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What is a functional currency?

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For the consolidation of the financial statements of a multinational corporation with one or more subsidiaries operating in a currency different to that of the parent company, a procedure is necessary to translate the amounts shown in financial statements in different foreign currencies into the currency of the reporting entity.  It is essential to establish the functional currency for the foreign currency translation process.  An entity’s functional currency is the currency of the primary economic environment in which the reporting entity operates.

Functional Currency – US GAAP vs. IFRS
US GAAP IFRS
If the presentation currency of a parent company is not the currency of the hyperinflationary economy of the foreign subsidiary, then amounts are not restated. Consolidation is based on the reporting entity’s “power-to-direct”, where the investor has rights to variable returns from the investee and the ability to affect the returns through power over the investee.
If the investment in a foreign subsidiary has been sold or substantially liquidated, the exchange differences are reclassified in their entirety to net income. If a parent loses control of a foreign subsidiary, the cumulative exchange differences in OCI are reclassified in their entirety to profit or loss.

Foreign currency translation is the process of expressing in the reporting currency of an enterprise all amounts that are denominated or measured in a different currency.  Income and expenses for each income statement are translated at exchange rates at the dates of the transactions; assets and liabilities are translated at the closing exchange rate at balance sheet date; historical rates are used for owners’ equity accounts.

Any translation gains or losses are reported in the statement of consolidated income and owners’ equity.  Translation gains and losses are included in net income only when a sale or liquidation of an investment in the foreign entity is realized.  For cash flow statements, the exchange rate used for translation of transactions denominated in a foreign currency and the cash flows of a foreign subsidiary should be the rate prevailing at the date of the cash flows.

Translation Rates
Account Balance Rate Used
Assets Cumulative Period-End
Liabilities Cumulative Period-End
Revenue Periodic Period Average
Expense Periodic Period Average
Owner’s Equity Cumulative Historical

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