What Is Functional Currency in Financial Reporting?

For businesses operating across borders, the functional currency serves as a common language for money. It represents the main currency of the primary economic environment where a company generates and expends cash. Accurately identifying this currency is a foundational step in accounting to ensure a company’s financial health is reflected properly, especially when its operations span multiple countries.

Determining the Functional Currency

Determining a functional currency is a conclusion based on an analysis of economic factors outlined in Accounting Standards Codification (ASC) 830. The framework centers on identifying the primary economic environment of a company’s foreign operation by reviewing several indicators.

• Cash flows: Management examines the currency in which the entity predominantly generates cash from its sales and the currency used for its major expenditures. If a foreign subsidiary’s cash flows are mainly in its local currency and are not regularly sent to the U.S. parent, this suggests the local currency is the functional currency.
• Sales market and pricing: The currency that most influences the sale prices of goods and services is a strong guide. If a subsidiary in another country sets its prices based on local market competition, its functional currency is likely the local one. If prices are dictated by global markets or tied to the U.S. dollar, this points toward the dollar.
• Operating expenses: The currency in which significant expenses, such as labor and materials, are incurred is a major consideration. When these costs are primarily settled in the local currency of the foreign operation, it strengthens the case for that currency being functional.
• Financing activities: The currency in which an entity raises debt or issues equity is an important indicator. If a subsidiary secures its own financing from local banks in the local currency, it points to financial independence and a local functional currency.
• Intercompany transactions: A high volume of transactions with the parent company suggests the parent’s currency should be the functional currency. For example, if a German subsidiary primarily assembles parts from its U.S. parent and ships the finished goods back, its economic fortunes are directly linked to the U.S. dollar.

Differentiating from Other Currencies

Understanding functional currency requires distinguishing it from two other terms: local currency and presentation currency. While these can sometimes be the same, they often differ, and each has a distinct meaning in financial reporting.

The local currency is the official currency of the country where a business entity is physically located. For a subsidiary operating in Japan, the local currency is the Japanese Yen. In many cases, an entity’s local currency will also be its functional currency, but this is not automatic.

The presentation currency is the currency in which a company presents its consolidated financial statements. For a U.S.-based parent company, the presentation currency is almost always the U.S. dollar (USD). This allows the parent to combine the financial results of all its operations into a single set of reports for investors and regulators.

A single foreign subsidiary can illustrate how all three currencies might differ. Consider a U.S. parent company (presentation currency: USD) that owns a subsidiary in the United Kingdom (local currency: British Pound). If this U.K. subsidiary conducts most of its business in Euros, then its functional currency would be the Euro.

Impact on Financial Reporting

The determination of a subsidiary’s functional currency governs how its financial statements are incorporated into the parent company’s consolidated reports. Depending on the functional currency, one of two methods is used: translation or remeasurement, each with different effects on the financial statements.

Translation is the method used when the subsidiary’s functional currency is its local currency. In this process, the subsidiary’s balance sheet assets and liabilities are converted to the parent’s presentation currency using the exchange rate at the balance sheet date. Income statement items are translated using a weighted-average exchange rate for the period. Any gain or loss from this process is recorded in “Other Comprehensive Income” (OCI), a separate component of stockholders’ equity.

Remeasurement is required when a subsidiary’s functional currency is different from its local currency, such as when it is the parent’s U.S. dollar. Monetary assets and liabilities are remeasured using the current exchange rate. Non-monetary items, like inventory and property, are remeasured using the historical exchange rates from when the assets were acquired. The resulting gains or losses from remeasurement are reported directly on the income statement, which can increase the volatility of reported net income.

Changing the Functional Currency

An entity’s functional currency is meant to be stable, and changing it is an infrequent event. A change is only justified when there are significant shifts in the underlying economic facts and circumstances that clearly indicate the primary economic environment of the entity has changed.

The accounting for such a change is handled prospectively, meaning it is applied from the date of the change forward, and past financial statements are not restated. The process involves translating balance sheet accounts into the new functional currency using the exchange rate on the date the change occurs. For nonmonetary assets, their translated values become their new historical cost basis.

Because a change can have a noticeable impact on financial reporting, companies must have a well-documented and clear justification for making the switch, as it signals a fundamental transformation in the entity’s operations.