What is Functional Currency?
The term functional currency represents the currency of the location in which business operates primarily and earns a major portion of revenue and incur the cost to generate the same revenue. We can also say that it is the home currency of the country where headquarter of the business is situated.
How to Determine a Functional Currency?
- Functional currency impacts the prices of goods and services.
- It impacts the cost structure of an entity.
- The currency where funds are generated and spent.
- The currency which 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 and they should be considered when primary factors failed to provide the desired information.
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 provides a loan amount of £ 2 million to Y & Z and both the entity recorded the transactions as intragroup payables.
- Z borrowed an additional £ 3 million funds from the third party and company Y provides the guarantee for the same to the third party.
- Z invested £ 5 million in building the infrastructure to serve the home market in the UK and planning to repay the loan borrowed from the third party from the profits being generated from the operations.
- Y invested £ 2 million in the marketable securities 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. The extent to which a particular currency has been used in the transactions and having 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 reason being this is the currency that can influence the selling prices and cost of goods being manufactured.
Company Y being incorporated in the US does not seem to have US dollar as its functional currency as it has invested the entire £ 2 million in marketable securities which are assumed as the extension of parent company X therefore for company Y functional currency will remain the same as for X which is € Euro.
US Dollar ($) as Functional Currency
As we all know that US Dollar $ is widely accepted in almost all major industries and the prices for the goods and services are being charged in US $. For instance Oil, shipping, insurance, and financial services, etc. Revenue of an entity whose major business is Oil will be highly impacted by US $. Even if invoices are raised in local currency the US dollar will remain the functional currency as the local currency will be referenced with US dollar
It is a major concern with multinational companies when they operate in more than one country and deal in different currencies at the same time they are exposed to currency risk.
For instance: German Bank having headquartered in Frankfurt also running operations in other major countries of the world UK, US, Asia pacific but major 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 major portion of revenue is, therefore, the Euro.
In cases when companies are doing business in more than one countries and the distinction between the major currencies contributing the revenues could not be done then management should give considerations to the financial results and respective client relationships. It is not necessary that functional currency is always reporting currency.
Following additional factors need to be considered when deciding the functional currency of entities doing operations in foreign locations:
- Independence: To determine the functional currency of an entity one should focus on the nature of business if it is an extension of reporting entity or doing business with a high degree of independence. In the former case it is reporting currency and in later case reporting currency is a local currency.
- Number of Transactions: If the number of foreign operations transactions is contributing a major 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 flows from foreign operations are high as compared to the local operations and the same cash flows have considerable impact on the cash flows activity of the reporting entity then it is the reporting entity and local currency if not.
- Debt Coverage: If foreign operation’s cash flows are capable of servicing their debt obligation without any funds transfer 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 reports are presented. If it is different from presentation currency, the financial results should be presented on the basis of presentation currency.
Following are the basic steps to be followed while converting foreign currency into functional currency:
- The reporting entity should determine its functional currency.
- All foreign operations are converted into such currency.
- The effect of translation of foreign currency into functional currency should be reported according to IAS 21.
The above-mentioned steps should be applied to a standalone entity with foreign operations like a parent with foreign subsidiaries.
The functional currency of an entity is a reflection of transactions, events, and circumstances in which an entity does business. Businesses cannot change the functional currency once it is decided. The only exceptions that qualify to change the currency depend on the nature of underlying events and transactions companies are engaged in.
If in any circumstances functional currency is changed, the new currency should be implemented from the very first day it is changed. The new currency should be used prospectively and not retrospectively and this transformation should be linked with underlying events and transactions going forward. For instance change in the major markets of doing business may have a considerable impact on the new currency in which goods or services are being sold.
This 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 –