What is Functional Currency and Why is it Important
One of the essential things foreign investors and manufacturers should learn is the functional currency. It is primarily the currency the entity uses to pay for labour and other production costs and one that companies set the sale prices of their commodities.
To be precise, a functional currency is a bill used in the economic environment where the company operates. When choosing a functional currency, the company should consider the currency they use to pay for labour, inventory, and other expenses.
Determining functional currency helps to keep the financial statements straight and avoid exchange differences in foreign transactions. This article will help you know what functional currency is, its importance, and how different it is from the local currency.
Understanding What is Functional Currency
Functional currency is the main currency used by an entity in its primary economic environment. For example, it helps a foreign company compile its financial statements in similar bills that influence expenses like labour and the prices of goods produced.
If the entity or company has other transactions in another currency, these transactions must be converted to the financial currency to keep the financial statements clear. Companies can translate foreign currency with the guidance of International Accounting Standards.
The exchange rates can affect the conversion of foreign currency to financial currency. Depending on where you exchange the currency, the exchange rates prevailing on the day of the transactions get considered, which could be high or low, leading to gains or losses.
The management can consider exchanging foreign currency at Knightsbridge FX to be safer. At KFX, you will enjoy more favourable exchange rates than banks and other exchange agencies, saving you some coins.
Choosing Functional Currency for a Company
While choosing a functional currency can be easy for some multinational companies, others find it hard to select a currency. Therefore, one of the significant factors to consider when choosing the primary currency is considering one that affects sales prices.
Retail and manufacturing companies should also consider the currency they use to pay for local labour, inventory, and other essential expenses. The company should also consider the country’s currency in which the competitors set their prices.
Other factors to consider when determining the functional currency of a foreign entity are;
Transaction volume is the number of transactions a company processes in a year divided by 12 months. These transactions should represent a significant portion of the total operations for the currency to be the functional currency.
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The Proportion of Cash Flow
Cash flow is the total amount of money affecting liquidity that a company transfers in and out of business. The cash flow could be in both foreign and local currency. The company should check the bill representing a significant proportion to determine the functional currency. If the foreign currency takes the lead, it can become the functional currency.
Autonomy is the state of being independent or self-governing. So, the company’s management should consider the degree of autonomy the foreign company enjoys in the foreign country.
The foreign entity can retain its country’s currency if its services are not highly recognized in the country it operates. However, if the company enjoys autonomy extensively, it can use the local currency as its functional currency.
Another way to determine functional currency is if the foreign company can meet its debt obligations using cash flows. Therefore, the management should check if the foreign entity can service its debts from its foreign operations without taking funds from the company.
Why is Functional Currency Important?
Functional currency is vital because it helps in the measurement of overall business performance. So, it allows the management to identify the weak and strong areas of the business and determine the factors to change to improve the company’s performance.
Determining the functional currency also helps in the identification of exchange differences. The differences are visible in transactions where foreign exchange variances shouldn’t have occurred.
Failure to identify functional currency can affect the entity’s financial statements. These cause the management to treat the transactions in the functional currency as foreign currency transactions, which can affect the report of comprehensive income.
Sometimes determining the functional currency for a company that operates in a market with two or more currencies can be challenging. In such cases, the management should consider different factors like the relationship with their clients, investors, and financial results in both markets.
The company should also use the US Generally Accepted Accounting Principles (GAAP) and International Accounting Standards (IAS) to guide foreign currency transactions into functional currency. The conversion is essential for reporting purposes.
Local Currency Vs. Functional Currency
The local currency is the country’s national currency where the foreign entity operates. It can sometimes be the entity’s functional currency and, in some cases, not. If the local currency is not a foreign entity’s functional currency, the entity terms it as a foreign currency.
On the contrary, a functional currency is a currency used in the economic environment of a foreign entity. The company’s management determines it using factors like transactional volume and proportion of cash flow. In most cases, the local currency is a foreign company’s functional currency.
What is Reporting or Presentation Currency?
Another vital currency type to know in a foreign company’s operation is reporting currency. Reporting currency is the currency in which the firm presents its financial statements. It can differ from functional currency if a multinational company operates in many countries with different currencies.
Having a reporting or presentation currency helps multinational companies compare the performance of their operations and calculate the results cumulatively for the entire company. Therefore, entities in various countries will convert their operations into the reporting currency when filing financial statements.
In most cases, the reporting currency is the currency of the country where the company’s headquarters are. When presenting the income and expenses in the income statement, the entities in foreign countries convert the results using the exchange rates of the transaction dates.
Reporting currency is different from functional currency. While functional currency depends on the bill of the economic environment in which the company operates, the reporting currency mainly relies on the currency of the country where the company’s headquarters are.
Also, while the functional currency is not affected by the exchange rates, foreign exchange rates can negatively or positively impact the reporting currency. However, some medium-scale companies have the same functional and reporting currency, mainly if they operate in one country.
Can a Company’s Functional Currency Change?
Although most companies set the functional currency once, some change it. The changes can happen if a significant shift in the money impacts the prices of the products sold by the entity. Changes are also crucial if the company uses a different bill to cater to expenses like labour and inventory.
When changing the company’s functional currency, the management should convert all the assets and liabilities into the new bill using the current exchange rates.
Final Words
Companies with entities in foreign countries should identify their functional currency. It is the currency of the economic environment where the entity is. Functional currency is mainly determined using autonomy, transaction volume, and the proportion of cash flows. Failure to identify a functional currency can affect the company’s financial statements, making it hard for the management to measure overall business performance.