IAS 21 Foreign Currency Transactions: Functional Currency, Monetary Items and Exchange Differences

A Nigerian importer buys machinery in United States dollars and pays three months later. When the invoice is recorded, one dollar costs ₦1,500. When it is paid, a dollar costs ₦1,560. The company has not bought a different machine, but its naira cost has changed, and the statements must show it.

International Accounting Standard (IAS) 21 The Effects of Changes in Foreign Exchange Rates decides what rate is used to record each foreign currency transaction, how balances are retranslated at the reporting date, and where the exchange difference is reported. This topic covers the objective, functional and presentation currency, the initial recording of a transaction, the treatment of monetary and non-monetary items at the reporting date, and exchange differences. The next topic covers the translation of a foreign operation.

In the diets reviewed for this page, November Diet, 2025, Question 2(e) asked for the objective of IAS 21 and the compulsory accounts questions regularly include foreign currency items. Read diluted earnings per share and presentation first.

Objective and currencies

The objective of IAS 21 is to prescribe how to include foreign currency transactions and foreign operations in the financial statements of an entity, and how to translate financial statements into a presentation currency. The main issues are which exchange rate to use and how to report the effects of changes in rates.

• The functional currency is the currency of the primary economic environment in which the entity operates, normally the one in which it mainly generates and spends cash.
• The presentation currency is the currency in which the financial statements are presented. It may be any currency, and a Nigerian company will usually choose the naira.
• A foreign currency is any currency other than the entity’s functional currency.

Determining the functional currency

The primary indicators are the currency that mainly influences sales prices for goods and services (often the currency in which they are denominated and settled), the currency of the country whose competitive forces and regulations mainly determine sales prices, and the currency that mainly influences labour, material and other costs.

Secondary indicators are the currency in which funds from financing are generated and the currency in which receipts from operating activities are usually retained. For a foreign operation, further factors are whether it operates as an extension of the parent, how much of its activity is with the parent, whether its cash flows directly affect the parent, and whether its cash flows are sufficient to service its debt.

The functional currency is not a free choice and is changed only if the underlying conditions change.

Initial recording

A foreign currency transaction is recorded at the functional currency amount by applying the spot exchange rate between the functional currency and the foreign currency at the date of the transaction, the date on which it first qualifies for recognition. For practical reasons an average rate for a week or a month may be used if rates do not fluctuate significantly.

Where a currency cannot be exchanged at the measurement date, amendments to the standard that apply to periods beginning on or after 1 January 2025 require the entity to estimate the spot rate that would have applied in an orderly exchange transaction between market participants.

For example, a company buys goods on credit for US$50,000 on 1 October, when the rate is ₦1,500 to the dollar. It records inventory and a payable of 50,000 × ₦1,500 = ₦75,000,000.

At the reporting date

Items are classified as monetary or non-monetary, and each class is treated differently.

• Monetary items are 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 and payables, loans and bonds. They are translated at the closing rate, the spot rate at the end of the reporting period.
• Non-monetary items measured at historical cost, such as property, plant and equipment, intangible assets and inventory at cost, are translated at the rate on the date of the transaction and are not retranslated.
• Non-monetary items measured at fair value, such as investment property or revalued assets, are translated at the rate when the fair value was measured. Where an item is carried at the lower of two amounts, such as inventory at the lower of cost and net realisable value, each amount is translated at the appropriate rate and the lower is taken.

Exchange differences

Exchange differences arising on settling monetary items, or on translating them at rates different from those at which they were initially recorded or translated in previous statements, are recognised in profit or loss in the period in which they arise. They are recognised whether they are realised (on settlement) or unrealised (at the reporting date).

When a gain or loss on a non-monetary item is recognised in other comprehensive income, such as a revaluation, the exchange component is also recognised there. If it is recognised in profit or loss, the exchange component is too.

Continuing the example: at the year end, 31 December, the rate is ₦1,600, so the payable is retranslated to 50,000 × ₦1,600 = ₦80,000,000, and an unrealised exchange loss of ₦80,000,000 − ₦75,000,000 = ₦5,000,000 is recognised in profit or loss. If the payable is settled on 15 February at ₦1,550, the company pays 50,000 × ₦1,550 = ₦77,500,000, and an exchange gain of ₦80,000,000 − ₦77,500,000 = ₦2,500,000 arises in the next period.

Similarly, an export sale of US$20,000 on 1 November at ₦1,480 gives a receivable of ₦29,600,000, retranslated at ₦1,600 to ₦32,000,000, with an unrealised exchange gain of ₦2,400,000.

The ideas in more depth

Why monetary and non-monetary differ

A dollar receivable will be settled in dollars, so its naira value changes with the rate and the change is a real gain or loss. A machine bought for dollars stays a machine, whose value does not depend on the rate at which it was paid for. Retranslating it would create gains and losses with no economic meaning.

Why differences go to profit or loss

Entities that take foreign currency risk bear its effect on their cash flows. Recognising the effect when rates change, not only at settlement, gives users earlier warning of the exposure.

Sources and references

• IAS 21 The Effects of Changes in Foreign Exchange Rates: objective, functional and presentation currency, initial recognition, reporting at the end of subsequent periods, and recognition of exchange differences.

These points are stated as at 5 November 2026.

Worked examples

1. 1 October.
   Inventory and payable 50,000 × ₦1,500 = ₦75,000,000.
2. 31 December.
   Payable 50,000 × ₦1,600 = ₦80,000,000.
   Loss in profit or loss: ₦5,000,000.
3. 15 February.
   Payment 50,000 × ₦1,550 = ₦77,500,000.
   Gain in the next year: ₦2,500,000.

1. Initial.
   20,000 × ₦1,480 = ₦29,600,000.
2. Year end.
   20,000 × ₦1,600 = ₦32,000,000.
3. Exchange gain.
   ₦32,000,000 − ₦29,600,000 = ₦2,400,000, in profit or loss.

1. Cost.
   10,000 × ₦1,450 = ₦14,500,000.
2. Net realisable value.
   9,500 × ₦1,600 = ₦15,200,000.
3. Carrying amount. The lower: ₦14,500,000. No write-down.

How to answer in the exam

• State the rule for each item. Monetary: closing rate; non-monetary at cost: historical rate; at fair value: rate at the measurement date.
• Show three dates. Transaction, reporting date, settlement, with the amount and difference at each.
• Say where the difference goes. Profit or loss for monetary items.
• Define the currencies. Functional, presentation, foreign.

Common mistakes in the exam

• Retranslating property, plant and equipment or inventory at cost at the closing rate.
• Using the closing rate on the date of the transaction.
• Taking an unrealised exchange difference to equity instead of profit or loss.
• Treating the exchange difference at settlement as the whole difference and ignoring the one at the reporting date.
• Confusing functional currency with presentation currency.

Quick revision

• Functional currency: primary economic environment. Presentation currency: any, usually naira.
• Initial: spot rate at the transaction date (average rate if stable).
• Reporting date: monetary at closing rate; non-monetary at cost at the historical rate; at fair value at the rate when measured.
• Differences on monetary items: profit or loss, realised or not.

Practice questions

These are original questions written in the style of the Institute’s exams. Try each one before you open the answer. Section A is a recall check, because the paper itself is written.

Recall check: multiple choice

Section B style: written questions

A further written question

Model answers

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