Consolidating Financial Statements: Determining the Functional Currency

When consolidating a foreign subsidiary's financial statements with those of the parent company, the correct identification of the subsidiary's functional currency is critical.

Commonly the subsidiary's functional currency is the local currency, but sometimes the functional currency is the parent's reporting currency or some third currency.

Selected IFRS Guidance for Determining the Functional Currency:

The subsidiary's functional currency is the currency that influences sales prices.

The subsidiary's functional currency is the currency of the country whose regulations and competitive structure influences sales prices.

Selected GAAP Guidance for Determining Functional Currency:

When the subsidiary is a relatively self-contained, independent business operation, operating primarily in local markets, then the local currency is the functional currency.

When the subsidiary is heavily integrated with the parent company and it serves as sales outlet type function for the parent, then the subsidiary's functional currency is the parent's reporting currency.

While GAAP and IFRS require certain disclosures regarding the treatment of foreign currency when consolidating multinational operations, parent company management retains some discretion in determining the functional currency. A well trained financial analyst must be aware that two companies in the same industry may use different translation methods. For comparability purposes, it is recommended to move all translation adjustments to equity from the balance sheet to the income statement.