The Key to Effective Reporting
The Key to Effective Reporting
Choosing the correct functional currency is key to effective reporting. As markets are increasingly globalized, companies are more often engaged in international trade, cross-border alliances and joint ventures. Businesses are no longer confined to their origin countries.
Companies conduct business in the international market for two main reasons:
- To buy goods and services from overseas suppliers or sell them to overseas buyers.
- To conduct business through overseas subsidiaries, branches and associates.
In this article, we mainly focus on the first of these reasons. In these cases, transactions are often expressed in foreign currencies. This raises a few questions:
- Which currency (functional currency) should these companies use when maintaining their accounting records?
- Which currency should these companies use when preparing and reporting their financial statements?
In the 1990s and earlier, all companies in Singapore maintained their books in Singapore dollar (SGD). Now, companies across the country are asking accounting firms in Singapore for valuable advice on which currency is right for their needs.
What is “Functional Currency”?
Singapore Financial Reporting Standard 21 (FRS 21) defines Functional Currency as “the currency of the primary economic environment in which the entity operates; normally, that is, the currency of the environment in which an entity primarily generates and expends cash.”
The currency in which a corporate entity normally generates and spends cash and in which transactions are normally denominated is called the Functional Currency. This is also the currency in which accounting records are recorded and financial statements are prepared. All transactions in currencies other than the functional currency (i.e. SGD) are treated as transactions in foreign currencies (i.e. USD). The company that provides you accounting services in Singapore can advise you further.
Key terms used:
|Exchange difference||The difference resulting from translating one currency (i.e. USD) into another currency (i.e. SGD) at a given exchange rate.|
|Functional currency||The currency of the primary economic environment in which the corporate entity operates.|
|Closing rate||The spot exchange rate at the balance sheet date.|
|Spot rate||The exchange rate quoted for immediate settlement on a currency.|
|Average rate||The average rate for the year, usually confined to income and expenditure items.|
|Presentation currency||The currency in which the financial statements are presented. It can be presented as either the functional currency or a desired currency.|
Why is it Important to Determine the Right Functional Currency?
Different countries stipulate that businesses and corporate entities keep their books and accounting records in certain currencies. If an entity uses different currencies to buy and sell their goods or services, then the question might be raised, “which currency should be used to record that entity’s accounting records?”
Any Singapore audit firm will tell you that choosing the right functional currency is crucial to business success.
If a company uses the wrong functional currency to present financial records and financial statements, real problems can arise. Some of these problems include:
- The company is deemed to contravene the Financial Reporting Standards 21;
- The company’s financial statements are not reported on a “true and fair” basis;
- Singapore audit firms will issue a qualified opinion on the entire financial statement;
- The incorrect choice of functional currency may lead to endless complex reconciliations which can be tedious, time consuming and costly.
- If there is an error in the functional currency, it should be applied from the date of error and accounted for retrospectively.
Choosing the right functional currency greatly helps a company generate effective financial reporting. This is key when it comes to avoiding misstatements in financial accounting and determining a realistic performance summary. Any reputable bookkeeping service in Singapore can help you ensure that you are on the right track.
Determination of Functional Currency
The functional currency should be determined by looking at several factors. These factors identify the currency in which the entity normally generates and spends cash, and in which transactions are normally denominated.
All transactions in currencies other than the functional currency should be treated as transactions in foreign currency.
Five key factors that determine an entity’s functional currency. Three are primary and two are secondary considerations:
First level factors:
|Primary indicator||Factors to be considered:|
|Sales and cash inflow||This mainly influences the prices at which goods and services are sold. This will often be the currency in which sales prices for goods and services are denominated and settled.|
|The country whose competitive forces and regulations mainly influence the entity’s price structure. Example: where government regulations determine that the local currency is the functional currency.|
|Expenses and cash outflow||The expenses and cash outflow that influence the cost of the entity. The currency that mainly influences purchases, materials, labour and other costs of providing goods and services|
Secondary level factors: designed to provide additional supporting evidence in the determination of an entity’s functional currency.
|Secondary indicator||Factors to be considered:|
|Financing activities||The finance activities in which funds are generated. Example, where financing (issuing of debt and equity instruments) is raised and serviced by a currency type (i.e. SGD). This indicates that SGD is the functional currency in the absence of other indicators to the contrary.|
|Retention of operating income||In which receipts from operating activities are retained. This is the currency in which the entity maintains its excess working capital balances.|
In our opinion (and the opinion of reputable audit firms in Singapore), when it comes to deciding the functional currency of an entity, priority should be given to the primary factors. Secondary factors should also be considered if clear-cut decisions cannot be made based on just the primary factors.
Secondary factors should also be considered if clear-cut decisions cannot be made based on just the primary factors.
In determining the functional currency, solid managerial judgment is required to determine the currency that most faithfully represents the economic effects of the underlying transactions and events. Are you confused or unsure? Consult with a reputable accounting firm in Singapore.
Pointers to Note
- Review your foreign exchange gain or loss in income statement in order to see if it makes sense and is practical? A huge exchange balance could be an indicator of mismatched functional currency.
- Regularly test foreign currency exchange rates used and whether the source from where such information is gathered is a reliable / accepted source in the eyes of the regulatory authority.
Regular Assessment of Functional Currency
We suggest that your functional currency should be assessed and reviewed on a regular basis, especially when there are changes in the underlying nature of the transactions, changes in relevant conditions and other important events.
Where there is a change in the functional currency, it should be applied from the date of change and accounted for prospectively (not retrospectively).
For further guidance: accountants should refer to Financial Reporting Standard (FRS 21) – The Effects of Changes in Foreign Exchange Rates. For better understanding on proper currency reporting, accountants can visit ISCA’s Functional Currency Highlights of Technical Clinic.