Some things are so obvious that we never really think about them. As a business owner you have to draw up annual financial statements for a company. Naturally. And, of course, these statements are drawn up in euros. Naturally. Right?
Currency: the euro
In the Netherlands, we often draw up our annual financial statements in the functional currency ‘euro’. We do that because the functional currency should be the same as the currency of the company’s economic environment in which it receives and spends cash. And because we buy and sell a lot in the Netherlands and often do that in euros we use the euro as the functional currency of our annual financial statements.
However, this is not a given. You see, when we talk about globalisation, this means a changing economic environment. Businesses are buying and selling outside the Netherlands, and so the economic environment in which they spend and receive money is also changing. And if a company adapts well to this economic environment, it may well be that its functional currency will change. Being in the eurozone offers quite an advantage: you can serve several countries without necessarily having to replace the euro as your functional currency.
If, for example, a grain merchant buys his grain in the Netherlands and sells it in the Netherlands or in the eurozone, his functional currency will be the euro. If, however, he starts to spread his wings even further and to trade on the global market, he will do his buying and selling in dollars. Transport costs will also be in dollars and his competitors will also generally trade in dollars.
You see, when we talk about globalisation, this means a changing economic environment.
When is it time for this grain merchant to start using dollars for his functional currency? The Guidelines for Annual Reporting provide an answer. Even if more internationally comparable accounting standards are applied (IFRS) these provisions are still valid. The following questions, in particular, are important when determining the functional currency:
- Which currency mainly influences the sales price for goods and services?
- What is the currency of the country whose competition and laws and regulations mainly determine the sales prices of its goods and services?
- Which currency mainly influences the labour, material and other costs of providing goods and services to the legal entity?
Exchange rate differences
When the answers to these questions begin to change in the direction of dollars, then our grain merchant will change his functional currency into dollars. The presentation of his annual financial statements (the presentation currency) will then be completely different as he will account for all his commercial purchases and sales in dollars. And because the payments and receipts of his trade are also in dollars, he won’t need to account for exchange rate differences much anymore. That can mean a substantial change to the income statement!
Which items may still be affected by exchange rate differences? Items which are in what is for him a foreign currency, such as the rent on his premises in the Netherlands and his costs for the Chamber of Commerce. After all, these will still be billed to him in euros. The euro is not his functional currency (dollars), and so he treats this as a foreign currency.
Different functional currency
The presentation of the annual financial statements often changes dramatically if you have a different functional currency. The presentation becomes truer; it reflects the reality more. And accounting becomes much simpler. This is because the primary record is made in the currency in which the activities actually take place and not in the local currency of the country in which the enterprise is based (coincidentally or otherwise).