By Victor Hugo Vazquez Aguilar, VP of the National Technical Committee of Financial Information of the Mexican Institute of Finance Executives (IMEF)
What is the functional currency of my company? This is a genuine question to be asked on more than one occasion in the lifetime of a business. The different stakeholders trust that it is raised and answered in a timely manner, so that their decision-making is not compromised as this determination plays a key role in the preparation of financial statements, having the ability to affect the reported profits and even the risk management of the companies. However, the answer is not always obvious, since a detailed analysis could require a high degree of judgement and may have to change dynamically over time following the evolution experienced by the business.
This article is a reminder of what the functional currency analysis is it is about, why it is important, who should determine it and how, and above all, a reminder that this is not a one-time analysis, as although the technical way to assess the functional currency has not undergone recent major changes, the way of doing business could be experiencing substantial transformations.
Determining the “functional currency”, a continuous challenge
The functional currency is generally defined as the currency of the primary economic environment of an entity. This definition gives rise to one of the basic principles to maintain: the functional currency is not a decision but a matter of economic facts and circumstances, which may imply a high degree of judgement and even involve particular aspects of industry, making this exercise a real challenge, which can sometimes be even highly complex.
An emphasis aspect with rescuing is that the functional currency of a company is not necessarily the legal currency of the country where it is incorporated and operates. Sometimes this is a generalized perception, and although it could reflect the economic reality of some entities, generalising would not be technically appropriate. To conduct this analysis adequately, there are technical guidances provided by practically any financial reporting framework, such as IFRS (issued by the IASB) or US GAAP (issued by the FASB), including various local GAAP. Later we will dive into the main evaluation factors that should be considered when performing this analysis.
Thus, it can be understood that if the facts and circumstances of the primary economic environment of an entity change the functional currency may also have to change. It is strategic to establish internal processes for the continuous monitoring of the main factors and arguments that were originally considered to determine the functional currency, to be sure if a change in one of them merits a change in functional currency.
Why is it important?
A foreign currency is any currency other than the functional currency. That is, the definition of a foreign currency is tangled to the definition of the functional currency and therefore this analysis can influence the financial results of the companies. Based on this definition we can understand that exchange gains or losses should not be presented for transactions carried out in the functional currency.
For example, if a company has the US dollar as its functional currency but records its financial information in an accounting system parameterized in Euros, the transactions carried out in dollars will generate a foreign exchange effect in the system, although this effect should not be reported in the financial statements, because according to the economic essence of the business, the real exchange gains or losses are those caused by any currency other than the dollar. In this example, the volatility recognised in the income statement for exchange differences should not be significant if most operations are carried out in dollars.
Therefore, by principle, the financial information of a company should be recorded in the functional currency.