Functional Currency in U.S. Dollars and Accounting in colones: What Every Business Owner Must Understand Under IFRS

By Rebeca Sequeira, Financial Analyst

Prices are negotiated in dollars, clients pay in dollars, and many commercial decisions are made in that currency. However, at the same time, the company must keep its legal accounting in colones for regulatory and tax purposes. Added to this is a third common dimension: the need to report financial information to a parent company abroad, usually also in dollars. As a result, many organizations operate with three different monetary references: the colón as the legal bookkeeping currency, the dollar as the business’s functional currency, and again the dollar as the presentation currency for consolidation purposes.

Understanding this structure is essential to correctly interpret financial statements under the International Financial Reporting Standards (IFRS), particularly as established in IAS 21 – The Effects of Changes in Foreign Exchange Rates.

What Determines the Functional Currency

IAS 21 establishes that each company must identify its functional currency, that is, the currency of the primary economic environment in which the business operates.

To determine it, three factors are mainly analyzed:

• the currency in which the prices of goods or services are set,

• the currency in which the most relevant costs are incurred,

• the currency in which financing is obtained or cash flows are maintained.

When these elements point predominantly to a specific currency, that is the currency that best reflects the company’s economic reality.

For this reason, a company located in Costa Rica may perfectly have the U.S. dollar as its functional currency, even when its legal accounting is kept in colones.

Example

Let us think of a hotel in Guanacaste that mainly receives international tourists. Rates are published in dollars, reservations are paid in dollars, and contracts with international operators are also negotiated in that currency.

However, payroll, utilities, some local suppliers, and tax reporting are recorded in colones.

From an economic standpoint, the business operates in dollars. From a legal standpoint, the accounting is recorded in colones. This type of situation is precisely what IAS 21 regulates.

How This Situation Is Managed in Practice

When the functional currency is the dollar, but the legal books are kept in colones, companies usually work with two levels of financial information.

On the one hand, they maintain legal accounting in colones for tax and regulatory purposes in Costa Rica. On the other hand, they prepare financial information in dollars, which reflects the functional currency of the business and is used for management analysis or reporting to the parent company. The important point is that both systems are reconciled and that the conversions are performed following the principles established by IFRS.

How the Financial Statements Are Converted

When legal accounting is kept in colones but the functional currency is the dollar, the financial statements must be converted into dollars to reflect the economic reality of the business.

According to IAS 21, the process works as follows:

• Assets and liabilities are converted at the closing exchange rate of the period.

• Income and expenses are converted at the exchange rate on the date of the transaction or at a reasonable average for the period.

• Equity is maintained at the corresponding historical exchange rate.

The differences that arise are recognized as exchange differences, reflecting the effect of the exchange rate on the company’s financial position.

Do Not Confuse This With Inflation Restatement

A common mistake is to confuse currency conversion with inflation restatement. Currency conversion is regulated by IAS 21, whereas inflation restatement corresponds to IAS 29, which only applies in hyperinflationary economies. Costa Rica is not considered a hyperinflationary economy, so in these cases this is a currency conversion process, not an inflation adjustment.

When a company generates income in dollars but records its accounting in colones, exchange rate fluctuations may generate foreign exchange gains or losses that affect the accounting result for the period. This means that financial results may change even when the operation of the business has remained stable. For this reason, it is essential to distinguish between the operating performance of the business and the accounting effects arising from the exchange rate.

Functional Currency, Recording Currency, and Presentation Currency. Understanding this difference makes it possible to better interpret the financial statements.

Understanding this difference makes it possible to better interpret the financial statements.

In open economies such as Costa Rica’s, where many companies generate income in foreign currency, it is normal for the business’s functional currency not to coincide with the currency of the country in which the company operates. The correct application of IAS 21 allows the financial statements to reflect the economic reality of the business, even when the legal accounting records are maintained in colones.

For management, understanding the difference between functional currency, recording currency, and presentation currency is important in order to interpret financial results and make more informed decisions.

Regulatory References

• IAS 21 – The Effects of Changes in Foreign Exchange Rates

• International Financial Reporting Standards (full IFRS)

• Central Bank of Costa Rica – Reference exchange rates

• College of Accountants – IFRS adoption framework