It is mainly important for a company that operates internationally or doing business in multicurrency to identify its functional currency. Functional currency should be the one in which the business transactions are normally denominated, whereas all other transactions not in functional currency are treated as foreign transactions. As the financial statements are presented in only one currency, the foreign currency transactions have to be converted into the functional currency, thus resulting in exchange differences.
The exchange gains or losses are recognized in financial statements. The risk is that incorrect exchange rates are used for the translation, leading to misstatements in financial reporting, hurting the bottom line, creating false understandings of business performance, and exposing companies to possible regulatory scrutiny. At worst, a business owner may be accused of fraud or tax evasion. In this regard, it is crucial to understand the effects of changes in foreign exchange rates.
The primary factors to consider when determining the functional currency are the currency that mainly influences the sales prices and cost of sales of the entity. Failing to recognize the appropriate exchange rate can result in a misstatement of revenue and cost of sales. For example, an overstatement of revenue can cause the company to become liable for GST registration if the revenue exceeds S$1 million at the end of any calendar year. In addition, the company may not be qualified for audit exemption if the annual revenue exceeding S$10 million. What happens when the cost of sales is stated too low? In this case, the net income before tax could be overstated by the amount of the inventory overstatement. The income tax must then be paid on the amount of the overstatement.
If it is not possible to determine the functional currency from the primary factors, the secondary factors that should be considered are the currency in which funds from financing activities are generated (i.e. debt or equity issuance) and the currency in which receipts from operating activities are usually retained. Investors and lenders rely on financial data to evaluate a company’s financial health and earnings potential. Understating net income makes your company look less profitable, less attractive to potential investors and less likely to be approved for business loans from banks and creditors. In contrast, the higher amount of net income means that the reported amount of retained earnings and shareholders’ equity are overvalued. That may give the stakeholders a distorted idea of how your business is doing.
When the abovementioned indicators are mixed and therefore do not give a clear indication of the functional currency of an entity, an exercise of judgement is required to determine the functional currency that most faithfully represents the economic effects of the underlying transactions, events and conditions.
In conclusion, a company can reduce the risk of misapplying the accounting rules for foreign currency translations by keeping the principles and requirements in IAS 21. It helps to ascertain overall business performance and ensures that a company’s financial statement shows the actual position.