What is Functional Currency?
The term functional currency represents the currency of the location in which business operates primarily and earns a significant 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.
- 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 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. A particular 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 reason being this is the currency that can influence the selling prices and cost of goods being manufactured.
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Company Y is incorporated in the US but does not seem to have the US dollar as its functional currency. It has invested the entire £ 2 million in marketable securities, which are assumed as the extension of parent company 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 that major industries accept US Dollar $, and the prices for the goods and services are charged in US $. For instance, Oil, shipping, insurance, and 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 companies 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 running operations in other major countries of the world UK, US, 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.
In cases when companies are doing business in more than one country, and the distinction between the major currencies contributing to the revenues could not be made. Management should give considerations to the financial results and respective client relationships. Functional currency doesn’t need to be 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 a 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 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 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 presents. 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.
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 decided. The only exceptions that qualify to change the currency depending 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 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 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 –