Functional currency in dollars and accounting in colones: what every entrepreneur should understand under IFRS.

By Rebeca Sequeira.

Financial Analyst.

In many companies operating in Costa Rica, especially in sectors such as tourism, international services, technology, or companies that are part of multinational groups, the operation of the business is clearly dollarized.

Prices are negotiated in dollars, customers pay in dollars, and many business decisions are made in that currency. However, at the same time, the company must maintain its legal accounting records in colones for regulatory and tax purposes. Added to this is a common third 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 record currency, the dollar as the functional business currency, and again the dollar as the presentation currency for consolidation purposes.

Understanding this structure is fundamental to correctly interpreting financial statements under International Financial Reporting Standards (IFRS), particularly as set out in IAS 21 – The Effects of Changes in Foreign Exchange Rates.

What determines the functional currency?

IAS 21 states 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 main factors are 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 mostly point 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 can perfectly well have the dollar as its functional currency, even though its legal accounting is done in colones.

For example:

Let's consider a hotel in Guanacaste that primarily receives international tourists. Rates are published in dollars, reservations are paid in dollars, and contracts with international tour operators are also negotiated in that currency. However, payroll, utilities, some local suppliers, and tax reports 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 is this situation handled 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 one hand, they maintain legal accounting records in colones for tax and regulatory purposes in Costa Rica. On the other hand, they prepare financial information in dollars, reflecting the functional currency of the business and used for management analysis or reporting to the parent company. The important thing is that both systems are reconciled and that conversions are performed following the principles established by IFRS.

How financial statements are converted

When legal accounting is done in colones but the functional currency is the dollar, the financial statements must be converted to 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.

• The assets are maintained at the corresponding historical exchange rate.

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

Not to be confused with inflation restatement

A common mistake is confusing currency conversion with inflation restatement. Currency conversion is governed by IAS 21, while inflation restatement is governed by IAS 29, which only applies to hyperinflationary economies. Costa Rica is not considered a hyperinflationary economy, so in these cases it is a currency conversion process, not an inflation adjustment.

When a company generates revenue in dollars but records its accounting in colones, exchange rate fluctuations can generate foreign exchange gains or losses that affect the accounting results for the period. This means that financial results can change even if the business's operations have remained stable. For this reason, it is essential to distinguish between the business's operational performance and the accounting effects of exchange rate fluctuations.

Functional currency, record currency, and presentation currency

In business practice, three distinct concepts of currency often coexist:

Concept	Meaning
Functional coin	Currency that reflects the economic reality of the business
Legal tender	Currency used for accounting and tax purposes in the country
Presentation coin	Currency in which financial statements are presented to investors or parent company

Understanding this difference allows for a better interpretation of financial statements.

In open economies like Costa Rica's, where many businesses generate revenue in foreign currency, it's normal for the business's functional currency to differ from the currency of the country where the company operates. Proper application of IAS 21 allows financial statements to reflect the business's economic reality, even when legal accounting records are maintained in colones.

For management, understanding the difference between functional currency, recording currency, and presentation currency is important for interpreting financial results and making 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.