Key Difference – Functional Currency vs Reporting Currency
Some companies conduct transactions in one currency and record the financial results in a different currency; thus, giving rise to two types of currencies, functional and reporting currency. IAS 21- ‘The Effects of Changes in Foreign Exchange Rates’ provides definitions to the terminologies of these two types of currencies. The key difference between functional currency and reporting currency is that functional currency is the currency of the primary economic environment in which the entity operates whereas reporting currency is the currency in which financial statements are presented.
What is Functional Currency?
According to IAS 21, functional currency is the “currency of the primary economic environment in which the entity operates”. In other words, this is the currency in which the company conducts business transactions. Usually, this is the national currency of the country in which the company is situated.
E.g., Company XYZ is a wholly owned subsidiary company situated in France. Since the national currency in France is Euro, XYZ conducts all its transaction in Euro.
What is Reporting Currency?
Reporting currency is the currency in which financial statements are presented. Thus, it is also known as the ‘presentation currency’. This may be different from the functional currency for some companies, especially for multinational companies. Such companies operate in many countries that have various functional currencies. If results are reported in each country in different currencies it becomes difficult to compare results and calculate results for the entire company. For this reason, all the operations in every country will be converted into a common currency and reported in financial statements. This common currency is usually the currency in the country where the corporate headquarters is based. IAS 21 provides the following guidelines for converting results into the reporting currency.
- Assets and liabilities in the balance sheet are translated at the closing rate at the date of the balance sheet (financial year end).
- Income and expenses in the income statement are translated at exchange rates at the dates of the transactions. Resulting exchange differences are recognized in other comprehensive income/loss in the income statement.
Continuing from the above example,
E.g., Company XYZ’s parent company is Company ABC, which is located in the USA. Company ABC also has subsidiaries in other European countries and Asian countries. All these subsidiaries report their results in US Dollar, including XYZ.
|Cost of sales||(756)|
Since the reporting currency for XYZ is the US Dollar, the above results will be converted to US Dollar prior to reporting them in the financial statements. Assume an exchange rate of $/€0.92. This means that one $ is equal to €0.92. Therefore, the amounts that will be reported in the financial statements of XYZ are,
|Sales (1,225 *0.92)||1,127|
|Cost of sales (756 *0.92)||(695.5)|
|Gross profit (469 *0.92)||431.5|
Since the Euro is higher in value compared to the US Dollar, the reported results are lower than the actual results. This is not an actual reduction and is purely due to the currency conversion. This is an exchange rate risk that the company is exposed to where the reported results may be higher or lower compared to the actual result based on the changes in the exchange rate. This is referred to as the ‘translation risk’.
What is the difference between Functional Currency and Reporting Currency?
Functional Currency vs Reporting Currency
|Functional currency is the currency of the primary economic environment in which the entity operates.||Reporting currency is the currency in which financial statements are presented.|
|Functional currency depends on the currency of the country that the company operates in.||Reporting currency for subsidiaries depends on the currency used by the company headquarters.|
|Exchange Rate Risk|
|Functional currency is not affected by the exchange rate.||Reporting currency is affected by the exchange rate.|
Summary – Functional Currency vs Reporting Currency
The difference between functional currency and reporting currency is that functional currency is the currency in which the company transactions are conducted while reporting currency is the currency in which financial statements are presented. In some companies, typically in the ones that are small or medium scale and does operate in a single country, both functional currency and reporting currency are the same. Translation risk is unavoidable in converting results where if the reporting currency is stronger, the results will be favorable and vice versa.
1. “IAS Plus.” IAS 21 – The Effects of Changes in Foreign Exchange Rates. N.p., 19 July 2012. Web. 04 May 2017. <https://www.iasplus.com/en/standards/ias/ias21>.
2.”Functional and Presentation Currency.” Financial Analysis. N.p., n.d. Web. 04 May 2017. <https://www.readyratios.com/reference/accounting/functional_and_presentation_currency.html>.
3.”Translation Exposure.” Investopedia. N.p., 29 July 2015. Web. 04 May 2017. <http://www.investopedia.com/terms/t/translationexposure.asp>.