Definition:
Functional currency can be defined as the primary or main currency in the company uses daily for economic or financial transactions, which normally dominate the company’s purchasing, selling, and currency that finances the company.
It basically represents the economic environment surrounding which the business operates and subsequently carries out the transactions.
Given the fact that there are numerous different currencies that a company might operate in. However, all these currencies then need to be converted to the local currency and ensure that it is all reported in one single currency, which stands to be the main functional currency of the company.
Therefore, to sum it up, it can be seen that functional currency is defined as the main currency in which a company conducts business.
Is Functional Currency Different from Local Currency?
There are many currencies that the company uses for its daily financial transaction, including paying suppliers, staff, taxes, collecting from customers, and so on.
The local currency is the national currency of the country in which the company operates. For example, Thai Bath is the local currency of the company that operates in Thailand. Khmer Riel is the local currency of that company that operates in Cambodia. Functional currency, as explained above, is the currency that dominates a company’s daily financial transactions.
The company that operates in Asia, especially Cambodia, uses USD majorly for its daily financial transactions. Yet, the local currency is Khmer Riel.
How Do You Find and Choose a Functional Currency?
There are many ways the company could find the company’s functional currency. The following are the point that you need to consider when determining the functional currency.
- We are understanding the currencies that the companies use. The company might use many different currencies besides the local currency. This might be because of the market’s practices and requirements. We need to identify what are the currency that the company is using. If we cant identify all of the currencies, at least we could list down the top three or four.
- Figure out which of the above currencies that you just are using the most in the company’s financial transactions including payments to suppliers, payments to staff, and collection from customers. The currency that dominates these transactions should be considered the functional currency of the company
- The company is financed by many different sources. Internal and external sources of funds. Determine which functional currency is used to finance the company
When you could identify all of these points, then you should be able to know which currency is the company’s functional currency. It is important to know that you could Not select which currency is the functional currency. You should only identify it and record your financial transactions accordingly.
Functional Currency and Presentation Currency: Are They Different?
When the company prepares the financial statements, the company can select which currency to use to present in its financial statements. That means the company could select whichever currency the company wants to present. However, the company could not select the functional currency. Only the economic environment could determine it.
What is a Company’s Functional Currency?
Functional currencies are mainly important when it comes to multinationals and companies that have a relatively bigger scale of operations.
In this regard, it can be seen that these are the type of companies that mostly have a wider scale of operations, and hence, they conduct transactions in not one but numerous different types of transactions.
However, mostly when companies are carrying out transactions, they use their local currency. If they are not using their local currency, they normally opt to choose a currency that is considered to be global, like the United States Dollar (USD).
They term this as their functional currency and prepare all the financial statements, keeping this particular currency as their main currency.
Similarly, it can also be seen that the functional currency is important because it helps companies ensure that all the transactions are on the same footing.
It also becomes increasingly important to make sure of the fact that all these transactions are considered to be on the same footing so that it is easier for the users of the financial statements to use this information for their own benefit.
Example:
The concept of functional currency, along with its usages, can be described using the illustration below:
Multinational Inc. is a manufacturing concern dealing with the production of automobiles. With plants situated In India, Dubai, and New York, they are considered to be a global player in the automobile sector.
For all the assembling plants, they procure parts from Thailand, Azerbaijan, and Pakistan. Therefore, they conduct international business and work in multiple different currencies. Their head office is based in New York.
In the example above, it can be seen that Multinational Inc. is operating in a number of locations, where they are selling their cars and producing. They are listed on the NYSE, and therefore, all the shareholders belong to the U.S.
As far as the financials for the individual assembly units are concerned, it can be seen that they are likely to deal in their local currency, which would be the functional currency in this aspect.
For example, the prices of cars would be in rupees in India, Dirhams in Dubai, and Dollars in the U.S.
However, when each of these entities would procure their parts from vendors based in Thailand, Azerbaijan, and Pakistan, they would use the global currency (the USD) in order to carry out these transactions.
They would then be converted into the local currency and then represented on the financial statements in order to get a holistic view of how the company is operating.
After the individual financial statements have been prepared, all the assembling plants would then convert it into the currency that is used in the head office so that all the individual financial statements can be used to prepare a clubbed financial account, based on which the financial statements would be prepared.
It is important for Multinational Inc. to utilize different currencies for different parts because it would help them ensure that they can transact in one currency. It would make it easier to comprehend financial statements if they are duly converted into the currency of the place where the company (or the subsidiary) is actually operating.
Functional Currency vs Presentation Currency
The main difference between functional currency and presentation currency is the fact that functional currency is used to carry out transactions, whereas the presentation currency is the currency on the basis of which financial statements are prepared.
In this regard, it is imperative to realize the fact that functional currency might be different from presentation currency if it is a multinational.
In the example that has been mentioned above, the functional currency for all the different subsidiaries would be Indian Rupee, Dirhams, and United States Dollar. However, for the parent financial statements that are prepared, the presentation currency would be the United States Dollar.