Functional Currency (FC), as the word suggests, is the currency of the location or the economic environment in which a firm works. Or, we can also say that it is the currency in which a firm mainly earns and spends cash. In simple words, we can say that it is the home currency of the country in which the company is headquartered. But that may not be the case always. The local currency and the FC can be different.
FASB (Financial Accounting Standards Board) was the first to come up with the idea of functional currency. As per the definition by IAS (International Accounting Standard) 21, it is the currency of the “primary economic environment in which the entity operates.”
There are several things that assist in determining the functional currency. In most cases, it the local currency in which a firm operates, or the currency of the parent company. But, in a number of cases, the U.S. dollar serves as the FC. This is because all major industries support USD by pricing their goods and services in this currency.
A good example of this is oil. This means if oil constitutes a sizable portion of a company’s business, then fluctuation in the USD would impact its performance. So, in this case, the USD will serve as the functional currency even if the company generates invoices in local currency.
Functional Currency – Importance
It is very crucial for a company to identify its functional currency. As one would appreciate, the concept of functional currency is applicable to companies that operate internationally. Or, the firms doing business in more than one currency, and hence face currency risk.
Basically, selecting a functional currency addresses reporting issues. These issues include recording of foreign currency transactions, as well as treatment of foreign subsidiaries’ financial statements.
Moreover, deciding on currency helps in measuring the overall performance of the business. Also, it ensures that a company’s financial statement shows the actual position.
Converting Other Currency to Functional
It is possible that functional and reporting currency could be different. That is why both U.S. GAAP and IAS detail processes on how firms can switch their transactions in other currencies to FC. When converting transactions, the exchange rate can affect the overall performance.
For conversion, mostly the exchange rate prevailing on the day of transactions is considered. Also, there are cases when companies use a standard rate, like the average or the maximum rate. When converting foreign currency into FC, a company must follow this process:
- It must first identify its FC.
- Then it needs to convert all transactions into the FC.
- Now, the company needs to report the effect of converting the transactions as per the IAS 21.
How to Determine Functional Currency?
A point to note is that an FC may or may not be the reporting currency for the company. In some cases, determining FC could be straightforward, but in some, it could get tricky.
Three easy ways to identify a functional currency are:
- It is the currency that impacts the prices of products or services that a company sells.
- If the regulation on a currency impacts a company’s pricing policy, then that currency is a functional currency.
- It is the currency that impacts the costs and expenses of a company.
- It should be the currency in which the company prices its inventory, labor, and expenses.
- Also, it is usually the currency in which a company issues its debt and equity instruments.
To determine the functional currency of a company’s foreign operations, the management must look at the following points:
Management must try to identify the degree of autonomy the foreign operations enjoy. If the operations are just an extension, then the currency remains the same. And, if the foreign operations enjoy a great deal of autonomy, then the local currency is the FC.
The company needs to determine whether or not the transactions with the foreign entity represent a significant portion of the total operations. If the amount of transactions is considerable, then the foreign currency becomes the FC.
The proportion of Cash Flows
One needs to determine whether or not the cash flows from the foreign entity represent a significant proportion of the company’s total revenue. If the foreign cash flows are more than the local, then the foreign currency is the FC.
Another deciding factor is if the cash flows from foreign operations are sufficient to meet its debt obligations. Or, the foreign operations don’t require any funds from the company to service its (foreign operations) debts.
Let’s take a simple example to understand the concept of this currency. A Chinese company has its headquarter in Beijing, but operates in the U.S. as well. In fact, the U.S. market accounts for more than 50% of the company’s total revenues. So, the functional currency for this company would be the U.S. dollar and not the Chinese Yuan.
In another example, a U.S. company has a Chinese subsidiary. The revenue and expenditures of the subsidiary are more or less the same in the U.S. dollar and Yuan. In this case, the subsidiary can choose either currency. However, the better solution, in this case, will be selecting Yuan because it is the local currency.
In cases where a company has operations in two or more currencies, and all markets are equally important, then it is up to the management to decide the functional currency. The management should take into consideration the relationship with clients, financial results, investors, regulations, and other factors to decide on the currency.
Deciding FC is very important for a multinational corporation. Only after the company selects FC and converts transactions into FC, it could give its true financial picture. A point to note is that a company can’t change its FC once it selects. However, it may change FC under a few rare circumstances and events. And, if the company changes its FC, then it should implement the change from the first day, i.e. prospectively and not retrospectively.