinflationary economy.
• IAS 28, Investments in Associates and Joint Ventures: relevant for the equity method accounting of foreign associates where translation adjustments arise.
• IFRS 10, Consolidated Financial Statements: governs the consolidation process in which IAS 21 translation of foreign operations takes place.