Functional currency definition
/What is a Functional Currency?
A functional currency is the currency used in the primary economic environment where an entity operates. This is the environment in which an entity primarily generates and expends cash. You should consider the following primary factors in determining an entity’s functional currency:
The currency that primarily influences sales prices (usually the currency in which prices are denominated and settled).
The currency of the country whose competition and regulations primarily influence sales prices.
The currency that primarily influences labor and other costs of goods sold (usually the currency in which prices are denominated and settled).
Less critical deciding factors are the currency in which an entity retains receipts from its operations, and the currency in which debt and equity instruments are issued.
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When determining the functional currency of an entity’s foreign operations, consider the following factors:
Autonomy
Whether the operation is essentially an extension of the reporting entity, or it can operate with a significant degree of autonomy. The functional currency is the reporting entity’s in the first case, and the local currency in the later. This makes sense, since an extension of the reporting entity is really just another office of the headquarters staff, with comparatively few local dealings. Conversely, an entity with a large amount of autonomy likely conducts most of its dealings in the local currency.
Proportion of Transactions
Whether the foreign operation’s transactions with the reporting entity constitute a high or low proportion of the operation’s activities. The functional currency is the reporting entity’s in the first case, and the local currency in the later.
Proportion of Cash Flows
Whether cash flows from the foreign operation directly affect the cash flows of the reporting entity, and are available for remittance. The functional currency is the reporting entity’s if so, and the local currency if not.
Debt Service
Whether a foreign operation’s cash flows can service its debt obligations without funds transfers from the reporting entity. The functional currency is the reporting entity’s if funds transfers are needed, and the local currency if not.