Under IAS 21, a foreign currency transaction is first recorded at the spot rate on the transaction date. At each reporting date, monetary items such as cash, receivables, payables and loans are retranslated at the closing rate, and the exchange difference goes to profit or loss. Non-monetary items carried at historical cost, such as equipment and inventory, stay at the rate on the date they were bought.
That monetary versus non-monetary split decides almost everything in the standard. This guide explains functional currency, works through a foreign purchase from the order to the payment, and covers where exchange differences go and how a foreign subsidiary is translated for consolidation.
Functional currency and presentation currency
Functional currency is the currency of the main economic environment a company operates in: the currency that mainly drives its selling prices and its labor and material costs. It is a matter of fact, decided by the circumstances, not a free choice.
Presentation currency is the currency the financial statements are presented in. That one is a free choice.
Everything in IAS 21 starts from the functional currency. A transaction is "foreign" if it is in any other currency.
Which rate to use
| Item | Examples | Rate at the reporting date |
|---|---|---|
| Monetary items | Cash, receivables, payables, loans | Closing rate |
| Non-monetary items at historical cost | Equipment, inventory at cost, prepayments | Historical rate (the transaction date); not retranslated |
| Non-monetary items at fair value | Revalued property, investment property at fair value | Rate on the date fair value was measured |
The test for "monetary" is a right to receive, or an obligation to pay, a fixed or determinable number of currency units. A receivable of €100,000 is monetary: you will receive exactly €100,000. A machine bought for €100,000 is not: you own a machine, not a claim to currency.
On initial recognition, use the spot rate on the transaction date. An average rate for a week or month is acceptable as a practical shortcut, but only if rates have not moved significantly.
Worked example: a foreign purchase
A company whose functional currency is the US dollar buys equipment from a European supplier for €200,000 on November 1, 2026, on credit. Its year end is December 31, 2026, and it pays the supplier on February 28, 2027.
| Date | Exchange rate |
|---|---|
| November 1, 2026 | €1 = $1.10 |
| December 31, 2026 | €1 = $1.15 |
| February 28, 2027 | €1 = $1.08 |
November 1: record the purchase at the spot rate
| Account | Debit | Credit |
|---|---|---|
| Equipment (€200,000 × 1.10) | 220,000 | |
| Accounts payable | 220,000 |
December 31: retranslate the payable only
The payable is now €200,000 × 1.15 = $230,000. It was recorded at $220,000, so there is an exchange loss of $10,000.
| Account | Debit | Credit |
|---|---|---|
| Foreign exchange loss | 10,000 | |
| Accounts payable | 10,000 |
The equipment stays at $220,000. It is a non-monetary asset carried at historical cost and is never retranslated. This is the step most often got wrong: retranslating the asset along with the liability feels symmetrical, but it is incorrect.
February 28: pay the supplier
The company pays €200,000 × 1.08 = $216,000 for a payable carried at $230,000, giving an exchange gain of $14,000.
| Account | Debit | Credit |
|---|---|---|
| Accounts payable | 230,000 | |
| Cash | 216,000 | |
| Foreign exchange gain | 14,000 |
Across the whole transaction, the net effect on profit is a $4,000 gain ($14,000 − $10,000), split across two years. Spreading it that way is exactly what retranslating at each reporting date is for.
Where exchange differences go
Exchange differences on monetary items are recognized in profit or loss in the period they arise. That covers the great majority of cases.
The main exception: exchange differences on a monetary item that forms part of a company's net investment in a foreign operation, such as a long-term loan to an overseas subsidiary that is not expected to be repaid, go to other comprehensive income in the consolidated statements. They build up in a separate part of equity and are reclassified to profit or loss when the foreign operation is sold.
When a gain or loss on a non-monetary item is itself recognized in OCI, such as a revaluation of overseas property, the exchange part of that gain or loss goes to OCI with it.
Translating a foreign subsidiary
When a foreign operation's financial statements are translated into the group's presentation currency for consolidation, the rules are different:
- all assets and liabilities, including non-monetary ones, at the closing rate;
- income and expenses at the rates on the transaction dates, or an average rate as an approximation; and
- all resulting exchange differences in other comprehensive income.
This is a separate exercise from recording foreign currency transactions. Mixing up the two sets of rules is one of the most reliable ways to lose marks on the topic.
Common foreign currency mistakes
- Retranslating non-monetary assets at the closing rate. Inventory at cost and PPE stay at the historical rate.
- Mixing up transaction rules and consolidation rules. Only on consolidation does the whole balance sheet move to the closing rate.
- Taking net investment differences to profit. They go to OCI and are recycled on disposal.
- Getting the direction wrong. If the foreign currency strengthens, a payable in that currency costs more (a loss) and a receivable is worth more (a gain).
- Waiting until settlement. Monetary items are retranslated at every reporting date, not only when they are paid.
- Treating a prepayment as monetary. It is a right to goods or services, not to currency.
Practice it
The reliable way through an IAS 21 question is to label every balance monetary or non-monetary before writing down a single rate. The label decides the rate, and the rate decides everything else. Accountely's foreign currency challenges mark the classification and the translation separately, so one mislabeled balance does not wipe out the rest. For where the OCI parts appear in the statements, see IAS 1 presentation of financial statements. It's free to start.
Frequently Asked Questions
What is the difference between functional currency and presentation currency?
Functional currency is the currency of the main economic environment a company operates in, and it is determined by the facts. Presentation currency is the currency the financial statements are shown in, and the company can choose it.
Which exchange rate is used for monetary items at the year end?
The closing rate at the reporting date. The difference from the previously recorded amount is an exchange gain or loss in profit or loss.
Are non-monetary items retranslated under IAS 21?
Not if they are carried at historical cost. Equipment, inventory at cost and prepayments stay at the exchange rate on the date of the original transaction. Non-monetary items carried at fair value use the rate on the date fair value was measured.
Where do foreign exchange differences go?
Usually to profit or loss. Differences on a net investment in a foreign operation, and on translating a foreign subsidiary's statements for consolidation, go to other comprehensive income and are reclassified to profit when the operation is sold.