Functional Currency Defined

Companies these days conduct business all over the world — most of it electronically. Making this possible are fast, efficient foreign-exchange services that can streamline cash flow management in multiple currencies, along with multicurrency ledgers that help businesses track transactions and balances in each currency. But when it comes to producing financial reports and paying taxes, one currency must rule them all: the business’s functional currency, also sometimes called its base currency. This is the currency in which the company primarily transacts business and, therefore, generates cash. It’s often — but not always — the official currency of the country or economic area in which the business is headquartered.

What Is Functional Currency?

Functional currency is the main currency in which a company conducts business. Most transactions are in this currency, and the company does its accounting and financial reporting in this currency. The functional currency is also usually the currency in which the company pays its taxes.

• Local Currency vs. Functional Currency

  Local currency is the official currency of the country where a firm is headquartered. If the company conducts most of its business in local currency, then the local currency is likely also to be the company’s functional currency. But if the company conducts more business in a foreign currency, then that foreign currency can be its functional currency. This is commonly the case for larger companies headquartered in developing countries (especially if it is difficult for them to obtain financing in their local currency) because they frequently conduct much of their business in U.S. dollars (USD). These companies are likely to use USD as their functional currency.

• Functional vs. Transactional Currency

  Many businesses trade in more than one currency. Any currencies they trade in, other than their functional currency, are considered transactional currencies. When the business prepares its financial reports, it must convert activities in transactional currencies into the functional currency, a process called “remeasuring.”

Key Takeaways

• Functional currency is the currency a company uses in its financial reports and for paying taxes.
• It’s usually the currency in which a company conducts the most business.
• The U.S. dollar is the functional currency for companies whose principal place of business is the U.S., even if they are headquartered outside the U.S.
• Many businesses that trade principally outside the U.S. also use the U.S. dollar as their functional currency, because the U.S. dollar is the most widely used currency for global trade and financing.
• Overseas business units of a multinational corporation have different functional currencies from their parent if they are “distinct and separable” and conduct most of their business in a different currency.

Functional Currency Explained

Every business must have a functional currency. Whether it’s a small business with no overseas presence or a sprawling multinational, there must be a single currency in which it primarily conducts business and keeps its books and accounting records. This might or might not be the official currency of the country in which the business is headquartered, depending on the way the company is structured and the markets in which it operates. What matters is that the functional currency meaningfully represents the business.

For simple businesses with no overseas units, the choice of functional currency is usually straightforward even if the company is trading in multiple currencies. It’ll be the currency in which the company principally trades. Thus, USD is the functional currency for companies whose principal place of business is the U.S., even if they also conduct business in other currencies. Companies whose principal business activity is international trade or which operate in global markets often use USD as their functional currency even if they are headquartered in other countries. This is because USD is the most widely used currency for international trade and the dominant currency in global markets.

For multinational corporations with operations in many countries, the picture can become more complex. Overseas business units frequently have different functional currencies from their parent, so there can be several functional currencies within a corporate structure. These must be converted, or “translated,” into the parent’s functional currency for financial reporting. Additionally, many corporations have complicated corporate structures involving offshore holding companies and debt vehicles. These may or may not have the same functional currency as the ultimate parent. Identifying the correct functional currencies for overseas business units and holding companies requires a detailed assessment of the nature of the business and its relationship with the ultimate parent and other entities within the group.

The next sections discuss how functional currencies work for multinational businesses with overseas entities.

How Does Functional Currency Work?

Consider a multinational corporation headquartered in the U.S. that has operating bases in Germany and Singapore. The corporation’s functional currency is USD. But what should the functional currencies of these operating bases be? The Financial Accounting Standards Board (FASB), which sets the Generally Accepted Accounting Principles (GAAP) used by U.S. companies, defines the functional currency of a U.S. multinational’s overseas operation (or its “foreign entity”), as follows:

“A [foreign] entity’s functional currency is the currency of the primary economic environment in which the entity operates; normally, that is the currency of the environment in which an entity primarily generates and expends cash.”

Note that it doesn’t say “company.” This is because a multinational business’s overseas operations can take many forms: a wholly-owned subsidiary, a branch, a business unit, a joint venture. The status of a foreign entity is an important factor in determining what its functional currency should be.

FASB recognizes two broad categories of foreign entity:

1. Entities that can stand alone as businesses within the country or economic area within which they operate. These entities transact and generate cash in the local currency, and their assets and liabilities are denominated in the local currency. They don’t significantly rely on the overseas parent for financing or asset acquisition, and they retain the proceeds of any asset sales. They are not dependent on the economic environment in which the overseas parent operates. For these “distinct and separable” entities, the functional currency should be their local currency.
2. Entities that are primarily an extension or component of the overseas parent’s operations. These entities rely significantly on the parent for financing and asset acquisition, and sales of assets generate cash flow for the parent. They are dependent on the parent’s economic environment, and the parent’s cash flow is directly affected by their operations. For these entities, the functional currency should be the parent’s functional currency.

The challenge is to determine which of these two categories best fits the foreign entity. Sometimes, whether an entity is distinct and separable is obvious. But, more often, foreign entities have characteristics of both categories. FASB identifies six indicators to help business managers determine whether a foreign entity should be considered distinct and separable for the purposes of identifying the right functional currency:

• Cash flow: Whether the entity’s cash flow is primarily in the local currency or the parent’s functional currency, and whether it affects the parent’s own cash flow.
• Sales price: Whether the sales prices of the entity’s products are determined mainly by local factors or are significantly affected by currency exchange rates.
• Sales market: Whether sales are mainly local and denominated in local currency or are international and/or denominated in the parent’s functional currency.
• Expense: Whether key expenses such as labor and raw materials are locally determined or depend on costs in the parent’s country.
• Financing: Whether the entity obtains financing in local currency and services debts from its own operations or the parent provides financing in the parent’s currency and/or transfers funds to service debts.
• Intercompany trade: The degree to which the foreign entity is integrated with its parent and/or other entities owned by its parent.

Why Does Functional Currency Matter?

In the example noted in the preceding section, it would be easy to say that since the corporation conducts its local business and produces its financial reports in USD, that should be the functional currency of the corporation’s bases in Germany and Singapore. This would have the advantage of simplifying financial reporting and eliminating foreign exchange translation risk in consolidated accounts.

But it might not be the best choice of functional currency for the Singapore and/or German entities. And this also matters for the parent corporation’s bottom line. If the overseas bases primarily operate in their local currencies — the euro and the Singapore dollar (SGD) — constantly remeasuring those transactions in USD would create considerable administrative overhead. It would also expose the corporation’s profits to foreign exchange risk.

For example, suppose the German business operated entirely in euros and its assets and liabilities were denominated in euros. If the euro’s exchange rate versus the USD fell sharply, the German business would be unaffected in euro terms, but in dollars it would look as if it had suffered a significant loss. If the German base’s functional currency were USD, this would feed directly through to the corporation’s bottom line. If the exchange rate subsequently rose again, the apparent profit increase from the exchange rate difference would similarly feed through to the corporation’s bottom line. Thus, the corporation’s reported profits would be volatile because of exchange rate differences between the currency used by the head office and the currency in which the German base conducted its business.

If the German base’s functional and operating currencies were both euros, the situation would be different. The German base would not need to constantly remeasure its transactions from euros to USD, eliminating the administrative overhead and foreign exchange risk concerns. Instead, the German base’s financial statements would be in its local currency, matching the currency of its business operations. When consolidating the German base’s financials into the parent corporation’s reports, the only step required would be translation, not remeasurement. Translation simply converts the euro-denominated figures into USD, with any resulting gains or losses reported in the parent’s equity — not the income statement.

By aligning the German base’s functional currency with its local operating currency, the parent avoids the volatility in its reported profits that can occur when a foreign subsidiary’s functional currency differs from its local currency. This approach provides a more accurate representation of the German base’s underlying financial performance without the distortions that can arise from constant remeasurement.

How to Choose Functional Currency

It’s important to identify functional currencies methodically. Here’s a step-by-step guide to choosing the functional currencies of a multinational corporation and its foreign entities.

1. Determine the currency in which the parent organization will report its consolidated finances. This is the entire multinational corporation’s functional currency. For U.S. corporations, this will be USD. Outside the U.S., it will usually be the official currency of the country or economic area in which the corporation is headquartered. However, if the corporation is principally involved in global trade conducted in USD and/or finances itself by issuing debt and equity in USD, the functional currency could be the dollar even if the corporation is headquartered in a country that does not use it.
2. Identify all foreign entities within the consolidated group. A “foreign entity” is any business unit, division, branch, subsidiary or joint venture that is located in a different country or economic area from the parent.
3. For each foreign entity, determine whether it is distinct and separable. Using FASB’s six indicators, assess whether the foreign entity stands alone as a distinct and separable business from the parent or is an extension or component of the parent’s operations. Entities that are not distinct and separable from the parent must use the parent’s functional currency.
4. For each distinct and separable foreign entity, identify the functional currency. Using the entity’s transaction records and books of account, determine the currency in which it primarily conducts business. This will usually be its functional currency. Under certain circumstances the functional currency for a distinct and separable foreign entity will be the functional currency of its parent (this is discussed further below).

Considerations for Choosing Functional Currency

Here are some additional factors to consider when choosing functional currencies for a multinational corporation.

• Shell and holding companies: Corporate structures can be complex, involving layers of legal entities, some of which may have no operational function or assets but carry significant amounts of debt. Corporate structures can also include offshore holding companies as a tax-efficient way of managing overseas activities or to gain access to foreign capital markets. These companies are known as “shell companies.” Although shell companies have often been associated with illegal activities such as money laundering and tax evasion, corporations also use them legally to raise capital or hold funds, access foreign markets, initiate hostile takeovers and minimize tax — legally.

  FASB’s six indicators don’t apply to foreign entities that have no operational function. So, FASB says that the parent’s currency “generally would be the functional currency if the foreign entity is a device or shell corporation for holding investments, obligations, intangible assets, and so forth, that could readily be carried on the parent’s or an affiliate’s books.”

  However, the picture is complicated when the shell company is the top company in a corporate structure. In this case, the correct functional currency is likely to be the currency in which the shell holds debt and issues equity. For example, if an offshore holding company that is at the top of a corporate structure issues debt and equity in U.S. capital markets, the functional currency is likely to be USD even if the main business activity of entities lower in the structure is in, say, China or Malaysia.

• Inflation: When distinct and separable foreign entities of multinational corporations are in countries or economic areas with high inflation and an unstable exchange rate, the FASB says the functional currency of the entity should be the functional currency of the parent. This should remain the case for as long as high inflation and instability persist. Once inflation has been brought down and the exchange rate stabilized, the functional currency should revert to the appropriate currency for the foreign entity.

• Tax: Because the U.S. Internal Revenue Service (IRS) requires U.S. businesses to pay taxes on their worldwide earnings in USD, it has a say over which currencies foreign entities can use as functional currencies. According to the IRS, all corporations that conduct their business mainly in USD, whose principal place of business is the United States or whose books and records are maintained in USD must use USD as the functional currency. This applies to “qualifying business units” (QBUs) of U.S. corporations as well as to standalone businesses. It’s wise to check with the IRS to determine whether a particular distinct and separable foreign entity qualifies as a QBU, and whether it can use local currency as its functional currency or must use USD. At the end of the financial year, any QBUs that are permitted to use local currency as their functional currency must translate their annual profits or losses into USD and pay any tax due in dollars.

• Currency translation: At the end of each financial year, multinational corporations produce financial accounts and pay corporate taxes in the jurisdictions in which they are headquartered. If they have foreign entities that use different functional currencies from the parent, any profits or losses made by those entities must be converted into the parent’s functional currency for inclusion in financial accounts, regulatory reports and tax returns. This process is known as translation. The exchange rate used in this process is typically the mid-spot rate on the reporting period’s end date. Currency translation effects can create gains and losses in the equity section of the corporation’s balance sheet. Corporations can hedge against this risk with derivative foreign exchange products, such as FX futures and options.

Functional Currency Examples

Here are three examples illustrating functional currency in practice. The corporations involved are fictional, but the business scenarios are real.

Example 1: Identifying the functional currency of overseas sales offices.

Great Lakes Wine Savants Inc. (GLWS) is a hypothetical distributor of high-quality wines sourced in and around northwestern New York State. It is located in Buffalo and sells its products to retail wine stores all over the U.S. Its functional currency is USD.

The company decides to make a major sales push into Europe. It sets up sales offices in the United Kingdom, France, Italy, Poland and Hungary. The sales offices are to sell GLWS wines into their local markets in the local currency. The currencies involved are the British pound sterling, the euro, Polish zloty and Hungarian forint. What will the functional currencies of these sales offices be?

These sales offices are not subsidiaries. They are thus not legally distinct from their U.S. parent. But this does not necessarily mean their functional currency must be USD. That depends on their degree of autonomy as business units. To determine whether these sales offices are distinct and separable from their U.S. parent, each needs to be assessed using the FASB’s six indicators.

Here’s the assessment for the U.K. office:

• Cash flow: Sales revenue and most expenses are in British pounds. However, the sales office remits its net revenue to GLWS after converting it to USD. The sales office’s cash flow is thus directly linked to GLWS’s cash flow.
• Sales price: GLWS sets the retail price of the products in USD. However, the U.K. sales office advertises them in British pounds and is free to mark up or discount the price in British pounds to suit local market conditions.
• Sales market: The sales office only sells to customers in the U.K.
• Expenses: The sales office employs local labor and pays its own overhead and administrative expenses. It is expected to be operationally self-sustaining.
• Financing: The sales office has a working capital facility at a British bank, but it’s not able to issue its own bonds or commercial paper. GLWS provides financing for capital investment.
• Intercompany trade: All products sold by the U.K. sales office are provided by GLWS. There is no transfer charge, but net revenue is remitted after deduction of local expenses.

The U.K. sales office is autonomous and self-sustaining from an operational point of view, and it has freedom to set the prices at which it sells to its customers in the local currency. However, it is entirely dependent on its U.S. parent for products and has no control over their price in U.S. dollars. It also depends on its parent for capital financing, and it remits profits to the parent in U.S. dollars at an exchange rate set by that parent. Despite its operational autonomy as a business unit, it is not distinct and separable from its parent. Its functional currency is, therefore, USD.

Had this and the other European sales offices been distinct and separable, GLWS would have found itself managing translation differences between USD and four foreign currencies. It is hardly surprising that the company decided to set the sales offices up in such a way that their functional currency remained USD. However, the profits remitted by the sales offices vary with the exchange rates between the local currency and the dollar. GLWS could mitigate this risk by allowing the sales offices to use FX hedging products, such as forward FX contracts or options.

Example 2: Identifying the functional currency of a foreign manufacturing operation.

Michigan Widgets Inc. (MWI) is a U.S. corporation with a wholly-owned German subsidiary, Michigan Widgets AG (MWAG), which actually makes the widgets for sale in the U.S. and Europe. The functional currency of MWI is USD. But what is the functional currency of MWAG?

MWAG is a subsidiary, not a branch or division, so it is incorporated in Germany and legally distinct from its parent. But this doesn’t necessarily mean it is functionally distinct and separable. If it isn’t, then its functional currency must be USD. Again, the six FASB indicators determine whether MWAG is distinct and separable.

• Cash flow: Cash flow is in both euros and USD. The dollar component is directly linked to the cash flow of MWI.
• Sales price: Sales prices in euros are determined by local market conditions, but USD prices are set by MWI, which acts as the U.S. distributor.
• Sales market: Sales are both local (direct) and international (via MWI). Approximately 75% of sales are international.
• Expenses: MWAG uses local labor and obtains its own raw materials and intermediate parts. Most expenses are in euros.
• Financing: MWAG issues euro debt on its own account and has a USD line of credit with MWI. Most of its financing is in euros.
• Intercompany trade: MWAG sells widgets to MWI for distribution in the U.S.

In many respects, MWAG appears distinct and separable. However, 75% of its sales are to its parent company and denominated in dollars. This does not necessarily mean that USD is its principal trading currency: MWAG sells into European markets at retail price, but to its parent at a discounted price. If the 25% of sales in Europe generated sufficient revenue for MWAG to be able to operate as an independent business without the USD revenue from its parent, then the correct functional currency for MWAG would be euros (considering the other indicators). But if sales to MWI are such a significant part of revenue that losing them would mean it could not remain a viable business, then it would not be distinct and separable. The correct functional currency would be USD.

Example 3: Identifying the functional currency of an offshore shell company.

Suppose MWAG has an offshore subsidiary, MW DebtCo, located in the Cayman Islands. This subsidiary exists solely as a vehicle to hold USD-denominated securities. What is the functional currency of this company?

It would be easy to assume that because the subsidiary operates entirely in USD, its functional currency would be USD. But FASB rules tell us that shell companies must use the functional currency of their parent. The parent of MW DebtCo is MWAG, not MWI, so MW DebtCo should use the functional currency of MWAG. If MWAG is distinct and separable, the correct functional currency for MW Debtco would be the euro.

Manage Currency Easily in NetSuite

For any business with overseas operations, managing currency effectively is key to generating strong, sustainable profits. Using NetSuite cloud accounting software, businesses can easily collect all the information they need to determine the functional currencies of overseas units and, where necessary, adjust operating models to prevent unnecessary complexity and reduce administrative overhead. Since NetSuite can be accessed anywhere in the world, head office and overseas units can use the same platform and share a single database. Qualifying business units can manage their business accounts in their own functional currencies, and all parts of the business can manage the FX risks arising from transacting in foreign currencies. NetSuite’s financial reporting tools simplify the process of currency translation and consolidated financial reporting, while ensuring that all parts of the business meet GAAP and IRS requirements. NetSuite relieves the headache of managing complex multinational organizations.

Today, even small businesses can have operations in many countries and transact in multiple currencies. But every business must choose a functional currency for financial accounting, reporting and tax payments. For many, this will be the U.S. dollar. But for some companies, the functional currency could be a foreign currency. Moreover, multinationals with autonomous foreign entities can have multiple functional currencies. Identifying the right functional currencies for the business and its overseas operations and having effective strategies for managing currency risks are keys to business success.

Functional Currency FAQs

What is “functional currency” and examples?

The functional currency of any company is the currency in which it primarily conducts business. It is usually, though not always, the official currency of the country or economic area in which it is located. For example, the functional currency of a U.S.-based automobile company that manufactures cars in China and sells them in the U.S. will be the U.S. dollar. However, if the manufacturing unit in China is self-financing in yuan and sells cars locally as well as through its U.S. parent, then the functional currency of that unit could be the Chinese yuan.

Is the U.S. dollar a functional currency?

The U.S. dollar is the functional currency of all businesses that operate primarily in the U.S., conduct most of their business in U.S. dollars and/or maintain their books and records in U.S. dollars.

What is the difference between functional and transactional currency?

A company or organization’s functional currency is the currency in which it conducts most of its business. If it trades in other currencies as well, these are transactional currencies.