While the rules and laws on accounting for foreign-currency translations haven’t changed in many years, note that mistakes in this area still persist. These mistakes can result in misstatements in a company’s financial reporting, and hurt the bottom line.
They can also create a misleading understanding of business results, exposing a business to possible regulatory scrutiny.
Functional Currency Explained
A company’s functional currency is the currency that it uses in order to maintain its daily operations.
Functional currency is the currency of the nation or country where the business operates. In other words, it is the currency in which the organization conducts business transactions.
For example, Company ABC is a wholly-owned subsidiary company located in France. As the national currency of France is the euro, ABC conducts all of its business transactions, such as sales, in euros.
As you can see, the functional currency of a business entity reflects the events, transactions, and conditions under which that entity operates or conducts its business. Once an entity decides its functional currency, it doesn’t change.
However, you can change a functional currency if there’s a significant change in the nature of events, underlying transactions, and relevant conditions.
Qualified Business Unit
A Qualified Business Unit (QBU) is any clearly identified and separate unit of a business or trade of a taxpayer or business that maintains separate accounting books and records.
A company might conduct transactions (payment for expenses) in multiple currencies. Each QBU of the business converts these transactions to its functional currency. This is done at a suitable exchange rate. After that, periodic reports of its position as well as activity are prepared in the functional currency.
When you combine various QBUs, these reports (balance sheet or income statement) are translated and consolidated to become official financial statements.
A spot rate is the current exchange rate at which you can buy or sell a specific currency on currency exchange markets.
When converting a currency, such as the US dollar, the exchange rates can either positively or negatively impact a company’s performance.
In most cases, conversions are done using the spot rate on the foreign currency transaction date. However, there are some instances where a standard rate is used, like a peak rate or the average rate for a specific period.
We translate transactions usually at the spot rate. This is the rate of exchange between the functional currency and transaction currency on the transaction date. Also, in currency markets, the spot rate is known as the immediate exchange rate.
How to Determine the Functional Currency of a Business’ Foreign Operations
You have to consider the following factors when determining the functional currency of an entity doing business or conducting operations in a foreign location.
If you would like to determine the functional currency of a company or business entity, you should focus on the nature of business.
The entity could be an extension of a reporting entity or conducting business with a high degree of autonomy or financial independence.
If the operations are merely an extension, the currency will remain the same. On the other hand, if the foreign operations have considerable autonomy, the local currency is the functional currency.
Amount of Total Transactions
Suppose the number of total foreign transactions contributes a significant portion of the revenue or sales of the reporting entity. In that case, the currency will likely be the functional currency of that reporting entity.
Can cash flows from foreign operations service the company’s debt obligation without any transfer of funds from the reporting entity? If that is the case, the functional currency is the one used by the reporting entity.
Amount of Cash Flows
Suppose the cash generated from foreign operations is higher than the local operations and these cash flows have a significant effect on the cash flows activities of the reporting entity. In that case, it’s the functional currency of the reporting entity.
Choosing a Functional Currency
There are many ways a company could choose the company’s functional currency. Selecting a suitable functional currency is vital to effective reporting.
This is because as markets are becoming increasingly globalized, businesses are more frequently engaged in international trade. The number of cross-border alliances and joint ventures is also on the rise.
As a result, businesses are no longer restricted to their origin countries. You have to consider the following when choosing the functional currency of a business entity.
You have to understand the currencies, such as the euro, that the company is using. The company may use several currencies besides its local currency. This may be because of the market practices and requirements.
It is no secret that the currency that considerably affects sales price is usually the most crucial factor in this determination. And that is not all; the currency in which labor, inventory, and expenses are incurred and paid is also quite significant when choosing a functional currency.
You also need to figure out which currency is used the most in the company’s financial transactions, such as payments to staff, suppliers, and customer collection.
Also, consider the currency for borrowing transactions and the currency in which the company maintains cash. Keep in mind that the currency that dominates these transactions should be considered the company’s functional currency.
Remember that choosing the correct functional currency considerably helps a company with effective financial reporting. And this is crucial when it comes to avoiding the risk of misstatements in financial accounting.
Example of Functional Currency
Here’s a simple example of functional currency.
A Japanese company is headquartered in Tokyo but also operates in the U.S. Actually, the US market accounts for over half of the company’s revenues. As a result, the functional currency for this Japanese company would be the U.S. dollar instead of the Japanese Yen.
Here is another example. A German Bank, with headquarters in Frankfurt, also has operations in many other major countries, such as the UK, U.S., and the Asia Pacific.
However, it generates significant revenues from Europe, which contribute 75% of the bank’s total revenue. So, the functional currency for the German bank is the currency where the bank generates the majority of its revenue. Hence it is the euro.
Let’s consider a U.S. company that has a Chinese subsidiary. If the subsidiary’s revenues and expenditures, such as rent, are roughly the same in both the US dollar and Yuan, the subsidiary may choose either currency. However, the better solution is to select Yuan because it is also the local currency and makes their accounting simpler.
Functional Currency vs. Reporting Currency
A company’s functional currency can be different from its reporting currency. Also known as the presentation currency, the reporting currency is used for financial reporting.
In simple words, a reporting currency, such as U.S. dollars, is the currency in which a parent entity prepares and presents its financial statements.
In most cases, the reporting currency is the currency used in a company’s home country. To issue financial statements, such as income statements, in the reporting currency, multinational firms have to first convert the reporting of their foreign subsidiaries to the reporting currency.
As you can see, the main difference between reporting currency and functional currency is that the functional currency is often the currency of the primary economic environment where the business entity operates.
On the other hand, reporting currency is the currency that a company uses to present financial statements. These include quarterly and annual reports.
In many small to medium-scale companies operating in one country, the reporting and functional currencies are the same.
Translation risk is often unavoidable in converting financial results. So, if the reporting currency is stronger than the functional currency, the results will be favorable.
Many large, multinational companies have operations in multiple countries. This often requires them to do business in various currencies. In these cases, the currency of the organization’s home office or the parent company where it prepares financial statements is the reporting currency.
IAS 21 Summary
Functional currency is the currency that a company uses in its operations. IAS 21 defines and outlines many factors that help determine whether a specific currency qualifies as the functional currency.
It is common to come across sale and purchase transactions in a foreign currency. These transactions must be recognized or recorded in the entity’s currency in the various accounts books. This is where IAS 21 comes into the picture.
This accounting standard prescribes how to include various foreign currency transactions, such as sales, and foreign operations, in the financial statements of a business entity.
It also specifies how to translate financial statements, including cash flow statements, into a presentation currency.
According to IAS 21, you should determine an entity’s functional currency by looking at several variables and factors. For example, this currency should ideally be the one in which the business entity usually generates and spends cash or the one in which transactions are denominated.
Whether it is foreign currency transactions or suitable translation of foreign operations, you have to use an appropriate exchange rate in order to ensure consistency between entities.
IAS 21 has rules and principles that tell you which currency exchange rate you should use for foreign currency transactions and translation of foreign operations.