Functional Currency

The term functional currency represents the currency of the location in which the business operates primarily, earns a significant portion of revenue, and incurs the cost to generate the same revenue. We can also say that it is the country's home currency where the headquarters of the business is situated.

It 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. Otherwise, it remains constant to maintain functional currency accounting documentation.

Functional currency of a business is the primary currency in which it conducts its day-to-day operations and maintains its financial records. This choice is not always synonymous with the local currency but is determined by the economic environment that significantly influences the entity's business activities.

The determination of a company's functional currency involves a thoughtful analysis of various factors. It goes beyond merely considering the local currency and extends to identifying the currency that plays the most substantial role in shaping the company's operations. This assessment takes into account the currency of the country where the business generates the majority of its revenue and incurs the bulk of its expenses. The goal is to pinpoint the currency that most accurately reflects the economic substance of the underlying transactions.

The importance of functional currency analysis lies in its role as the foundation for financial reporting and accounting practices. All financial transactions, regardless of the currency in which they occur, are recorded in the functional currency. This standardized approach ensures consistency and facilitates a clear assessment of the company's financial performance, providing stakeholders with a reliable and uniform representation of the business's economic activities.

For businesses operating on a global scale, understanding and correctly identifying the functional currency is not merely a technicality but a strategic necessity. It influences financial decision-making, risk management, and ensures compliance with international accounting standards. As companies continue to expand their footprint across borders, a nuanced comprehension of functional currency becomes increasingly vital in navigating the intricate terrain of cross-border financial management.

Since we now understand the basics of this concept, it is natural to have the question of how to determine and document for functional currency accounting. Let us understand how through the discussion below.

• Functional currency impacts the prices of goods and services.
• It impacts the cost structure.
• 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.

Now that we understand the basics, how to determine, and related factors of functional currency analysis, let us apply the knowledge to practical application through the examples below.

Example #1

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 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 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 company X. Therefore, for company Y, the functional currency will remain the same as for X, which is € Euro.

Example #2

Auriant Mining AB is a Swedish Mining company that focuses mainly on gold exploration and production in Russia, mainly in Zabaikalya, Tyva, and the Republics of Khakassia. In August 2023, they declared their annual report, where their consolidated revenue added up to $17.6 million in comparison to the $26.3 million in the previous year.

The net profit in the previous year was $9.7 million, whereas in 2023, the company incurred a net loss of $10.8 million. The company also changed its functional currency from the USD to the Russian Rouble as of January 1, 2023.

As we all know, significant industries accept US Dollars $, and the prices for the goods and services are charged in US $. For instance, Oil, shipping, insurance, financial services, etc. The 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 are exposed more to currency risk.

For instance, German Bank, headquartered in Frankfurt, also runs operations in other major countries of the world, such as UK, the US, and the Asia Pacific. Still, significant revenues are being generated from Europe, contributing 70% of the 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 constantly through reporting currency calculator. 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.

Following additional factors need to be considered when carrying out the functional currency analysis 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.

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 the presentation currency, the financial results should be presented based on the 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 the 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 technical terminologies for companies operating outside of their home countries are a little complicated. They are often confused for one another. Let us understand the differences between functional currency analysis and reporting currency through the comparison below.

Functional Currency

• The primary currency in which a business conducts its daily operations and maintains financial records.
• Based on the economic environment that significantly influences the entity's operations, considering factors like revenue generation and major expenses.
• Used as the baseline for financial reporting and accounting, ensuring consistency and a standardized framework for assessing the company's performance.
• May differ from the local currency, reflecting the global nature of business operations.

Reporting Currency

• The currency in which a company prepares and presents its financial statements for external reporting purposes.
• While it can be the same as the functional currency, international businesses often choose a reporting currency that aligns with the needs of stakeholders, such as investors or regulatory bodies.
• Facilitates clear communication with stakeholders who may prefer or require financial information in a specific currency.
• Businesses operating in multiple jurisdictions must navigate the potential impact of currency fluctuations when selecting a reporting currency.

This article has been a guide to Functional Currency and its definition. Here, we explain its additional indicators, example and compare it with reporting currency. You can learn more about financing from the following articles –

• Currency Market Definition
• Currency Depreciation
• Currency Devaluation Definition
• Money vs Currency