A functional currency is what, exactly?
A functional currency is utilized in the leading economic setting in which a company conducts business. This is the setting in which an entity generates and spends money most frequently. Therefore, when defining the functional currency of an entity, the following key considerations should be taken into account:
- The currency influences retail prices (usually the currency in which fees are denominated and settled).
- The money of the nation whose laws and competition have the most significant impact on retail pricing.
- The exchange rate impacts labor costs and other selling costs.
- The currency in which an organization keeps its operating revenues and the money in which debt and equity instruments are issued are less critical decision factors.
These components should be taken into account when choosing the functional currency for an entity’s overseas operations:
Autonomy
Whether the activity may function mostly independently or is primarily an extension of the reporting entity. In the first instance, the functional currency is that of the reporting entity, whereas, in the second, it is the local currency.
Proportion of transactions
Whether a large or small amount of the overseas operation’s activities are comprised of its transactions with the reporting company, in the first instance, the functional currency is that of the reporting entity, whereas, in the second, it is the local currency.
The proportion of cash flows
If the overseas operation’s cash flows are available for remittance and directly impact the reporting entity’s cash flows, the reporting entity’s currency is the functional currency; otherwise, the local currency.
Debt Service
Whether a foreign enterprise’s cash flows can pay its debts without receiving money transfers from the reporting entity if money transfers are required, the reporting entity’s currency is the functional currency; otherwise, the local currency is used.
Why Is It Important to Choose the Functional Currency?
Financial statements could be materially misstated by using the wrong functional currency. This is because the selection of the functional money influences the accounting treatment of some transactions. The following example illustrates how one set of transactions is accounted for differently due to this decision.
A business’s primary form of money for its operations is the functional currency. Multinational firms who operate in different currencies will find it most useful. The most accurate way to gauge overall business performance is correctly identifying the functional currency.
FINAL INSIGHT
The impact of a change in the functional currency is anticipated. As a result, an entity converts all items using the exchange rate applied on the change date into the new functional currency. Non-monetary goods are given their historical cost using the translated amounts that arise.
The most crucial element is frequently the currency with the most significant impact on sales pricing. The currency in which labor, inventories, and expenses are incurred is also substantial. It’s also essential to take into account the money used for borrowing transactions and in which the business keeps cash on hand. In the end, management makes the decision based on its judgment and consideration of all relevant circumstances.
