Definition
Functional currency refers to the main currency that a business or company uses in its operations. It’s the currency of the primary economic environment in which the company operates and generates cash flow. This is typically the currency where the company conducts most of its business transactions.
Phonetic
The phonetic pronunciation of “Functional Currency” is:Functional : fuhngk-shuh-nlCurrency : kuhr-uhn-see
Key Takeaways
<ol><li>Functional Currency: This refers to the main currency used by a business or company. This is typically the currency of the country where the business primarily conducts its operations or where its headquarters is located. It is the currency in which the firm generates its revenues and incurs its expenses.</li><li>Determination of Functional Currency: This is usually calculated based on various economic factors such as cash flows, sales prices, market structure, financing activities, inter-company transactions etc. All these factors are pondered upon to decide the functional currency to be used for business accounting.</li><li>Significance: The use of the functional currency is essential for financial statements because it gives the most accurate picture possible of a company’s financial health. It eliminates the effect of fluctuating exchange rates, making the financial statements more comprehensible and comparable across different periods.</li></ol>
Importance
Functional currency is a crucial concept in business and finance because it signifies the main currency that a company uses in their primary economic environment. It’s typically the currency of the country in which the company primarily conducts its operations. Understanding the concept of functional currency is vital for financial reporting purposes as it serves as the benchmark for accounting calculations, recording transactions, and financial statement preparations. Additionally, it holds immense importance in foreign exchange risk management, as the fluctuations in the functional currency’s value can significantly affect the company’s operations and profitability.
Explanation
The functional currency plays an essential role in international businesses as it forms a common base for recording and reporting the company’s financial performance. It’s mainly used for measuring and reporting the financial statements of the company. The selection of an appropriate functional currency is crucial as it significantly influences financial reporting, tax liabilities, and the value of the company in global markets. The purpose of designating a functional currency is to enable a consistent approach towards financial reporting across diverse geographical and economic environments comprising different currencies. This currency is essentially used to reduce exchange rate risk by maintaining all financial records in a stable or predictable currency. It aids companies in understanding their true economic results without the distortive effects of fluctuations in foreign exchange rates. Moreover, functional currency is vital in the consolidation of financial statements for companies operating in multiple countries, providing a uniform measure for comparing the financial performance of various branches and divisions. Thus, the selection and use of a functional currency lay a foundation for financial transparency and comparability across international boundaries.
Examples
1. Apple Inc: As an international company based in the United States, Apple Inc. conducts a large proportion of its transactions in USD. Therefore, its functional currency is the USD, where it reports its financial statements.2. Toyota Motor Corporation: Headquartered in Japan and conducting a significant part of its operations there, Toyota mainly uses Japanese Yen as their functional currency. This means all business transactions, financial reporting, and performance evaluations are done predominantly in Yen.3. Siemens AG: A powerhouse in European’s industrial manufacturing sector, Siemens is based in Germany, thus using the Euro as its functional currency. Despite conducting business in many different countries, the Euro is the currency they use to measure economic results and make financial decisions.
Frequently Asked Questions(FAQ)
What exactly is Functional Currency?
Functional Currency refers to the primary currency that a company uses in its operations. It’s the currency of the primary economic environment in which an entity operates and generally is the currency in which the firm generates and spends cash.
Why is the Functional Currency important?
The Functional Currency serves as a benchmark for a company’s financial reporting. It aids in accurately interpreting financial statements and helps provide a clear image of the company’s financial health.
How is the Functional Currency decided for a company?
The main factors in deciding a company’s functional currency include the currency in which the company primarily generates and disburses cash, the currency in which sales prices for goods and services are denominated and settled, and the currency of the country whose competitive forces and regulations mainly determine the sales prices of goods and services.
Can a company have more than one Functional Currency?
Typically, a company will have only one functional currency, which would be used for reporting purposes. However, multinational companies may have different functional currencies for their various international branches or divisions.
Is Functional Currency and Presentation Currency the same thing?
No, they are not the same. Functional currency refers to the currency of the primary economic environment in which an entity operates. In contrast, the presentation currency is the currency in which the financial statements are presented.
What is the significance of changes in the Functional Currency?
Changes in the Functional Currency can significantly impact a company’s financial statements. It can affect the company’s assets, liabilities, equity, income, and expenses. That’s why it is a vital aspect of financial accounting and management.
How often is the Functional Currency reassessed?
Determination of the functional currency is made upon the initial set-up of the accounting records, and it’s typically not changed unless there is a change in underlying transactions, events, and conditions.
Related Finance Terms
- Exchange Rate
- Translation Risk
- Foreign Currency Transactions
- FASB Statement No. 52
- International Financial Reporting Standards (IFRS)
Sources for More Information
- Investopedia
- Financial Accounting Standards Board (FASB)
- International Financial Reporting Standards (IFRS)
- Corporate Finance Institute
