028: How to determine the functional currency when a company deals with more currencies?
“I have a query related to determining the “functional currency”. The standard IAS 21 does not have a lot of examples or details on determining the functional currency where there are various currencies involved in the entity’ economic environment.
E.g. Co is registered in India, however 80% of sales are in EUR, it buys raw materials in USD, labour costs are in INR. Generally any loans are in INR…. how would we decide functional currency in this instance?”
Answer: Assess the indicators
IAs 21 says that the functional currency is the currency of the primary economic environment in which the entity operates.
In most cases, it is crystal clear.
Normally, it’s the currency in which the company makes and spends money. And, in most cases it will be just the currency of the country where you operate.
But, not in all cases.
One good example are factories owned by Western countries, operating in low labor cost countries like India, Cambodia or so – such a subsidiary in India makes sales mostly in Western currency, like USD.
People are paid in INR, but the materials are again purchased in USD.
In this case, the functional currency is USD despite the fact that the subsidiary is incorporated in India.
Factors to consider when determining functional currency
To help you with the determination, IAS 21 lists some indicators to consider when determining your functional currency.
If it is still not obvious from those indicators, then the management must use its judgment to determine the functional currency.
How to do that?
Well, I would say that there is a certain hierarchy of the indicators to consider.
So, not all indicators are equally important and you should give priority to some of them and only then consider the others.
The most important, top priority factors to consider are two:
- The currency of your sales; and
- The currency of your cost of sales and other expenses.
Factor #1: Currency of your sales
The currency of your sales is probably the most important.
Which currency mainly influences sales prices for your goods or services?
Secondly, what country (if any) and its market or regulations or other forces determine your sales prices?
Let’s say that you are a holding in Europe and you set up a subsidiary in India.
The subsidiary makes 80% of sales in EUR and the remaining 20% are in INR for domestic Indian market, but the prices in INR are updated monthly based on the foreign exchange rate EUR/INR.
In this case, well, the functional currency is EUR, because 100% of sales are either denominated or affected by EUR.
The currency of your cost of sales.
The second primary factor is cost of sales – I mean cost of materials, labor, services that you purchase, utilities, etc.
The standard IAS 21 puts sales and cost of sales to one level. In other words it says that these 2 factors are primary and equally important.
So, if in the above example, the costs of Indian company are denominated mostly in EUR, then the functional currency is for sure EUR.
Let’s say that the same Indian company pays its employees in Indian rupees, but purchases materials in EUR.
In this case, I would say that again, the functional currency is EUR, because the sales are denominated in EUR, and significant portion of costs is denominated in EUR, too.
When primary factors are not enough…
What happens if this Indian company is financed by the loan denominated in USD?
The functional currency is still EUR, because you made your conclusion based on the assessment of the first 2 primary factors – sales and cost of sales, so you do NOT take the other things into account.
But what happens when it is not possible to determine the functional currency from the first 2 primary factors?
What happens when the sales are in EUR and expenses are in USD and INR?
In this case, we need to look at additional indicators:
- Funding: What is the currency of financing, like debt or equity instruments?
So, what is the currency of share capital? Loans? And,
- Cash flows: In what currency does the company retains cash received from operating activities?
Group considerations
When your company is a subsidiary of a foreign parent, we must take that into account, too.
What’s the degree of autonomy of the subsidiary?
Is the subsidiary acting independently? Or, is the subsidiary totally dependent on the parent?
Let’s take our Indian company again.
Let’s say that it makes 100% sales in EUR and it incurs 100% of expenses in INR.
So it’s not possible to say from first 2 primary factors what’s the functional currency.
We have to ask – in what currency did the company receive its financing?
If it’s in EUR, then yes, maybe it’s OK to conclude that the functional currency is EUR.
If it’s in USD, it does not help that much, because it’s the third currency in a game.
So let’s ask again:
What’s the relationship between the Indian company and its European parent? How does the Indian company operate?
If it produces some goods based on parent’s instructions, purchases materials from parent’s suppliers and sells 80% to the parent, then there’s almost no autonomy and it’s likely that the functional currency will be the same as that of a parent.
However, if the Indian company incurs its own expenses and makes own sales, and the transactions with the parent are in relatively low proportion, then the functional currency is not necessarily that of a parent.
As you can see, in some situations it might be very challenging to determine your functional currency and you have to use a lot of judgments and assessments.
I can’t give you the outright definite answer as I don’t know all the facts surrounding your own situation.
Also, last but very important: I strongly recommend keeping the appropriate documentation to support your conclusion, especially in these foggy situations.
Well, the reason is that your auditors might have another opinion and judgment, so you should be able to support your own.
Any comments or questions? Please add them below – thank you!
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Thx silvia
Hi – We have a question about triggers for changes in functional currency. We have a UK incorporated company (A), 100% owned by another UK company whose functional currency is GBP. Company A had investments in companies with functional currency in USD, it is also used for financing and has USD denominated loans from the parent and to other group companies. Company A had functional currency USD but we have now dissolved the USD subsidiary so now is just used for the financing part. Can we keep functional currency as USD or do we have to change to GBP?
Hi silvia, thanks for the insightful article.
I’m working in a commodity (basically metal) trading company which is a subsidiary of a China-based MNC. It operates just like a typical commodity company does, actively trading in both physical commodity and future commodity contract. The only notable difference would be that it also actively trades in USD future contract as instructed by group management for group-wide currency hedging purposes. Management assessed that functional currency is USD as commodity prices are globally traded in and driven by USD.
Everything work’s fine until it ceased commodity trading, both physical and futures, in it’s most recent financial year, but continue to have significant amount of USD future contract trading. USD futures are all denominated in RMB.
My question is whether this constitute a change in functional currency?
Hello
Thank you for the article. May I also ask a question based on the situation I am faced with. I am in Zimbabwe and our company is more like a trade union which collects membership fees in local currency. However, my company receives some grants and donations in USD which used to be regarded as 1:1 with our local currency and it usually constitutes about 70% of the total organisation income. Now the USD no longer have the equal value with our local currency. The USD that we receive is spend in that currency. Staff salaries are also paid in USD but the income base of my company is local membership fees which constitutes 30% of the total income. Which one then should I regard as our functional currency
Well, that’s up to you to assess but I would say USD, because most expenses are paid in USD and 70% of income is in USD, too.
First of all, thanks for a great site.
I’m curious regarding IAS 21 and functional currency. Why is it necessary to identify the functional currency? Is that because accounting transactions must be recorded in the functional currency? Put differently, if the functional currency is EURO, can one still use USD when recording postings to the general ledger?
I have a case of a company (lets say Company A) dealing with financing and refinancing of related companies. It has a loan payable to its parent company (denominated in EUR) and simultaneously grants several loans receivable from related companies (all denominated in GBP). Loans payable are equal to loans receivable. All other balances are of a minor amount (all denominated in EUR). The company and its parent are acting in a country with EUR as the local currency. The related companies are operating in GB (local currency GBP). The question is which is the functional currency of Company A?
Good explanation. I feel offended at you terming India as a ‘low cost country’ and grouping it with Cambodia.
Oh no need to be offended and please read what I wrote – low LABOUR cost, not low cost. That’s a HUGE difference. And yes, compared to Europe, India is a low labour cost country. In fact – I absolutely LOVE India, mainly its people – I visited it in 2015 and will never ever forget that.
You dont need to mention that you like people. Just stick to your truth. Low Labour cost
I bought equipment in EUR and my currency USD I paid prepayment and I had loss from exchange rate .
Can I capitze this loss ( exchange rate ) or recognised it in profit and loss ( income statement)
Hi Mohamed, you can learn about acquiring PPE in foreign currency and prepayments here, you will find the full answer.
Thanks Silvia 🙂 much appreciated
Thanks Praneith for this question! 🙂
Thank you for the article and also for the motivational quote.
Hi Silvia
Thanks very much for this educative article
We are a flight operations management company and we operate world wide, we invoice our clients in both USD and in Euro and same currencies form our cost of sales but all our expenses are generally made in the Ghana cedi except bank charges. All vendor payments are also made in foreign currency with bank charges also in the respective currency of our funds transfer.
For a particular month, we may have 60% of sales in USD and 40% in Euros, and in another month we may have 30% of sales in USD and 70% in Euros and it keeps changing month by month. In this case, which currency should be our functional currency even though our financial statements are presented in Ghana cedi and that is our presentation currency.
We are not a subsidiary of any foreign company but an independent one incorporated in Ghana.
Hi JB,
very difficult to say from this description. In this case, I would be really looking at your pricing decisions. Are prices in EUR and in USD set autonomously? Or, do the prices in EUR depend on the exchange rate with USD? (in other words – do you have fixed prices in USD and EUR prices are derived from USD prices based on the recent exchange rate?)
It is just one example of the assessment you need to make and sometimes, it is not an easy process. Good luck!