Let us see how the functional currency is determined for a foreign operation.  So what are the factors to be considered in determining the functional currency of a foreign operation?

Basically, there are four factors to be considered. Let us see those factors one by one.

The first factor to be considered is the degree of autonomy.  The question that needs to be asked is whether the foreign operation is conducted as an extension of the reporting entity. Are the activities in such foreign operation carried out without significant autonomy? If the answer is ‘No’, then the local currency would be the functional currency of such foreign operation. However, if the answer is ‘Yes’, then the reporting entity’s currency would be the functional currency of the foreign operation.

The second factor to be considered is the transactions of the foreign operation with the reporting entity.  The question that needs to be asked is – Is the percentage and frequency of transaction with the reporting entity significant?  If the answer is ‘Yes’, then the reporting entity’s currency would be the functional currency of the foreign operation.  If the answer is ‘No’, then the local currency would be the functional currency of such foreign operation.

The third factor to be considered is the effect of cash flows. The question that should be asked is – Does the cash flow of foreign operation affect the cash flows of the reporting entity.  If the answer is ‘No’, then the local currency would be the functional currency of the foreign operation. If the answer is ‘Yes’, then the reporting entity’s currency would be the functional currency of such foreign operation.

The fourth factor to be considered is about financial and debt servicing. The question that should be asked is whether the cash flows of foreign operations is sufficient to service its own debt? If the answer is ‘Yes’, then the reporting entity’s currency would be the functional currency of such foreign operation. If the answer is ‘No’, then the local currency would be the functional currency of the foreign operation.

If the indicators are mixed, the management should use its discretion to determine the functional currency of the foreign operation.

A change in the functional currency is not generally permitted.

It is changed only when there is a change in underlying factors.

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