Let us see how the functional currency is determined for an entity.
Functional currency is determined based on the primary economic environment in which it operates.
The primary economic environment is determined based on two primary factors as specified in the Standard viz., the currency in which cash is generated and the currency in which major expenses are incurred by the entity.
When there is a conflict between the two primary factors, then the entity should look for further indicators viz., the currency in which funds are generated which could be either equity or debt instruments and the currency in which the receipts from the customers are retained.
These two are known as the secondary indicators. The entity need to look for secondary indicators only when there is conflict in the primary factors.
It should be noted that the functional currency is determined separately for every entity, as there is no concept of group functional currency.
The importance of functional currency cannot be over-emphasized, as it has a serious impact on the financial statements.
Exchange differences may not be correctly recorded if the functional currency is not determined properly.
Profits may also be completely distorted.
These are the consequences of incorrect determination of functional currency.
Functional currency for entities in the same group
Let us assume Parent ‘P’ as the functional currency of INR. It may have subsidiaries and each of the subsidiaries can have different functional currency as can be seen in this graphical representation.