How to Solve the Dual Currency Problem?
More and more Polish companies are operating on the international market, and Poland is also becoming highly appreciated by foreign investors who are eager to open subsidiaries in our country. As a result, many companies are now facing the challenge of dual currency accounting, meaning the need to maintain accounting records in two different currencies. This challenge arises from the guidelines of International Accounting Standard 21 “The Effects of Changes in Foreign Exchange Rates” (referred to as “IAS 21” / “the Standard”).
This standard applies to:
- Recognizing transactions and balances in foreign currencies.
- Converting the financial results and the financial position of foreign operations included in the financial statements of the reporting entity through full consolidation or the equity method.
- Converting the financial results and financial position of the entity into the presentation currency.
Functional Currency vs. Foreign Currency
A foreign currency is any currency other than the functional currency of the entity. To determine which currencies should be treated as foreign currencies, it is crucial to establish which currency meets the definition of the functional currency.
According to IAS 21, the functional currency is the currency of the primary economic environment in which the entity operates. The primary economic environment is typically the environment in which the entity primarily generates and spends cash. What does this mean in practice? Companies that prepare their financial statements in accordance with International Financial Reporting Standards (IFRS) must first determine which currency constitutes the functional currency and which other currencies (other than the functional currency) will be recognized as foreign currencies.
This is of particular importance when calculating exchange rate differences, as it may not always be the case that the functional currency of entities operating in Poland will be the Polish zloty (PLN). To determine which currency meets the definition of functional currency, the following factors must be considered:
- The currency that primarily influences the prices of goods and services (in practice, this is the currency in which the entity issues its sales invoices).
- The currency of the country where competitive forces and regulations primarily affect the prices of goods and services sold or provided by the entity.
- The currency that primarily influences labor and material costs and other expenses related to the supply of goods or provision of services (in practice, this is the currency in which these costs are invoiced or paid).
- The currency in which funds are generated from financial activities (e.g., issuance of debt and equity instruments).
- The currency in which the operational cash flows are typically maintained.
Additionally, when determining the functional currency for entities operating abroad in relation to the parent entity preparing consolidated financial statements, the following questions must be answered:
- Is the foreign operation conducted as an extension of the parent entity’s operations, or does the foreign operation act independently?
- Do transactions with the parent entity represent a significant part of the foreign operation’s activities?
- Do cash flows from the foreign operation directly affect the parent entity’s cash flows and can they be transferred to the parent at any time?
- Are the cash flows from the foreign operation sufficient to service existing and future debt incurred in the normal course of business, without the need for funding from the parent entity?
Upon analyzing the above criteria, it may turn out (as often happens in practice) that determining the functional currency is ambiguous. Therefore, in order to establish the functional currency, management typically relies on judgment and first focuses on criteria 1-3, and then, to make the right decision, analyzes the remaining criteria.
It is important to maintain consistency and apply the chosen functional currency in subsequent reporting periods until significant changes in the factors analyzed lead management to draw different conclusions.
Functional Currency vs. Presentation Currency
Equally important is the presentation currency, which is the currency used to present financial statements. In the case of entities operating in Poland, the presentation currency will always be the Polish zloty (PLN). This is explicitly required by the Accounting Act, which mandates that books must be kept in Polish language and currency.
When Might the Functional Currency Need to Be Determined for Entities Operating in Poland?
Below are two example scenarios:
- Company A operates a manufacturing business in Poland and is a subsidiary of a company operating in Germany (Company B). Company A prepares its statutory financial statements in PLN, as required by the Accounting Act. However, for consolidation purposes (prepared by Company B), Company A prepares a consolidation package according to IFRS. Most raw material purchases and sales of finished goods are conducted in EUR, with Company B being the main customer of Company A. Company A’s management has decided that the functional currency for reporting to Company B is EUR. What does this mean for Company A? The books of Company A are maintained in PLN, the statutory financial statements are in PLN, but the consolidation package for group purposes is prepared in EUR.
- Company C operates in Poland and prepares its statutory financial statements under IFRS (management decided to maintain books in accordance with IFRS). The sales of Company C are made in EUR, and a significant portion of costs is also incurred in EUR. The company also has external financing denominated in EUR. Management has decided that the functional currency of the company is EUR. What are the consequences for Company C? Company C’s books are maintained in PLN, the functional currency of the company is EUR, but this does not mean that the statutory financial statements will be presented in EUR. The Accounting Act requires that the financial statement be presented in PLN. Therefore, the presentation currency is PLN, and the financial statement will be presented in PLN, with the assumption that the functional currency is EUR.
Dual Currency – Most Common Challenges
The need to prepare financial information (financial statements, consolidation packages for group purposes, etc.) assuming that the functional currency is a currency other than PLN (e.g., EUR) means that the entity is essentially required to maintain a second set of books in the functional currency (e.g., EUR). All transactions are recorded in EUR, and all other currencies are treated as foreign currencies (including PLN).
Exchange rate differences are calculated on transactions in foreign currencies (i.e., currencies other than EUR). All additional analytical records (e.g., fixed asset registers, accounts receivable and payable, inventory registers, etc.) must also be maintained in EUR.
Some entities use simplifications when converting financial data into the functional currency, applying the closing exchange rate for balance sheet items and an average exchange rate for income statement items. However, these are far-reaching simplifications that can lead to significantly different results. The financial result with this approach may be distorted compared to data converted to the functional currency according to IAS 21 requirements.
Assuming that most of the entity’s costs are incurred in EUR, sales are invoiced in EUR, and the company has high debt in EUR, we reach a situation where financial costs or revenues due to exchange rate differences have a significant impact on the financial result. If the entity applies IAS 21 correctly, the financial result will be cleansed of the impact of exchange rate differences, which will significantly affect the entity’s financial outcome.
Converting the functional currency into the presentation currency for the financial statement is much simpler. In scenario 2, Company C first maintains a parallel set of books in EUR, while for financial reporting purposes, transactions in the functional currency are converted into the presentation currency – in this case, PLN.
For converting the functional currency into the presentation currency (provided the entity is not operating in a hyperinflationary economy), the following approach is applied:
- Assets and liabilities are converted at the closing rate on the balance sheet date.
- Revenues and expenses are converted using the exchange rates on the transaction date, but for practical reasons, the standard allows for a simplification by using the average exchange rate for the period (e.g., the average monthly exchange rate, provided there are no significant fluctuations in the exchange rate during the period).
Solving the Dual Currency Problem
To properly apply the requirements of IAS 21, it is crucial to implement IT solutions that will continuously assist the entity in correctly recording and valuing all business transactions in the parallel set of books maintained in the functional currency. This is, of course, time-consuming and costly, especially for entities that record a significant number of transactions in the reporting period.
If your company is struggling with the challenge of dual currency accounting, contact us and take advantage of our know-how. These solutions will help you meet the requirements of IAS 21. Our team will assist you in preparing accurate data and reflecting your entity’s financial position according to IAS 21 guidelines.
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