Functional Currency The functional currency of an entity is the currency of the primary economic environment in which that entity

operates. The primary economic environment in which an entity operates is normally the one in which it primarily generates and expends cash

How to determine Functional Currency The functional currency is determined separately for individual entities. An entity includes a foreign operation i.e., subsidiary, branch, JV or associate. There is no such thing as a group functional currency IAS 21 gives the factors, primary and additional, that to determine the functional currency of an entity The functional currency is determined by applying the factors in IAS 21. It cannot be chosen freely by an entity. Once determined, it is not changed unless there is a change in those underlying circumstances

Importance of identifying functional Currency Identifying the functional currency of the entity is a very important requirement of IAS 21. This helps identify if the entity is engaging in foreign currency transactions as all currencies other than functional currency is treated as foreign currency transactions. This has a direct impact on the treatment of the foreign exchange gains/losses arising from the various transactions.

Primary Factors of IAS 21 The currency: i. ii. that mainly influences sales prices for goods and services (this will often be the currency in which sales prices for its goods and services are denominated and settled); of the country whose competitive forces and regulations mainly determine the sales prices of its goods and services. The currency that mainly influences labor, material and other costs of providing goods or services (this will often be the currency in which such costs are denominated and settled)

Additional Factors a. The currency in which funds from financing activities (i.e.,issuing debt and equity instruments) are generated b. The currency in which receipts from operating activities are usually retained. This is the currency in which the excess of receipts over the payments is maintained and usually this would be the local currency

Importance of Functional Currency Incorrectly determining the functional currency can have a major impact on the financial statements. If it is determined incorrectly, transactions in the correct functional currency will be recorded as if they were foreign currency transactions. Exchange differences will be recognized on transactions for which no foreign exchange difference should have arisen.

Similarly, transactions that should have led to recognition of foreign exchange differences will not be provided for. This may have a significant impact on both the statement of comprehensive income and the statement of financial position

An Example An entity is located in Paris, France and trades primarily in crude oil where all its sales and purchases are denominated in US Dollars. As per IAS 21 it is determined that the functional currency of this entity is USD The entitys capital is funded in Pound Sterling by its English parent based at London. Also it has significant transactions in Euros. How should the Sterling & Euros transactions be recorded? Answer Since as per IAS 21 it is determined that the functional currency of this entity is USD, all transactions other than USD are treated as foreign currency transactions. Sterling & Euro currency transactions should be treated as foreign currency transactions and dealt with according to IAS 21. It does not matter that the entity is located in Paris and that it is funded through Sterling