What is a functional currency?
Popular with multinationals, functional currency represents the main economic environment in which an entity generates cash and spends cash. The functional currency is the main currency used by a company or a business unit. As a monetary unit of account, a functional currency represents the main economic environment in which this entity operates.
Understanding functional currency
Sometimes the functional currency of a business can be the same currency as the country in which it operates most. Other times, the functional currency may be a currency separate from the currency in which a business is headquartered.
Example of functional currency
For example, a Canadian business with most of its activities in the United States would consider the US dollar to be its functional currency, even if the financial figures on its balance sheet and income statement are expressed in Canadian dollars.
International Accounting Standards (IAS) and United States Generally Accepted Accounting Principles (GAAP) provide guidance for converting foreign currency transactions and financial statements. Perhaps SFAS 52, which introduced the concept, best sums up functional currency: “the currency of the main economic environment in which the entity operates; normally, that is, the currency of the environment in which an entity mainly generates and spends cash ”.
Today, the economies of the world have become increasingly interdependent. Multinational companies recognizing the integration of global markets, including trade in commodities and services and international capital flows, are thinking globally to remain competitive.
International operations result in the difficult choice of selecting a functional currency, which must resolve several financial reporting issues, including determining the appropriate functional currencies, accounting for foreign currency transactions, and converting subsidiaries’ financial statements to currency of a parent company for consolidation.
Factors may include finding the currency that most affects the sale price. For retail and manufacturing entities, the currency in which inventory, labor and expenses are incurred may be the most relevant. In the end, it is often the management judgment between a local currency, that of a parent company or the currency of a main operational hub.
Determining the overall performance of the business can be difficult when various currencies are involved. Therefore, US GAAP and IAS describe how entities can convert foreign currency transactions into the functional currency for reporting purposes.