What Is a Functional Currency?
Popular with multinationals, functional currency represents the primary economic environment in which an entity generates cash and expends cash. Functional currency is the primary currency used by a business or business unit. As a monetary unit of account, a functional currency represents the primary economic environment in which that entity operates.
Understanding Functional Currency
At times, a company’s functional currency may be the same currency as the country where it does most its business. Other times, the functional currency may be a separate currency from the currency in which a firm is headquartered.
Example of Functional Currency
For example, a Canadian company with the bulk of its operations in the United States would consider the U.S. dollar its functional currency, even if financial figures on its balance sheet and income statement are expressed in Canadian dollars.
International Accounting Standards (IAS) and U.S. Generally Accepted Accounting Principles (GAAP) offer guidance for the translation of foreign currency transactions and financial statements. Perhaps, SFAS 52 which introduced the concept, best sums up functional currency: "the currency of the primary economic environment in which the entity operates; normally, that is, the currency of the environment in which an entity primarily generates and expends cash."
Now, the world's economies have grown increasingly interdependent. Multinational corporations recognizing the integration of world markets, including the trade of commodities and services and the flow of international capital are thinking global to remain competitive.
With international operations comes the tough choice of selecting a functional currency, which must address several financial reporting issues, including determining appropriate functional currencies, accounting for foreign currency transactions, and converting financial statements of subsidiaries into a parent company’s currency for consolidation.
Factors may include finding the currency that most affects sales price. For retail and manufacturing entities, the currency in which inventory, labor, and expenses are incurred may be most relevant. Ultimately, it’s often managements’ judgment between a local currency, that of a parent, or the currency of a primary operational hub.
It can be difficult to ascertain overall business performance when a variety of currencies are involved. Therefore, both U.S. GAAP and IAS outline procedures for how entities can convert foreign currency transactions into the functional currency for reporting purposes.