New accounting law and introduction of a functional currency

In this article, we will focus on the extension of the use of international accounting standards and one of the most discussed changes, namely the possibility of accounting in a currency other than Czech.

How are international accounting standards going to be extended?

The new law includes an extension of the obligation or possibility to use international accounting standards They should be mandatory for commercial corporations whose investment securities are traded on a European-regulated market and for most financial institutions, including investment funds Voluntarily, international accounting standards could then be used by tax entities subject to the Specialised Financial Institution or by entities that expect to be included in the consolidated financial statements prepared in accordance with international accounting standards during the financial year. In this context, it will be important from a tax point of view whether there will be an expected change in the Income Tax Act that would allow the use of financial statements prepared in accordance with international accounting standards and also for the determination of the tax base.

What does the institution of a functional currency mean?

The law newly introduces a new institution of functional currency. This is the currency in which the entity performs the majority of its activities.  A suitably chosen functional currency should meet the following criteria:

• the currency that most influences the prices of the entity's goods and services;
• the currency of the country whose competitive environment and legal regulations predominantly affect the selling price of goods and services offered by the entity or the currency that most significantly affects the cost of goods and services;
• the currency in which income from the entity's operating activities is usually generated;
• the extent to which the currency affects the labour and other costs that the unit must incur in producing and selling goods and services;
• the currency in which resources are generated from financial activities or income is derived from foreign operations;
• the proportion of the entity's transactions denominated in that currency is greater than 50 %.

In assessing whether a currency is indeed a functional currency, an entity should consider the above criteria in the context of both past accounting periods and the entity's expected future development. The entity will have the obligation to demonstrate that the conditions for using a foreign currency are met.

What are the prerequisites for using a functional currency?

• Switching to a functional currency is an option, not an obligation.
• The functional currency proposed for the time being is EUR, USD, or GBP, assuming that the majority of the entity's transactions are recorded in that foreign currency. For example, functional currency accounting may be used by entities that realise most of their revenues in a foreign currency (e.g., EUR) and likewise have most of their expenses in that foreign currency. As the current legislation requires accounting in Czech currency units, these entities incur accounting exchange gains and losses, and by switching to a functional currency accounting regime, the entity avoids these exchange differences.
• The change is possible only on the first day of the accounting period.
• Switching back to reporting in CZK or another functional currency is not possible. The change is possible only if there is a factual change in the reported transactions in the entity, i.e., the selected currency ceases to be the functional currency.

And what are the advantages and disadvantages of changing the functional currency of an entity?

Advantages related to the switch to foreign currency in accounting include:

• reduction or complete elimination of exchange rate differences, which should lead to simpler accounting and a more accurate representation of the company's performance;
• simplifying the preparation of consolidated financial statements and simplifying internal reporting if the Czech entity can switch to the same currency as the group;
• increasing the comparability of accounting with foreign countries.

The disadvantages related to the transition to accounting in a currency other than the CZK are considered to be:

• the unpreparedness of the company's payroll system, i.e., the payroll system does not allow to calculation of wages in foreign currency - everything will always have to be converted to and from crowns;
• accounting software may not be able to work properly with functional currency;
• the state generally assumes that entities are accounting in CZK. For example, audit and consolidation limits are set only in CZK, although the draft law describes the mechanism for converting them into functional currency. Grant titles may require some accounting values and it is questionable whether they will be prepared to work with currencies other than CZK.

How will it be with the functional currency in taxes?

The amendment to the Act on Income Taxes is also related to the functional currency. However, this will only apply to corporate entities that keep accounts in the functional currency. Although we have already learned above that the switching of an accounting entity to a functional currency is an option, not an obligation, in the area of taxes after this switching, the choice will not be possible, and the functional currency must be used to calculate corporate income tax. However, the current situation is such that it will be possible to claim and determine the tax only in Czech crowns, due to the limiting technical possibilities of the tax administrator´s system. However, this area may also develop in the future. Nevertheless, this does not limit the sending of payment in a foreign currency, which has been so far possible and is credited to the tax administrator's account in Czech crowns.

In conclusion, the purpose of introducing a functional currency into the Czech environment is to enable companies to use for accounting the currency in which they actually conduct their business and in which most of their business transactions take place and to contribute to more efficient accounting in practical terms by reducing the number of conversions and minimizing exchange rate differences, as well as facilitating internal reporting of individual branches within one corporation. Globally, the possibility of using international accounting standards in accounting will improve the comparability of accounting data across the EU and the world.