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4.7 Functional Currency

4.7.1 Overview

Oil and gas entities commonly undertake transactions in more than one currency, as commodity prices are often denominated in US dollars and costs are typically denominated in the local currency. Determination of the functional currency can require significant analysis and judgement.

An entity’s functional currency is the currency of the primary economic environment in which it operates.

This is the currency in which the entity measures its results and financial position. A group comprised of multiple entities must identify the functional currency

of each entity, including joint ventures and associates.

Different entities within a multinational group often have different functional currencies. The group as a whole does not have a functional currency.

An entity’s presentation currency is the currency in which it presents its financial statements. Reporting entities may select any presentation currency (subject to the restrictions imposed by local regulations or shareholder agreements). However, the functional currency must reflect the substance of the entity’s underlying transactions, events and conditions; it is unaffected by the choice of presentation currency.

Exchange differences can arise for two reasons: when a transaction is undertaken in a currency other than the entity’s functional currency; or when the presentation currency differs from the functional currency.

4.7.2 Determining the functional currency

Identifying the functional currency for an oil and gas entity can be complex because there are often significant cash flows in both the US dollar and local currency. Management should focus on the primary economic environment in which the entity operates when determining the functional currency. The denomination of selling prices is important but not determinative. Many sales within the oil and gas industry are conducted either in, or with reference to, the US dollar. However, the US dollar may not always be the main influence on these transactions. Although entities may buy and sell in dollar denomination they are not exposed to the US economy unless they are exporting to the US or another economy closely tied to the US.

Dollar denomination is a pricing convention rather than an economic driver. Instead, the main influence on the entity is demand for the products and ability to produce the products at a competitive margin, which will be dependent on the local economic and regulatory environment. Accordingly, it is relatively common for oil and gas entities to have a functional currency which is their local currency rather than the US dollar, even where their sales prices are in dollars.

Functional currency is determined on an entity by entity basis for a multi-national group. It is not unusual for a multi-national oil and gas company to have many different functional currencies within the group.

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There are three primary indicators of functional currency: the currency of sales prices, the currency of the country that will consume and regulate the products and the currency of the cost of labour.

It is difficult to identify a single country whose competitive forces and regulations mainly determine selling prices in oil and gas. If the primary indicators

do not provide an obvious answer to the functional currency question , the currency in which an entity’s finances are denominated should be considered i.e., the currency in which funds from financing activities are generated and the currency in which receipts from operating activities are retained.

How to determine the functional currency of an entity with products normally traded in a non-local currency (1)

What is the functional currency of an entity which is based in Saudi Arabia but prices all products sold in US dollars?

Background

Entity A operates an oil refinery in Saudi Arabia. All of the entity’s income is denominated and settled in US dollars. Refined product is primarily exported by tanker to the US. The oil price is subject to the worldwide supply and demand, and crude oil is routinely traded in US dollars around the world. Around 55% of entity A’s cash costs are imports or expatriate salaries denominated in US dollars. The remaining 45% of cash expenses are incurred in Saudi Arabia and denominated and settled in riyal. The non-cash costs (depreciation) are US dollar denominated, as the initial investment was in US dollars.

Solution

The factors point toward the functional currency of entity A being the US dollar. The product is primarily exported to the US. The revenue analysis points to the US dollar. The cost analysis is mixed. Depreciation (or any other non-cash expenses) is not considered, as the primary economic environment is where the entity generates and expends cash. Operating cash expenses are influenced by the riyal (45%) and the US dollar (55%). Management is able to determine the functional currency as the US dollar, as the revenue is clearly influenced by the US dollar and expenses are mixed.

How to determine the functional currency of an entity with products normally traded in a non-local currency (2)

What is the functional currency of an entity which is based in Russia but prices all products sold in US dollars?

Background

Entity A operates a producing field and an oil refinery in Russia and uses their product to supply independent petrol stations in Moscow. All of the entity’s income is denominated in US dollars but is settled in a mixture of dollars and local currency. Around 45% of entity A’s cash costs are expatriate salaries denominated in US dollars. The remaining 55% of cash expenses are incurred and settled in Roubles.

Solution

The factors point toward the functional currency of entity A being the Russian Rouble. Although selling prices are determined in dollars, the demand for the product is clearly dependent on the local economic environment in Russia. Although the cost analysis is mixed based on the level of reliance on the Moscow marketplace for revenue and margin management is able to determine the functional currency as Russian Rouble.

Determining the functional currency of holding companies and treasury companies may present some unique challenges; these have largely internal sources of cash although they may pay dividends, make investments, raise debt and provide risk management services. The underlying source of the cash flows to such companies is often used as the basis for determining the functional currency.

4.7.3 Change in functional currency Once the functional currency of an entity is determined, it should be used consistently, unless significant changes in economic facts, events and conditions indicate that the functional currency has changed.

Oil and gas entities at different stages of operation may reach a different view about their functional currency.

A company which is in the exploration phase may have all of its funding in US dollars and be reliant on their parent company. They may also incur the majority of its exploration costs in US dollars (the availability of drilling rigs may require these to be sourced from the US). At this stage they may conclude US dollars as being the functional currency.

However, when it reaches the development phase, its transactions may be predominantly denominated in local currency as they are more reliant on the local workforce and suppliers to perform the development activity. The functional currency may then change to being the local currency.

The functional currency may then change again when the project reaches the production phase and revenue is generated in US dollars. As explained above a selling price in dollars would not automatically mean that the functional currency is US dollars and factors such as the territory the company sells to and marketplace in which they operate would have to be considered.

This does, however, illustrate that determination of the functional currency can be an ongoing process and conclusions may change depending on the current facts and circumstances.

A change in functional currency should be accounted for prospectively from the date of change. In other words, management should translate all items (including balance sheet, income statement and statement of comprehensive income items) into the new functional currency using the exchange rate at the date of change. Because the change was brought about by changed circumstances, it does not represent a change in accounting policy and a retrospective

adjustment under IAS 8, ‘Accounting policies, changes in accounting estimates and correction of errors’, is not required.

The resulting translated amounts for non-monetary items are treated as their historical cost. It would be consistent that the equity items are also translated using the exchange rate at the date of the change of functional currency. This means that no additional exchange differences arise on the date of the change.

Entities should also consider presentation currency when there is a change in functional currency. A change in functional currency may be accompanied by a change in presentation currency, as many entities prefer to present financial statements in their functional currency. A change in presentation currency is accounted for as a change in accounting policy and is applied retrospectively, as if the new presentation currency had always been the presentation currency. It may be that the presentation currency does not change when there is a change in functional currency.

For example, an entity previously presented its financial statements in its functional currency being Euros.

Subsequently on account of certain change in economic facts its functional currency changes to US dollar.

Since it is based in a country where Euros is the local currency, it does not wish to change its presentation currency and so continues to present its financial statements in Euros. In such a case the numbers in the entity’s financial statements for the period up to the change in functional currency do not change in presentational currency terms. From the point that the functional currency changes new foreign exchange differences will arise in the entity’s own financial statements when items expressed in the new functional currency are translated into the presentation currency.

4.8 Leasing

4.8.1 Overview

The IASB Leases project is ongoing. The new standard is likely to contain a model for lessee accounting whereby all existing and new leases will be recognised on balance sheet. A final standard is not expected to be issued until 2012 at the earliest. This section deals with the current requirements of IAS 17 Leases.

IAS 17 excludes application to leases to explore for or use oil, natural gas and similar non-regenerative resources. The exemption includes exploration and prospecting licences. IAS 17 is, however, applicable to

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other arrangements that are in substance a lease, and this would include the plant and machinery used to perform the exploration activity.

Many oil and gas entities enter into other arrangements that convey a right to use specific assets and these may need to be classified as leases. Examples of such arrangements include:

4.8.2 When does a lease exist?

IFRIC 4 Determining whether an Arrangement contains a lease establishes criteria for determining whether a contract should be accounted for as a lease.

The following conditions must be met for an arrangement to be considered a lease:

ÛÙ ^mdxde]flÙg^Ùl`]ÙYjjYf_]e]flÙakÙ\]h]f\]flÙgfÙl`]Ù use of a specific asset; and

ÛÙ l`]ÙYjjYf_]e]flÙ[gfn]qkÙl`]Ùja_`lÙlgÙmk]Ùl`]ÙYkk]lÙ

4.8.2.1 Use of a specific asset

A specific asset is identified either explicitly or implicitly in an arrangement. A specific asset is implicitly identified when:

ÛÙ alÙakÙfglÙ][gfgea[YddqÙ^]YkaZd]ÙgjÙhjY[la[YdÙ^gjÙl`]Ù supplier to use alternative assets;

ÛÙ l`]Ùkmhhda]jÙgfdqÙgofkÙgf]ÙkmalYZd]ÙYkk]lÙ^gjÙl`]Ù

An arrangement that involves the use of assets located at or near an oil or gas field, where the geographical isolation precludes any practical form of substitution of the assets, would often meet this test.

4.8.2.2 Right to use the specific asset Payment provisions under an arrangement should be analysed to determine whether the payments are made for the right to use the asset, rather than for the actual use of the asset or its output. This requires a consideration of whether any of these conditions are met:

ÛÙ l`]Ùhmj[`Yk]jÙ`YkÙl`]ÙYZadalqÙ¦gjÙja_`l§ÙlgÙgh]jYl]Ù or direct others to operate the asset in a manner it determines while obtaining (or controlling) more than an insignificant amount of the output of the asset;

ÛÙ l`]Ùhmj[`Yk]jÙ`YkÙl`]ÙYZadalqÙ¦gjÙja_`l§ÙlgÙ[gfljgdÙ physical access to the asset while obtaining (or controlling) more than an insignificant amount of the output of the asset; and

ÛÙ l`]Ùhmj[`Yk]Ùhja[]ÙakÙfglÙYÙxp]\¢eYjc]lÙhja[]Ùh]jÙ unit of output, and it is remote that any third party will take more than an insignificant amount of the output of the asset.

Arrangements in which an oil and gas entity takes substantially all of the output from a dedicated asset will often meet one of the above conditions, resulting in treatment as a lease. This occurs sometimes in the oil and gas industry because of the remote location of fields.

4.8.2.3 Reassessment of whether an arrangement contains a lease The reassessment of whether an arrangement contains a lease after inception is required if any of the following conditions are met:

ÛÙÙYÙ[`Yf_]ÙakÙeY\]ÙlgÙl`]Ù[gfljY[lmYdÙl]jek”Ùgl`]jÙ than renewals and extensions;

ÛÙ YÙj]f]oYdÙghlagfÙakÙ]p]j[ak]\ÙgjÙYfÙ]pl]fkagfÙakÙ agreed that had not been included in the initial arrangement;

ÛÙ YÙ[`Yf_]ÙakÙ\]l]jeaf]\ÙafÙj]dYlagfÙlgÙl`]ÙYkk]kke]flÙ of whether fulfilment is dependent on a specified asset; or

ÛÙ l`]j]ÙakÙYÙkmZklYflaYdÙ[`Yf_]ÙlgÙl`]ÙYkk]l

The above conditions require arrangements to be continued to be assessed for treatment as a lease, however a change in the determination of whether other parties obtain more than an insignificant amount from an asset is not a reassessment trigger.

For example, where a third party previously identified as obtaining more than an insignificant amount of an assets output shuts production, the entity continuing to operate is not required to reassess the arrangement under IFRIC 4.

4.8.3 Accounting for a lease

When an arrangement is within the scope of IFRIC 4, cash flows under the arrangement must be separated into their respective components. The components frequently include the right to use the asset, service agreements, maintenance agreements, and fuel supply. The payments for the right to use the asset are accounted for as a lease in accordance with the guidance in IAS 17. This includes the classification of the right of use as either an operating lease or a finance lease. The accounting for the other components is in accordance with the relevant guidance in IFRS.

4.8.3.1 Operating lease

If an arrangement contains an operating lease, the specific asset leased remains on the balance sheet of the lessor. Operating lease payments are recognised by the lessee on a straight-line basis over the life of the lease.

4.8.3.2 Finance lease

If an arrangement contains a finance lease, the specific asset leased is recorded on the balance sheet of the lessee and not the lessor. The lessor recognises a lease receivable which falls within the scope of IAS 39’s derecognition and impairment provisions.

The impact of this accounting treatment to the lessee is a gross-up on the Statement of Financial Position of both assets and liabilities, whilst earnings will be impacted by the depreciation of the leased asset as well as an imputed interest charge. As a result of the finance lease accounting treatment, the earnings profile and key financial ratios may be materially impacted.

4.8.4 Presentation and disclosure IAS 17 contains detailed disclosure requirements for leases. Common disclosures required include:

ÛÙ YÙ_]f]jYdÙ\]k[jahlagfÙg^ÙYfÙ]flalq½kÙka_fax[YflÙd]Yk]Ù arrangements;

ÛÙ l`]ÙlglYdÙg^Ù^mlmj]ÙeafaemeÙd]Yk]ÙhYqe]flkÙYf\Ùl`]Ù present value for each of the following periods:

– no later than one year;

– later than one year and not later than five years; and

– later than five years; and

ÛÙ l`]Ù[Yjjqaf_ÙYegmflÙg^ÙYkk]lkÙ`]d\Ùmf\]jÙ finance leases.