Functional currency and foreign currency translation in Hong Kong financial statements

Functional Currency and Translation in Hong Kong

A Hong Kong company must decide which currency it uses to measure its financial performance and position. That decision , the functional currency , determines how every transaction is recorded and how the financial statements are presented. HKFRS sets the rules. The Companies Ordinance (Cap. 622) enforces them.

Hong Kong Functional Currency Determination

The functional currency is the currency of the primary economic environment in which the company operates. Under HKFRS, a company considers three factors: the currency that mainly influences sales prices for goods and services; 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 of providing goods or services.

For a Hong Kong incorporated company, the functional currency is often the Hong Kong dollar because revenue and expenses are denominated in HKD. A company that conducts most of its business in another currency , the US dollar or the renminbi, for instance , may adopt that currency as its functional currency. The directors must document the basis for their decision. The auditor will review whether the choice is consistent with the company's actual operations.

If a company changes its functional currency, it must apply the new currency prospectively from the date of change. The change must be disclosed in the financial statements, and the reason for the change must be explained.

Foreign Currency Translation Hong Kong HKFRS

Once the functional currency is established, every foreign currency transaction must be translated into that functional currency. Under HKFRS, the translation is done at the spot exchange rate on the date of the transaction. A company may use an average rate for a period, provided the rate approximates the actual rate at the transaction dates.

At each reporting date, monetary items denominated in a foreign currency are retranslated using the closing rate. Non-monetary items measured at historical cost in a foreign currency are translated using the exchange rate at the date of the transaction. Non-monetary items measured at fair value in a foreign currency are translated using the exchange rate at the date when the fair value was determined.

Exchange differences arising on settlement or retranslation of monetary items are recognised in profit or loss in the period they arise. A company holding a US dollar bank account when the exchange rate moves takes the gain or loss through the income statement.

Hong Kong Accounting Currency Rules

The Companies Ordinance (Cap. 622) requires a company to keep accounting records that are sufficient to show and explain its transactions and to disclose its financial position with reasonable accuracy. Section 359 of the Ordinance provides a reporting exemption for qualifying companies. The exemption does not remove the requirement to keep proper accounting records.

The accounting records must be kept for seven years. They may be kept outside Hong Kong, but the company must send to and keep in Hong Kong accounts and returns that are sufficient to disclose the financial position with reasonable accuracy. This requirement applies regardless of the functional currency chosen.

The presentation currency for statutory filing is the Hong Kong dollar. A company may present its financial statements in a currency other than HKD if that currency is the functional currency. The Companies Registry accepts financial statements prepared in a foreign currency, provided the company clearly states the functional currency and the presentation currency.

HKFRS Foreign Exchange Translation

When a Hong Kong company has a foreign operation , a subsidiary or branch that uses a different functional currency , the financial statements of that foreign operation must be translated into the presentation currency of the parent company. The translation method under HKFRS: assets and liabilities are translated at the closing rate at the reporting date; income and expenses are translated at the exchange rates at the dates of the transactions, or at average rates if they approximate the actual rates; all resulting exchange differences are recognised in other comprehensive income and accumulated in a separate component of equity, known as the foreign currency translation reserve.

On disposal of the foreign operation, the cumulative exchange differences are reclassified from equity to profit or loss as part of the gain or loss on disposal.

Presentation Currency and the Auditor's Report

The auditor's report is issued on the financial statements as presented. If the financial statements are prepared in a currency other than the Hong Kong dollar, the auditor will confirm that the translation has been performed correctly and that the financial statements comply with HKFRS and the Companies Ordinance.

The auditor will also review the company's determination of its functional currency. If the auditor disagrees with the choice, the auditor's report may include a modified opinion. A company using the US dollar as its functional currency when the primary economic environment is clearly Hong Kong risks the auditor concluding that the financial statements are not fairly presented.

Practical Considerations for Business Owners

A company that operates in multiple currencies must maintain accounting records in the functional currency. The accounting system should handle multi-currency transactions and generate reports in the functional currency. The company must also keep records of exchange rates used for translation.

Document the basis for the functional currency determination. Retain that documentation for the statutory audit. The auditor will request it.

If the company qualifies for the reporting exemption under section 359, it may apply the SME Financial Reporting Framework and Standard (SME-FRF and SME-FRS) instead of full HKFRS. The SME-FRS includes simplified guidance on foreign currency translation. The principles remain the same: the functional currency is determined by the primary economic environment, and foreign currency transactions are translated at the spot rate.

Summary of Key Points

• The functional currency is the currency of the primary economic environment.
• Foreign currency transactions are translated at the spot rate on the transaction date.
• Monetary items are retranslated at the closing rate at each reporting date.
• Exchange differences are recognised in profit or loss, except for those arising on foreign operations, which are recognised in other comprehensive income.
• The presentation currency for statutory filing is HKD, but another currency is permitted if it is the functional currency.
• Accounting records must be kept for seven years, and sufficient accounts must be kept in Hong Kong.
• The auditor reviews the functional currency determination and the translation methods used.

For further guidance, refer to the Hong Kong Institute of Certified Public Accountants (HKICPA) website and the Companies Registry.