Guide
Foreign currency translation in consolidation: an IAS 21 worked example
When a subsidiary's functional currency differs from the group's presentation currency, its financial statements must be translated before they are consolidated. This guide explains the IAS 21 approach for foreign operations and works through a simple example.
Updated · 9 min read · Conso 360
Key points
- Assets and liabilities are translated at the closing rate at the reporting date.
- Income and expenses are translated at transaction-date rates; an average rate is acceptable when rates do not fluctuate significantly.
- Share capital and pre-acquisition equity are commonly kept at historical rates.
- The resulting exchange differences go to other comprehensive income and are reclassified to profit or loss when the foreign operation is disposed of.
Functional and presentation currency
IAS 21 distinguishes the functional currency, the currency of the primary economic environment in which an entity operates, from the presentation currency, the currency in which the group presents its financial statements. Each entity determines its functional currency from its own facts, such as the currency that mainly influences its sales prices and costs.
Translation into the presentation currency is a consolidation step. It is different from the remeasurement of foreign currency transactions inside an entity, for example a euro-reporting company's US dollar receivable, where exchange differences are recognised in profit or loss.
This guide does not cover subsidiaries in hyperinflationary economies, which follow IAS 29 and specific IAS 21 requirements.
Which rate applies to which item
| Item | Rate | Basis |
|---|---|---|
| Assets and liabilities | Closing rate at the reporting date | IAS 21.39(a) |
| Income and expenses | Rates at transaction dates, or an average rate as an approximation | IAS 21.39(b), 21.40 |
| Goodwill and fair value adjustments from the acquisition | Closing rate, as assets and liabilities of the foreign operation | IAS 21.47 |
| Share capital and pre-acquisition reserves | Historical rate | Common practice; IAS 21 does not prescribe a rate for equity items |
| Retained earnings after acquisition | Accumulated translated results | Follows from translating each year's profit |
An average rate is only an approximation. If rates fluctuate significantly during the period, IAS 21.40 says the average is inappropriate, and transaction-date rates or shorter averaging periods are needed.
Why a translation difference appears
Because the balance sheet is translated at the closing rate while the opening equity and the year's result were translated at other rates, the translated balance sheet does not balance on its own. The difference has two main sources:
- Opening net assets, translated last year at the previous closing rate, are now translated at the new closing rate.
- The profit for the year, translated at the average rate, sits in net assets translated at the closing rate.
IAS 21.39(c) requires these differences to be recognised in other comprehensive income. They accumulate in a separate component of equity, usually called the translation reserve or cumulative translation adjustment.
Worked example
A euro-reporting parent sets up a Swedish subsidiary at the start of the year with share capital of SEK 11,000. Its functional currency is the Swedish krona. Rates are quoted as SEK per EUR: 11.00 when the shares were issued and at the opening date, 11.30 on average for the year and 12.00 at the reporting date. The subsidiary earns a profit of SEK 2,260 and ends the year with assets of SEK 18,000 and liabilities of SEK 4,740.
| Item | SEK | Rate | EUR |
|---|---|---|---|
| Total assets | 18,000 | 12.00 (closing) | 1,500 |
| Total liabilities | (4,740) | 12.00 (closing) | (395) |
| Net assets | 13,260 | 1,105 | |
| Share capital | 11,000 | 11.00 (historical) | 1,000 |
| Profit for the year | 2,260 | 11.30 (average) | 200 |
| Translation reserve | (95) | ||
| Total equity | 13,260 | 1,105 |
The translation reserve of EUR (95) is the balancing figure, and it can be explained exactly: opening net assets of SEK 11,000 are worth EUR 1,000 at 11.00 but EUR 916.7 at 12.00, a difference of EUR (83.3). The profit of SEK 2,260 is EUR 200.0 at the average rate but EUR 188.3 at the closing rate, a difference of EUR (11.7). Together, EUR (95.0).
The krona weakened against the euro, so the euro value of the group's investment in Sweden fell. That loss is recognised in other comprehensive income, not in profit or loss.
Non-controlling interests
If the subsidiary is not wholly owned, the translation difference is shared. IAS 21.41 requires the part attributable to non-controlling interests to be allocated to them. If the parent in the example owned 80%, EUR (76) would go to the group's translation reserve and EUR (19) to non-controlling interests.
What happens on disposal
The translation reserve is not permanent. When the group disposes of the foreign operation, IAS 21.48 requires the cumulative exchange differences relating to it to be reclassified from equity to profit or loss as part of the gain or loss on disposal. Partial disposals and loss of control need careful analysis under IAS 21.48A–48D.
Common mistakes
- Translating share capital and other equity at the closing rate, which hides the translation difference.
- Recognising the translation difference in profit or loss instead of other comprehensive income.
- Using an annual average rate in a year with large currency movements.
- Mixing rate conventions, such as SEK per EUR in one tab and EUR per SEK in another.
- Expecting exchange differences on intragroup loans to disappear on consolidation. Under IAS 21.45 they remain in consolidated profit or loss, unless the loan forms part of the net investment in the foreign operation (IAS 21.32).
The last point often explains why intercompany balances do not eliminate cleanly; see our guide to intercompany eliminations.
How Conso 360 handles translation
In Conso 360 each account is assigned a closing, average or historical rate type, so the same treatment is applied every period. ECB reference rates can be synchronised automatically, translation differences are posted to a dedicated translation reserve account, and a missing rate stops the consolidation run instead of producing a silent error. Determining each entity's functional currency remains your decision. Read more about IFRS consolidation in Conso 360.
This guide is general information for finance professionals, not accounting, tax or audit advice. Apply it to your own facts with your advisers and auditors. Standard references are to IFRS Accounting Standards as issued by the IASB.