The currency employed in the major economic context in which an entity function is referred to as the functional currency. This describes the setting in which a company produces and spends the majority of its cash. When determining the functional currency of an entity, you should consider the following factors: The primary factor affecting pricing levels in retail transactions. The unit of currency used in the nation whose market conditions and regulatory policies impact global pricing for goods and services. The currency has the most impact on labor expenses and other aspects of selling products.
Recognizing the Role of a Functional Currency
Because only one currency is used to report a company's financial information on its financial statements, any business interactions or transactions conducted in a different currency need to be translated to the primary currency utilized on the financial statements. The International Accounting Standards (IAS) and the generally accepted accounting principles (GAAP) provide direction on how foreign currency transactions should be translated into domestic currency. Under its Statement of Financial Accounting Standards (SFAS) No. 52, the Financial Accounting Standards Board (FASB) was the first regulatory authority to propose the concept of a functional currency. This was done by the Financial Accounting Standards Board (FASB).
Selecting an Appropriate Functional Currency
The economic systems of different countries are becoming more reliant on one another. The integration of global markets, which includes the exchange of goods and services and the movement of foreign money, has forced multinational firms to adopt a global mindset to maintain their position as market leaders.
One of the factors may be determining the currency that impacts the selling price most. The currency in which inventory, labor, and costs are incurred may be the one that matters the most for retail and manufacturing businesses. In the end, management often leaves the decision between using a local currency, the currency of a parent company, or the currency of a key operational center.
When many different currencies are involved, it may not be easy to get an accurate picture of how well an entire company is doing. For this reason, U.S. GAAP and IAS detail the processes that must be followed to convert transactions involving foreign currencies into the entity's functional currency so that they may be reported.
There are occasions when a company's "functional currency" could be the same as the currency of the nation where most of its trade occurs. There are other situations in which a company's operational currency is not the same as the currency in which its headquarters are located.
When changing one currency into another, the exchange rates may either favorably or negatively affect the success of a corporation. Conversions are typically completed using the spot rate that was in effect on the day the transaction took place. There are a few situations in which a standard rate could be used, such as when referring to a peak rate or an average rate for a certain period.
Examples
Take, for example, the Spanish division of a company based in the United States. Because the overall transaction values in U.S. dollars and euros are the same, there is no way to determine which currency should be used as the functional currency in this business because the total cash revenues and expenditures add up to the same amount. Either dollars or euros may end up becoming the operational currency. Because the euro is the money used in the area, the firm has adopted it as the functional currency. Even though its financial statements are stated in terms of Mexican pesos, a Mexican firm that does most of its business in the United States could utilize the United States dollar as its functional currency. This is one example of a scenario in which this might occur.
Autonomy
Whether the operation can function with a substantial degree of independence from the reporting entity or whether it is simply an extension of the reporting institution, in the first scenario, the reporting entity's currency is considered the functional currency, whereas, in the second scenario, the local currency is used.
The Percentage Of Total Transactions
Whether the foreign operation's transactions with the reporting entity make up a significant amount of the operation's operations or a negligible fraction of those activities, in the first scenario, the reporting entity's currency is considered the functional currency, whereas, in the second scenario, the local currency is used.
Cash Flows as a Percentage of Total
Whether or not the cash flows from the overseas activity directly impact the cash flows of the reporting firm and whether or not those cash flows are accessible for remittance. If this is the case, the reporting entity's currency serves as the functional currency; otherwise, the local currency is used.
Payment on the Debt
Whether or not the cash flows generated by a foreign business can meet its debt commitments in the absence of financial transfers from the reporting organization. If there is a requirement for financial transfers, the reporting entity's currency is used as the functional currency; otherwise, the local currency is used.
