What Is a Functional Currency?
Popular with multinationals, functional currency represents the primary economic environment in which an entity generates and expends cash. It is the main currency used by a business in its dealings.
Key Takeaways
- A functional currency is the main currency that a company conducts its business in.
- As companies transact in multiple currencies but report their financial statements in one, foreign currencies need to be translated into the functional currency.
- The guidelines for translating foreign currencies for financial statements are laid out in the International Accounting Standards (IAS) and generally accepted accounting principles (GAAP). The functional currency does not always have to be the currency of the country where the company is headquartered.
Delving Deeper into Functional Currency
Financial statements are reported in just one currency. Any dealings or transactions conducted in another currency must be converted back to the primary currency used in the financial statements. IAS and GAAP offer guidelines on converting these transactions.
The Financial Accounting Standards Board (FASB) was the pioneering regulatory body to present the concept of a functional currency under their Statement of Financial Accounting Standards (SFAS) No. 52.
How to Choose a Functional Currency
Global interdependence of economies affects multinational corporations who trade commodities and services, and control the flow of international capital, necessitating a global perspective to remain competitive.
With international operations, choosing a functional currency involves multiple financial reporting aspects. These include determining appropriate functional currencies, accounting for foreign currency transactions, and converting financial statements from foreign subsidiaries for consolidation into the parent company’s currency.
Several factors come into play, such as finding the currency that most affects the sales price. For retail and manufacturing entities, the relevant currency may be that in which inventory, labor, and expenses are mainly incurred. Often, it comes down to management’s decision – be it the local currency, the parent’s currency, or that of a primary operational hub.
Evaluating overall business performance involves deciphering various currencies. Consequently, both U.S. GAAP and IAS outline procedures for converting foreign currency transactions into the functional currency for accurate reporting.
A functional currency might be the same as the country where most business is conducted, or it could be different from the headquarters’ currency.
Conversion Mechanics
During currency conversion, exchange rates can significantly impact a company’s performance. Conversions often occur at the spot rate or the prevailing exchange rate on the transaction date. In some instances, a standard rate, such as a peak rate or an average rate for a specific period, might be used.
Understanding how to manage and report in the chosen functional currency is crucial for accurate financial reporting and overall business health.
Related Terms: currency, foreign exchange, conversion rate, spot rate, financial statements, inventory.
