Base Currency Explained — What It Is and How It Works in Accounting and Finance

What Is a Base Currency?

A base currency is the first currency quoted in a currency pair. It is the currency whose value is expressed in terms of the second currency, known as the quote currency or counter currency.

For example, in the currency pair GBP/USD 1.27, GBP is the base currency and USD is the quote currency. This means that £1 is equal to US$1.27.

Base Currency and Financial Reporting

In financial reporting, an entity's functional currency is the currency of the primary economic environment in which it operates. Under IAS 21 (The Effects of Changes in Foreign Exchange Rates), foreign currency transactions are initially recognised in the entity's functional currency.

The functional currency should not be confused with the base currency used in a foreign exchange quotation. Base currency is an FX quotation concept, whereas functional currency is an accounting concept. An entity's functional currency may be the base currency in a particular currency quotation, but the two terms are not synonymous.

A foreign currency is any currency other than the entity's functional currency. Under IAS 21, a foreign currency transaction is a transaction that is denominated in, or requires settlement in, a foreign currency.

On initial recognition, a foreign currency transaction is recorded in the functional currency by applying to the foreign currency amount the spot exchange rate between the functional currency and the foreign currency at the date of the transaction. Under IAS 21, the date of the transaction is the date on which the transaction first qualifies for recognition in accordance with IFRS Accounting Standards.

For practical reasons, an exchange rate that approximates the actual rate at the transaction date may be used, such as an average rate for a week or month, provided exchange rates do not fluctuate significantly during the period.

How Exchange Rates Are Quoted

In a currency-pair quotation, the first currency is the base currency and the second is the quote currency. The quoted rate expresses how many units of the quote currency are equivalent to one unit of the base currency.

• GBP/USD 1.27: £1 = US$1.27.
• USD/GBP 0.79: US$1 = approximately £0.79.

The terms direct quotation and indirect quotation can be used differently depending on the country or perspective. For clarity, it is generally preferable to identify the base currency and quote currency explicitly.

Base Currency and ACCA Examinations

Understanding currency quotations and foreign exchange rates is important for ACCA candidates, particularly when studying foreign currency transactions, foreign exchange risk and hedging.

• Financial Reporting (FR): Foreign currency transactions and the translation of foreign operations under IAS 21.
• Financial Management (FM): Foreign exchange risk management, hedging strategies, and the interpretation of spot and forward exchange rates.
• Advanced Financial Management (AFM): More advanced foreign exchange risk management, including currency swaps, options and futures.

Worked Example

A UK company has a GBP functional currency and purchases goods from a US supplier for USD 50,000 on 1 March. The spot exchange rate on that date is GBP/USD 1.25.

Because GBP/USD 1.25 means that £1 is equivalent to US$1.25, the transaction is initially recorded in GBP as:

USD 50,000 ÷ 1.25 = GBP 40,000

At the year end, 31 December, the closing exchange rate is GBP/USD 1.20. The USD payable is a monetary item. Under IAS 21, foreign currency monetary items are translated using the closing rate at the end of the reporting period.

The payable is therefore retranslated as follows:

USD 50,000 ÷ 1.20 = GBP 41,666.67

The carrying amount of the payable has increased from GBP 40,000 to GBP 41,666.67. The resulting exchange loss of GBP 1,666.67 is recognised in profit or loss, assuming no specific IAS 21 exception applies.

IAS 21: Monetary and Non-Monetary Items

After initial recognition, IAS 21 requires foreign currency items to be treated according to whether they are monetary or non-monetary:

• Foreign currency monetary items: translated using the closing rate at the end of the reporting period.
• Non-monetary items measured in terms of historical cost in a foreign currency: translated using the exchange rate at the date of the transaction.
• Non-monetary items measured at fair value in a foreign currency: translated using the exchange rate at the date when the fair value was measured.

The carrying amount of an item is determined in conjunction with the other applicable IFRS Accounting Standards. Where a non-monetary item is subject to a measurement based on comparing two or more amounts, IAS 21 also specifies how the relevant amounts are translated.

Exchange Differences

An exchange difference arises when the same number of units of a foreign currency is translated into the functional currency at different exchange rates.

For foreign currency monetary items, exchange differences arising on settlement or translation at different exchange rates are generally recognised in profit or loss in the period in which they arise. However, IAS 21 contains specific exceptions, including certain monetary items that form part of an entity's net investment in a foreign operation.

Functional Currency and Presentation Currency

The functional currency is the currency of the primary economic environment in which an entity operates. It reflects the underlying economic environment in which the entity primarily generates and expends cash.

The presentation currency is the currency in which an entity presents its financial statements. Under IAS 21, an entity may present its financial statements in a currency different from its functional currency. Where the presentation currency differs from the functional currency, the entity translates its financial statements in accordance with the requirements of IAS 21.

Key Terms to Know

• Base currency — the first currency in a currency pair; its value is expressed in terms of the quote currency.
• Quote currency — the second currency in a currency pair; it expresses the value of one unit of the base currency.
• Functional currency — the currency of the primary economic environment in which an entity operates.
• Foreign currency — any currency other than the entity's functional currency.
• Foreign currency transaction — a transaction that is denominated in, or requires settlement in, a foreign currency.
• Presentation currency — the currency in which an entity presents its financial statements.
• Spot exchange rate — the exchange rate for immediate delivery.
• Closing rate — the spot exchange rate at the end of the reporting period.
• Forward exchange rate — an exchange rate agreed for the exchange of currencies at a future date.
• Monetary items — units of currency held and assets and liabilities to be received or paid in a fixed or determinable number of units of currency.

Summary

The base currency is the first currency in a currency pair and provides the reference unit for an FX quotation. For example, GBP/USD 1.27 means that £1 is equal to US$1.27.

In accounting, the concept of functional currency is different. Under IAS 21, the functional currency is the currency of the primary economic environment in which an entity operates. Foreign currency transactions are initially recorded in the functional currency using the applicable spot exchange rate at the date of the transaction.

Subsequently, foreign currency monetary items are generally translated at the closing rate, while non-monetary items are translated using the exchange rate applicable to their measurement basis. Non-monetary items measured at historical cost use the transaction-date rate, while non-monetary items measured at fair value use the exchange rate at the date the fair value was measured.

For ACCA candidates, it is therefore important to distinguish between base currency and functional currency, understand how exchange-rate quotations work, apply the appropriate exchange rate to foreign currency transactions, and recognise exchange differences in accordance with IAS 21.