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Functional Currency: Definition & Examples

Instructor: Elizabeth Branum
Functional currency is the primary type of money that a company uses in its business activities. It is most relevant for multinational corporations that conduct business in multiple currencies. With the functional currency properly identified, overall business performance can be measured most accurately.

Definition

International Accounting Standard 21 (IAS 21) defines functional currency as the currency of the primary economic environment in which the entity operates. It is a term that generally applies to multinational companies. The choice of the functional currency depends on many factors, and is usually either the local currency or that of its parent company. It is important to establish the functional currency so that overall business performance can be properly measured and the financial statements can most accurately represent the true financial state of the company.

Examples

Consider the case of the Spanish branch of a U.S. entity. In this company, the total receipts and expenditures of cash lead to no clear decision on the proper functional currency, as the total transaction values in both U.S. dollars and euros is the same. Either dollars or euros could be used as the functional currency. The company chooses euros as the functional currency because it is the local currency.

In another circumstance, a Mexican company with most of its operations in the United States would use the U.S. dollar as its functional currency, even if its financial statements are expressed in terms of Mexican pesos.

Choosing the Functional Currency

There are several factors that should be considered in determining the most appropriate functional currency. The currency that most affects sales price is often the most important factor. In addition, the currency in which inventory, labor, and expenses are incurred is also very significant. The currency for borrowing transactions and in which the company maintains cash should also be considered. In the end, management uses its own judgment and weighs all factors to make the determination.

Often the choice for functional currency is between the local currency and that of the parent company. At times the local currency is quite inflationary. If this is the case, the local currency should not be used due to this lack of stability.

Why is Choosing the Functional Currency Important?

An incorrect functional currency can result in significant misstatement in the financial statements. This is because the choice of functional currency affects the accounting treatment of certain transactions. The following is one example that demonstrates how one set of transactions is accounted differently due to this choice.

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