Most companies prepare their financial statements in their local currency. This currency is the same in which these companies transact. For example, a company that reports its financial statements in dollars may also conduct its operations in the same currency. For some companies, however, the same may not apply, as these currencies may differ.
Some companies conduct business in an environment where the transactional currency may differ from the financial statement currency. This case may apply to companies that prepare financial statements in a currency other than the one that it uses for its operations. For example, a company may prepare its financial statements in Euros while its currency of operations is the USD.
For accounting purposes, differentiating between both of these currencies is crucial. One of these currencies is known as a functional currency, while the other is the presentation currency.
What is a Functional Currency?
A company’s functional currency represents the currency that it uses to maintain its daily operations. It is the currency of the country or nation where the company operates. For example, for a company operating in the US, it will be US Dollars. For most companies, determining the functional currency is straightforward. However, for some others, it may not be as simple.
There are several factors that may impact whether a currency may qualify as functional currency or not. As mentioned, for accounting purposes, differentiation is crucial. For that reason, companies can use the guidance from IAS 21. The standard defines several factors that can help in identifying it.
What are the Factors that are Crucial in Determining the Functional Currency?
IAS 21 suggests that companies should look at various aspects when determining their functional currencies. The standard divides these factors into two categories, namely, primary and secondary factors. IAS 21 that a company must only use the secondary factors when the primary factors are inconclusive in determining the functional currency.
Primary Factors
The primary factors when determining a company’s functional currency include three points. The first one is any currency that mainly influences a company’s products’ sales prices. In some circumstances, however, the differentiation may not be as straightforward. For example, some companies may make sales abroad, which can influence the sales prices.
The second primary factor is considered as the nation’s currency, whose competitive forces and regulations mainly determine the sale prices of a company’s products. However, some companies may have operations in various environments, making it challenging to identify such currency.
The third primary is the currency that influences labor, materials, and other costs of providing a company’s products. It is the last point in the primary factors. As mentioned, some companies may have operations in several countries where they will use material, labor, and other costs. In those cases, making a decision can be difficult.
Secondary Factors
If none of the above primary factors helps companies reach a conclusive decision, they can use the secondary factors defined by the IAS. The secondary factors include the currency in which a company generates funds from financing activities. Similarly, it consists of the currency in which a company retains receipts from operating activities.
How does the Functional Currency differ from the Presentation Currency?
The comparison of functional currency vs presentation currency is straightforward. It is the currency that companies use to conduct their business operations. As mentioned, several factors play a role in determining whether a specific currency applies as the functional currency. However, that may not be the same currency that a company uses to prepare its financial statements.
The currency that a company uses to prepare its financial statements is known as the presentation currency. The presentation currency does not require any specific requirements. Several factors may play a role in which currency a company chooses as its presentation currency. However, there are no specific requirements from the IAS in determining it.
Why do Companies Identify Functional Currency?
Companies need to identify their functional currency to differentiate it from the presentation currency. The differentiation between functional and presentation currency is crucial for accounting purposes. When preparing financial statements, companies need to convert their figures to the presentation currency. In that case, the differentiation between functional and presentation currency is crucial.
Similarly, identifying this is crucial for recording transactions. In most cases, companies need to translate their transactions to the functional currency before recording. These companies can use a spot exchange rate or an average rate over some time. In some cases, exchange rate gains or losses may also arise, which will become a part of a company’s income statement.
Conclusion
Functional currency is the currency that companies use in their operations. IAS 21 defines several factors that may determine whether a currency qualifies as functional. Mostly, companies can use the primary factors to identify their functional currency. In cases when these factors don’t apply, the secondary factors can be helpful.
