IAS 21: Effects of Changes in Foreign Exchange Rates

IAS 21, The Effects of Changes in Foreign Exchange Rates, tells an entity how to record transactions in a foreign currency, how to translate the financial statements of a foreign operation into its own reporting currency, and where the resulting gains and losses land. The mechanism turns on a single choice made from economic facts rather than policy: the functional currency. Every foreign currency amount is measured against that anchor, and the rate used to translate it — plus whether any exchange difference hits profit or loss or other comprehensive income — follows from a small set of rules keyed to what the item is and how it is measured.¹

The standard covers three activities: recording foreign currency transactions and balances, translating foreign operations consolidated or equity-accounted by the reporting entity, and translating an entity’s own financial statements into a presentation currency that differs from its functional currency. Foreign currency derivatives and hedge accounting sit inside IFRS 9 instead, though embedded foreign currency derivatives outside IFRS 9 stay within IAS 21.²

Identifying the Functional Currency

The functional currency is the currency of the primary economic environment in which the entity operates — the environment in which it generates and spends most of its cash. An entity does not choose this currency so much as discover it by examining the economic facts, and every subsequent measurement and translation flows from getting it right.³

The primary indicators look at what drives revenue and costs. Which currency principally influences the selling prices of goods and services? Which currency shapes the competitive and regulatory forces behind those prices? Which currency mainly determines labor, materials, and other production expenses?¹ When sales and production point to the same currency, the answer is usually straightforward. When they pull in different directions, secondary indicators break the tie: the currency in which the entity raises debt and equity capital, and the currency in which it ordinarily retains its operating cash receipts. An entity that borrows in euros, invoices in euros, and holds its cash balances in euros is making a strong case for the euro even when some costs sit elsewhere.

The presentation currency is a separate concept. An entity can publish its financial statements in any currency it likes, and when the presentation currency differs from the functional currency, the standard’s translation procedures for foreign operations apply. That divergence, and the reason for it, must be disclosed.

Recording Foreign Currency Transactions

A foreign currency transaction is any transaction denominated in a currency other than the entity’s functional currency — a sale invoiced in dollars by a euro-functional entity, a purchase settled in yen, a loan drawn in sterling. On the transaction date, the amount is recorded in the functional currency using the spot exchange rate.¹ For practical convenience, an average rate for a week or a month may be used when rates do not fluctuate significantly during the period. If rates swing sharply, the shortcut is off the table and actual transaction-date rates must be used.

Measurement at Each Reporting Date

Once foreign currency items are on the books, the question at each reporting date is whether to retranslate them. The answer depends on whether the item is monetary or non-monetary, and, for non-monetary items, on how they are measured.

Monetary Items

Monetary items are rights to receive, or obligations to deliver, a fixed or determinable number of currency units. Cash balances, trade receivables, trade payables, and loans are the usual examples. At each reporting date, these items are retranslated at the closing rate so the balance sheet reflects their current value in the functional currency.¹

Non-Monetary Items at Historical Cost

Non-monetary items carried at historical cost — property, plant and equipment recorded at cost, or inventories at cost — stay translated at the exchange rate that existed on the original transaction date. They are not retranslated at the reporting date, because the underlying measurement basis has not changed.

Non-Monetary Items at Fair Value

Non-monetary items measured at fair value in a foreign currency are translated at the exchange rate on the date the fair value was determined. The nuance that catches people out is where the exchange component lands. It follows the fair value gain or loss itself. If the fair value change is recognized in other comprehensive income, so is the exchange component; if it hits profit or loss, so does the exchange component.⁴

Where Exchange Differences Go

Exchange differences arise when a monetary item is settled at a rate different from the one used at initial recognition, or when an outstanding monetary balance is retranslated at a new closing rate. The general rule is direct: recognize these differences immediately in profit or loss for the period.¹

There is one significant exception. Monetary items that form part of a net investment in a foreign operation receive different treatment on consolidation, with the exchange difference routed through other comprehensive income. That case is dealt with below.

Translating a Foreign Operation

When a parent consolidates a foreign subsidiary, or applies the equity method to a foreign associate, whose functional currency differs from the presentation currency, IAS 21 sets out a specific translation process.

All assets and liabilities are translated at the closing rate on the reporting date. This applies to monetary and non-monetary items alike. It also covers goodwill arising from the acquisition of the foreign operation and any fair value adjustments to that operation’s assets and liabilities at acquisition, which are treated as belonging to the foreign operation and translated at the closing rate along with everything else.¹

Income and expense items are translated at the exchange rates on the dates the transactions occurred. In practice, an average rate for the period is used, provided it reasonably approximates the cumulative effect of the actual rates. Significant fluctuations during the period rule out the average.

Using the closing rate for the balance sheet and average rates for the income statement, alongside historical rates for opening equity, produces a mismatch. That mismatch is the exchange difference on consolidation, and IAS 21 requires it to be recognized in other comprehensive income and accumulated in a separate component of equity, sometimes called the cumulative translation adjustment, or CTA. Routing it through OCI keeps exchange rate volatility from distorting the consolidated income statement period by period.

Net Investment in a Foreign Operation

The net investment in a foreign operation is the reporting entity’s interest in that operation’s net assets, and the definition reaches beyond the equity investment. A long-term intercompany loan receivable from, or payable to, the foreign operation qualifies as part of the net investment when settlement is neither planned nor likely in the foreseeable future. Trade receivables and trade payables do not qualify, even between group entities, because they are expected to settle in the normal course of business.²

On consolidation, exchange differences arising on retranslation of qualifying monetary items go to other comprehensive income rather than profit or loss. That mirrors the treatment of the translation differences on the foreign operation’s net assets. Both sit in OCI until disposal. In the individual financial statements of the entity holding the monetary item, the exchange difference is still recognized in profit or loss under the general rule; the OCI treatment applies only on consolidation.

An entity may designate a hedging instrument, such as a foreign currency borrowing or a derivative, against the exchange risk on a net investment. Under IFRS 9, the effective portion of the hedge gain or loss goes to other comprehensive income, mirroring the treatment of the net investment’s own translation differences, while the ineffective portion goes to profit or loss. On disposal, the cumulative hedge amount is reclassified to profit or loss alongside the CTA.⁵

Disposal of a Foreign Operation

The accumulated translation differences in equity are not permanent. On disposal of a foreign operation, the entire cumulative amount relating to that operation is reclassified from equity to profit or loss in the same period as the gain or loss on disposal.⁶

Disposal is broader than outright sale. The standard treats the following as disposals even if the entity keeps a residual interest:

losing control of a subsidiary that includes a foreign operation
losing significant influence over an associate that includes a foreign operation
losing joint control of a joint arrangement that includes a foreign operation

Partial disposals that do not trigger a loss of control, significant influence, or joint control work differently: only the proportionate share of the accumulated exchange differences is reclassified. A write-down of a foreign operation’s carrying amount for impairment is not a partial disposal and triggers no reclassification.

Hyperinflationary Economies

When a foreign operation’s functional currency is that of a hyperinflationary economy, the normal translation rules do not apply. An economy is generally considered hyperinflationary when cumulative inflation over three years approaches or exceeds 100 percent, though qualitative indicators also matter, such as a population that prices goods in a stable foreign currency or links wages and prices to a price index.

The foreign operation’s financial statements are first restated for inflation under IAS 29. Once restated, all amounts — assets, liabilities, equity, income, and expenses — are translated into the presentation currency at the closing rate on the reporting date, without the usual split between closing rates for the balance sheet and average rates for the income statement. Comparatives are presented as the current-year amounts from the prior year’s financial statements, without adjustment for subsequent inflation or exchange rate changes.¹

When the economy ceases to be hyperinflationary and IAS 29 restatement stops, the inflation-adjusted amounts at the date of cessation become the historical costs for future translation. Amendments to IAS 21 effective for annual periods beginning on or after January 1, 2027, with earlier application permitted, address a gap in the existing rules by specifying the treatment when an entity translates into a hyperinflationary presentation currency.

Change in Functional Currency

A change in functional currency is not a policy choice. It happens when the underlying economic facts change — when an entity shifts its operations or markets significantly enough to alter which currency drives its economics. When that occurs, the entity applies the translation procedures for the new functional currency prospectively from the date of the change. All items are translated into the new functional currency at the exchange rate on that date, and for non-monetary items those translated amounts become the historical cost going forward. No retrospective restatement is required. Because the effect on reported results and balances can be material, the change and the reason for it must be disclosed.

Required Disclosures

IAS 21 requires several disclosures aimed at helping users understand how foreign currency exposure has affected the financial statements:

the total exchange differences recognized in profit or loss during the period¹
the net exchange differences recognized in other comprehensive income and the accumulated balance in the equity reserve
the method used to translate income and expenses, typically a statement that average rates were used
if the presentation currency differs from the functional currency, that fact, the functional currency, and the reason for using a different presentation currency
any change in the functional currency of the reporting entity or a significant foreign operation, with the reason

When an entity presents supplementary information in a currency other than its functional or presentation currency, it must also disclose the currency used, its functional currency, and the translation method applied. Taken together, these disclosures give users enough context to gauge how sensitive the reported numbers are to exchange rate movements.

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IFRS Foundation. IAS 21 – The Effects of Changes in Foreign Exchange Rates
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IFRS Foundation. IAS 21 – The Effects of Changes in Foreign Exchange Rates
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IFRS Foundation. IAS 21 The Effects of Changes in Foreign Exchange Rates
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IFRS Foundation. IAS 21 – The Effects of Changes in Foreign Exchange Rates
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IFRS Foundation. IFRS 9 Financial Instruments – Net Investment Hedges
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IFRS Foundation. IAS 21 – The Effects of Changes in Foreign Exchange Rates