Functional currency refers to the main currency that a business or a company’s foreign operation generates and spends cash, as well as incurs expenses. It’s the currency of the primary economic environment in which an entity operates. The concept is used in international businesses to standardize the currencies used in their various operations.
The determination of the functional currency should reflect the underlying transactions, events, and conditions that are relevant to the entity. Factors that could influence what the functional currency is include:
- The currency that mainly influences the sales prices for goods and services.
- The currency of the country whose competitive forces and regulations mainly determine the prices of its goods and services.
- The currency that mainly influences labor, material, and other costs of providing goods or services.
Once the functional currency is determined, the financial statements are prepared in that currency. When the entity has foreign operations, it might need to translate foreign currency items into its functional currency. This process is regulated by accounting standards like IFRS (International Financial Reporting Standards) and U.S. GAAP (Generally Accepted Accounting Principles), which provide guidance on how to handle currency translation for preparing consolidated financial statements.
For instance, a U.S.-based company might have a subsidiary operating in Japan. While the U.S. parent company’s functional currency would be USD, the functional currency for the Japanese subsidiary might be the Japanese Yen if its business activities are primarily carried out in Yen. The Japanese subsidiary would prepare its financial statements in Yen, and those financials would then be translated into USD for consolidation with the parent company’s financials.
Example of the Functional Currency
Suppose TechX, a tech company, is based in the United States but has operations in several other countries, including a major software development center in India. This center in India operates independently, receiving revenues from local clients in Indian Rupees (INR), paying salaries in INR, and even purchasing equipment from local suppliers in INR.
In this scenario, even though TechX’s reporting currency (the currency in which it presents its consolidated financial statements) is the U.S. Dollar (USD), the functional currency for the Indian subsidiary would be the Indian Rupee (INR). This is because the primary economic environment in which the subsidiary operates is India, and the currency that mainly influences its day-to-day operations and cash flows is the Indian Rupee.
So, the Indian subsidiary would initially prepare its individual financial statements in INR. When TechX consolidates its financial statements, it would then need to translate the subsidiary’s financial statements from INR into USD.
This translation process can lead to what are known as foreign exchange gains or losses, which occur due to changes in the exchange rate between the functional currency and the reporting currency from one period to another. These gains or losses are typically reported as a separate component of equity in the consolidated financial statements.
This example shows how functional currency is determined and used in an international business context. Keep in mind, though, that actual situations can be more complex, and the choice of functional currency can have significant implications for financial reporting and tax obligations. Therefore, companies often seek advice from accounting professionals or consultants when making this decision.