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Plain‑English explainer of HKAS 21 / IAS 21 for students, junior accountants and non‑specialists who find official standards too dense to read.
This article is based on Hong Kong Accounting Standards (HKAS / HKFRS), which are fully aligned with IAS / IFRS except for minor local tweaks, so the same principles generally apply under IAS / IFRS unless noted otherwise. The goal is to unpack HKAS 21 The Effects of Changes in Foreign Exchange Rates (equivalent to IAS 21) using plain English and practical, real‑life examples instead of technical jargon. It is written for students, junior accountants, audit juniors and finance professionals who want to understand not just “what the standard says” but how to actually read and prepare financial statements in line with it.
When you see “the company” or “the entity” below, you can think of any entity that prepares general purpose financial statements under HKFRS / IFRS.
Why HKAS / IAS 21 matters in a place like Hong Kong
In an international financial centre like Hong Kong, foreign currency transactions are everywhere. A listed company might borrow in USD, while a small trading business might bill customers in RMB, and both have to decide how to convert foreign currency amounts into the currency used in their accounting records. If this conversion is based on the wrong assumptions, the financial statements will not properly reflect the company’s real performance.
HKAS 21 exists exactly to deal with this problem of “which exchange rate, which currency, and when”. One of its most important ideas is functional currency: the currency of the company’s main economic environment, which drives how transactions, profits and losses and even consolidation are measured. Understanding HKAS / IAS 21 is therefore not just a technical box‑ticking exercise; it is a core skill for anyone who prepares or analyses financial statements involving more than one currency.
What You Should Be Able To Do After Reading?
By the end, you should be able to:
- Understand the objective and scope of HKAS / IAS 21, and where it stops because other standards (especially HKFRS / IFRS 9) take over.
- Distinguish clearly between three currency roles: functional currency, presentation currency and foreign currency, and see how they relate to each other.
- Apply the main and secondary indicators to decide a company’s functional currency in a structured way.
- Grasp the logic behind deciding the functional currency of a foreign operation (subsidiary / branch) within a group.
- Understand when a change in functional currency is allowed and how it is accounted for.
- Avoid common mistakes, such as treating the presentation currency as if it must always be the functional currency.
1. Get the FX basics right – how to read “HKD / USD”
Before jumping into HKAS / IAS 21, it helps to get comfortable with basic exchange rate notation. An exchange rate is simply the ratio between two currencies. For example, if USD / HKD = 7.80, this means 1 US dollar can be exchanged for 7.80 Hong Kong dollars.
You can express the same relationship as the inverse: HKD / USD = 0.128, meaning 1 Hong Kong dollar can be exchanged for 0.128 US dollars (because 1 ÷ 7.80 ≈ 0.128). The direction of the quote matters when you talk about appreciation and depreciation:
- If you use USD / HKD = 7.80:
- Smaller number → HKD has strengthened;
- Larger number → HKD has weakened.
- If you use HKD / USD = 0.128:
- Larger number → HKD has strengthened;
- Smaller number → HKD has weakened.
Consider a Hong Kong exporter that keeps its books in USD and invoices customers in USD.
- If HKD strengthens (for example, USD / HKD moves from 7.80 down to 7.60), the same USD revenue converts into fewer HKD, so the HKD equivalent looks lower.
- If HKD weakens (USD / HKD moves from 7.80 up to 7.90), the same USD revenue converts into more HKD, so the HKD equivalent looks higher.
This is an accounting translation effect only; it does not mean the company actually earned more or less in economic terms. These translation gains or losses are one of the key things HKAS / IAS 21 is designed to deal with.
2. What HKAS / IAS 21 actually covers (and what it does not)
HKAS 21 focuses on two big questions:
- How to account for foreign currency transactions and foreign operations In other words, how a company should reflect exchange rate movements when it enters into foreign currency transactions or holds foreign currency assets and liabilities.
- How to translate financial statements into a presentation currency This is about how to translate the financial statements of an entity with one functional currency into another currency chosen for reporting, especially in a group where the parent and subsidiaries have different functional currencies.
HKAS / IAS 21 applies to all situations where transactions involve foreign currencies. The main carve‑out is for translation issues that are already covered by HKFRS / IFRS 9 “Financial Instruments”, such as derivatives or certain foreign currency financial instruments measured at fair value. In simple terms, HKAS / IAS 21 is about how exchange differences are reflected, not about how the fair value of a complex financial instrument is measured.
In practice, accountants use this standard most often for foreign currency purchases and sales, translation of overseas subsidiary financial statements, and dealing with exchange differences during group consolidation.
3. Three currency roles you must not mix up
Within the world of HKAS / IAS 21, three currency roles are crucial:
- Functional currency: The currency of the primary economic environment in which the company operates. It is the currency that most faithfully reflects the company’s sales prices, costs and cash flows.
- Presentation currency: The currency in which the company chooses to present its financial statements. This can be freely chosen; for example, a Hong Kong listed group may present in HKD even if some subsidiaries operate in USD or RMB.
- Foreign currency: Any currency that is not the company’s functional currency. If the company’s functional currency is HKD, then USD, RMB, EUR and others are all foreign currencies.
A key point: the company cannot freely choose its functional currency in the same way it chooses its presentation currency. The standard requires the functional currency to reflect the primary economic environment, not management’s convenience or preference. By contrast, the presentation currency is a choice; the company can translate its financial statements into any presentation currency, with translation differences usually shown in other comprehensive income.
4. How to decide the functional currency: main indicators
HKAS / IAS 21 provides several indicators to help decide the functional currency. These can be grouped into primary and secondary indicators.
Primary indicators – start here
The first and most important questions are:
- In which currency are the sales prices of goods and services mainly denominated?
- In which currency are labour, materials and other production costs mainly paid?
If a Hong Kong company mainly sells products to the US, invoices in USD, and its main costs are also in USD or linked to USD, then USD is very likely to be its functional currency.
Secondary indicators – when the answer is not obvious
If the primary indicators do not give a clear answer, the standard suggests looking at additional factors:
- The currency in which financing activities are conducted, for example, the currency in which borrowings are denominated.
- The currency in which the company holds cash and operating funds.
These secondary indicators help clarify the real economic environment. For example, a manufacturer might sell into many markets, but if its main financing, receipts and payments are all in RMB, then RMB is likely to be its functional currency.
Typical work scenario:
Sometimes a company earns both HKD and USD revenue. If, however, its pricing strategy is driven mainly by the USD market, HKAS / IAS 21 would point towards USD as the functional currency. This is a reminder that functional currency is about economic substance, not a simple percentage split of invoice currencies.
5. Foreign operations: “extension of the parent” vs “independent business”
When a group has subsidiaries or branches in other countries, it has to decide whether each foreign operation is essentially an extension of the parent or a more autonomous business. This assessment directly affects the functional currency of the foreign operation.
- If the foreign operation’s activities are tightly integrated with the parent (same customers, centrally managed cash flows and financing, and pricing set by the parent), it is more like an extension of the parent, and the functional currency is often the same as the parent’s.
- If the foreign operation has its own local sales, local financing and local pricing, it is generally treated as an autonomous operation, and its functional currency is usually its local currency.
Example:
Group A is a Hong Kong parent with a subsidiary B in Singapore.
- If B only manufactures products for A, and all its revenue is settled in HKD with A, B’s functional currency is likely to be HKD.
- If B sells directly to the Singapore market, procures locally and arranges its own financing in Singapore, its functional currency is likely to be SGD.
This judgement also links to the concept of net investment in a foreign operation. When a foreign operation has its own functional currency, the parent has to present related exchange differences separately in the consolidated financial statements, which becomes important in later parts of HKAS / IAS 21, especially on disposal or partial disposal of the foreign operation.
6. When and how can the functional currency change?
The standard is very clear: the functional currency can only change when there is a real change in the underlying economic environment. This could happen when the company’s main markets shift, its main borrowing becomes dominated by another currency, or its business model is fundamentally restructured.
When a functional currency change is justified, it is accounted for prospectively. From the date of change onwards, the company translates all assets, liabilities and equity items into the new functional currency using the exchange rate on that date, and treats the resulting amounts as the new historical cost base going forward. Past figures are not restated, which keeps the change transparent.
Example:
A Hong Kong company has long operated in HKD, but over several years its operations shift almost entirely to Mainland China. Revenue, costs and financing are now mainly in RMB, and prices are set in RMB. At that point, the company should consider changing its functional currency to RMB and re‑translate all balance sheet items into RMB at the rate on the date of change, using RMB as the base going forward.
7. Functional currency vs presentation currency – the classic trap
One of the most common practical mistakes is to treat the presentation currency as if it must also be the functional currency. For example, a group may present its consolidated financial statements in HKD, while a subsidiary actually operates mainly in TWD; if that subsidiary incorrectly records its transactions directly in HKD, the financial information will not reflect its real performance and risk.
Another frequent error is to let management preference lead the decision, such as “we are a Hong Kong company, so let’s just use HKD”. HKAS / IAS 21 explicitly requires the functional currency to be determined based on the primary economic environment, not administrative convenience.
The IASB has clarified in its interpretations that the purpose of functional currency is to ensure the financial statements reflect economic reality, not to give companies free choice over currencies. Even if a listed company presents its financial statements in HKD, if its real business base is the USD market, exchange rate effects against HKD must still be properly disclosed in the financial statements.
Important clarification:
It is perfectly normal and fully compliant for the functional currency and presentation currency to be different. For example, a company listed in Hong Kong might present its financial statements in HKD, while its operations, revenue, expenses and financing are mainly in TWD, making TWD its functional currency. The real mistake is the reverse thinking: deciding the functional currency based on the desired presentation currency, and recording transactions directly in that presentation currency.
The order required by the standard is:
- Determine the functional currency based on the primary economic environment.
- Record transactions and balances using that functional currency.
- Only then, translate the financial statements into the group’s chosen presentation currency.
8. Reading financial statements through an FX lens
Learning HKAS / IAS 21 is essentially learning how to read the economic story behind the currencies. If a company’s functional currency is USD but it presents its financial statements in HKD, the foreign currency translation differences you see are like a mirror reflecting the interaction between its USD‑based operations and the Hong Kong environment.
When you read financial statements, you can start asking yourself:
- What is this company’s functional currency?
- Why is that the most reasonable conclusion?
- How does this choice affect its exchange rate risk and the volatility you see in profit or equity?
Once you form the habit of asking these questions, you lay a strong foundation for later topics such as foreign currency transactions, translation of foreign operations and consolidation of overseas subsidiaries under HKAS / IAS 21.
Key Takeaways for Students and Junior Accountants
- When reading any set of financial statements, always identify the functional currency first, then check whether the presentation currency is different and how translation differences are presented.
- In exams and real‑life work, do not rely on “country of incorporation” or “convenience” to decide the functional currency; walk through the primary and secondary indicators step by step and state your reasoning.
- When drafting or reviewing journal entries, make sure the base records are in the functional currency, and treat any other currency as foreign currency that may create exchange differences.
- In group reporting, pay special attention to foreign operations: decide whether they are “extensions of the parent” or “autonomous”, and ensure their functional currencies and translation treatment are consistent with that judgement.
- When reviewing contracts (e.g. sales, purchases, loans), always ask which currency really drives pricing, costs and cash flows; use this thinking as evidence for your functional currency assessment and your working papers.
- If a client or manager insists on using a certain currency “because it’s easier”, be ready to explain why the standard requires substance‑based judgement and how getting this wrong can distort performance and risk.
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