What is Functional Currency?

How to Determine a Functional Currency?

  • Functional currency impacts the prices of goods and services.It impacts the cost structureCost StructureCost Structure refers to those costs or expenses (fixed as well as variable costs) which businesses will incur or will have to incur to produce the desired objective of the business; such costs include the cost of purchasing the raw material to the cost of packaging the finished products.read more.The currency where funds are generated and spent;The currency is mostly affected by the regulatory and market policy decisions;The currency in which cash flows from operating activities is retained.The currency in which funds have been raised through debts and equity instruments;

The factors like the currency in which financial resources are raised and the currency in which the entity holds the assets are secondary factors. They should be considered when primary factors fail to provide the desired information.

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Example of Functional Currency

Company X uses Euro as a functional currency. Company X has two subsidiaries, Y and Z. Company Y is incorporated in the US, and company Z is incorporated in the UK.

  • X provided a loan amount of £ 2 million to Y & Z, and both the entities recorded the transactions as intra-group payables.Z borrowed an additional £ 3 million funds from the third party, and company Y provided the guarantee for the same to the third party.Z invested £ 5 million in building the infrastructure to serve the UK’s home market and plans to repay the loan borrowed from the third party from the operations’ profits.Y invested £ 2 million in the marketable securitiesMarketable SecuritiesMarketable securities are liquid assets that can be converted into cash quickly and are classified as current assets on a company’s balance sheet. Commercial Paper, Treasury notes, and other money market instruments are included in it.read more in the international markets.

Now we will understand the functional currency of company Y and company Z.

At the very outset, such currency in the economic environment should provide adequate information on the underlying events and transactions associated with respective entities. A currency that is used significantly in the transaction and has a considerable impact can be used as a functional currency.

In the above illustration, we have observed GBP Great Britain pound has been used as functional currency for entity Z in the UK. The currency can influence the selling prices and cost of goods being manufactured.

Company Y is incorporated in the US but does not seem to have the US dollar as its functional currency. It has invested £ 2 million in marketable securities, which are assumed to be the extension of parent companyParent CompanyA holding company is a company that owns the majority voting shares of another company (subsidiary company). This company also generally controls the management of that company, as well as directs the subsidiary’s directions and policies.read more X. Therefore, for company Y, the functional currency will remain the same as for X, which is € Euro.

US Dollar ($) as Functional Currency

As we all know, major industries accept US Dollar $, and the prices for the goods and services are charged in US $. For instance, Oil, shipping, insurance, financial services, etc. Revenue of an entity whose significant business is Oil will be profoundly impacted by US $. Even if invoices are raised in a local currency, the US dollar will remain the functional currency as the local currency will be referenced with the US dollar.

It is a significant concern with multinational companiesMultinational CompaniesA multinational company (MNC) is defined as a business entity that operates in its country of origin and also has a branch abroad. The headquarter usually remains in one country, controlling and coordinating all the international branches. read more when they operate in more than one country and deal in different currencies. At the same time, they expose more to currency risk.

For instance: German Bank, having headquartered in Frankfurt, also runs operations in other major countries of the world UK, the US, and the Asia Pacific, but significant revenues are being generated from Europe, contributing 70% of the revenue Bank’s total revenue. The functional currency for this German Bank is the currency where the Bank is generating a significant portion of revenue is, therefore, the Euro.

Functional currency doesn’t need to be always reporting currency. Management should consider the financial results and respective client relationships. In cases when companies are doing business in more than one country, the distinction between the major currencies contributing to the revenues could not be made.

Additional Indicators

Following additional factors need to be considered when deciding the functional currency of entities doing operations in foreign locations:

  • Independence: To determine an entity’s functional currency, one should focus on the nature of business, if it is an extension of a reporting entity or doing business with a high degree of independence. In the former case, it is reporting currency, and in the latter case reporting currency is a local currency.Number of Transactions: If the number of foreign operations transactions contributes a significant portion of the revenue of the reporting entity, then that currency will be the functional currency of the reporting entity.Cash Flows from the Transactions: If the cash flow from foreign operations is higher than the local operations and the same cash flows have a considerable impact on the cash flow activity of the reporting entity, then it is the reporting entity and local currency if not.Debt Coverage: If foreign operations’ cash flows can serve their debt obligation without any funds transferred from the reporting entity, then the functional currency is the reporting entity’s if the funds are required and the local currency if not.

Presentations of Functional Currency

An entity can present financial results in any currency. Generally, it is a functional currency in which financial reportsFinancial ReportsFinancial reporting is a systematic process of recording and representing a company’s financial data. The reports reflect a firm’s financial health and performance in a given period. Management, investors, shareholders, financiers, government, and regulatory agencies rely on financial reports for decision-making.read more are presented. If it is different from presentation currency, the financial results should be presented based on presentation currency.

Following are the primary steps to be followed while converting foreign currency into functional currency:

  • The reporting entity should determine its functional currency.All foreign operations convert into such currency.The effect of translation of foreign currency into functional currency should be reported according to IAS 21.

The steps mentioned above apply to a standalone entity with foreign operations like a parent with foreign subsidiaries.

Conclusion

The functional currency is a reflection of transactions, events, and circumstances in which an entity does business. Businesses cannot change the functional currency once decided. The only exceptions that qualify to change the currency depend on the nature of underlying events and transactions companies engage in.

If, in any circumstances, the functional currency changes, the new currency should be implemented from the very first day. New currency should be used prospectively and not retrospectively. The transformation should be linked with underlying events and transactions in the future. For instance, changes in the major business markets may considerably impact the new currency in which goods or services are sold.

This article has been a guide to what is the functional currency. Here we discuss Primary and additional indicators of functional currency along with presentation and illustrations. You can learn more about financing from the following articles –

  • Currency Market DefinitionCurrency DepreciationCurrency Devaluation DefinitionMoney vs Currency