When a reporting entity prepares financial statements, IAS 21, The Effects of Changes in Foreign Exchange Rates, requires each individual entity included in the reporting entity – whether it is a stand-alone entity, an entity with foreign operations (such as a parent) or a foreign operation (such as a subsidiary or branch) – to determine its functional currency and measure its results and financial position in that currency.
The concept of functional currency is key to understanding translation of foreign currency financial statements.
Functional currency is defined as being the currency of the primary economic environment in which an entity operates. This is normally, but not necessarily, the currency in which that entity principally generates and expends cash.
An entity considers the following factors in determining its functional currency :
- the currency that mainly influences sales prices for goods and services (this will often be the currency in which sales prices for its goods and services are denominated and settled); and
- the currency of the country whose competitive forces and regulations mainly determine the sales prices of its goods and services
- the currency that mainly influences labor, material and other costs of providing goods or services (this will often be the currency in which such costs are denominated and settled
- the currency in which funds from financing activities (ie issuing debt and equity instruments) are generated
- the currency in which receipts from operating activities are usually retained
The first three items are generally considered to be the most influential in deciding the functional currency.
The entity’s functional currency reflects the underlying transactions, events, and conditions under which the entity conducts its business. Accordingly, once determined, the functional currency is not changed unless there is a change in those underlying transactions, events and conditions.
If the functional currency is the currency of a hyperinflationary economy, the entity’s financial statements are restated in accordance with IAS 29, Financial Reporting in Hyperinflationary Economies.
Where there is a change in the functional currency, it should be applied from the date of change. A change must be linked to a change in the nature of the underlying transactions. For example, a change in the major market may lead to a change in the currency that influences sales prices. The change is accounted for prospectively, not retrospectively (HRD).