Question

Define and explain the terms "foreign exchange exposure risk" and "functional currency." Explain the purpose of using a functional currency in the translation of financial statements.

Answer 1

Foreign exchange exposure risk:

Foreign exchange exposure risk is the type of risk associated with foreign exchange rates which fluctuate frequently and can have an adverse effect on the financial statements which are prepared in the foreign currency denomination rather than its own domestic currency. This risk is not only for the company making financial transactions in the foreign currency but also related parties who are exposed to the related foreign currency transaction.

The main effect of it is seen in the future cash flows which the company has estimated and may change due to these foreign exchange rate fluctuation. This badly effects the balance sheet balances.

Functional Currency :

Functional Currency is the primary currency used by an organization in case of a multinational company. It is the basic currency in which the organization and its subsidiaries operate. The functional currency choosed by an organization is either the local currency of that region or the currency of that of its parent company.

The main advantage of functional currency concept is that it gives a clear, accurate and reliable financial results of the company throughout its different regional subsidiaries and does not have a foreign exchange rates difference while consolidating the books of all the companies.

Purpose of Functional Currency:

Functional Currency is mainly adopted by an organization to overcome the foreign exchange rate issues while consolidation of group accounts. Different regional subsidiaries can have different currency of recording and maintaining there accounts. But this creates a huge tantrum while combining them with there parent company unnecessary showing foreign exchange loss or difference which is difficult to sort out.