Functional currency is the currency of the primary economic environment in which an entity operates. It is the currency in which that entity actually generates and spends cash, and it governs how every transaction is recorded in its books. IAS 21 sets the concept, and the key point is that it is determined by facts rather than chosen.
Primary indicators carry the most weight: the currency that mainly influences sales prices, the currency of the country whose regulations determine those prices, and the currency that mainly influences labour, material and other operating costs. Secondary indicators follow: the currency in which financing is raised and the currency in which operating receipts are retained.
It is frequently not the local currency. A Swiss subsidiary selling oil products priced in dollars, incurring dollar costs and financed in dollars has a US dollar functional currency despite operating in Switzerland. Conversely, a French sales office of a US group that sells in euros to French customers, with euro costs, has a euro functional currency even though its parent reports in dollars.
The distinction matters because it separates two mechanisms that are often confused. Transactions in a currency other than the functional currency generate an FX gain or loss through profit. Restating an entity's accounts from its functional currency into the group's presentation currency generates a translation adjustment in equity instead.
Determining it correctly is a prerequisite of currency translation, and therefore of the whole consolidation of a multi-currency group. Where an entity handles supplier invoices in several currencies, multi-currency invoice control is where the practical work happens day to day.
