1.4 Functional-Currency Approach

Under the functional-currency approach, the reporting entity must perform four steps:

Because the functional-currency approach requires an entity to measure the assets, liabilities, and operations in the functional currency, an entity that enters into transactions in currencies other than its functional currency must first remeasure those amounts in its functional currency before they are translated into the reporting currency.

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It is important to understand the difference between remeasurement and translation under ASC 830. By remeasuring financial results in the functional currency, an entity provides information about its future net cash flows. That is, as exchange rates fluctuate, so too will the related cash flows. For this reason, the effects of remeasurement are generally reported in the income statement. Translation, on the other hand, simply refers to the process of converting the financial statements from the functional currency into a different currency. In other words, the translation process has no impact on an entity’s future cash flows. For this reason, the effects of translation are reported in equity.

To illustrate the application of the functional-currency approach under ASC 830, this section is divided into the following two subsections:

“Decision Points” — This section discusses the two key decisions that management must make to apply the functional-currency approach: (1) identify the distinct and separable operations and (2) determine the functional currency of each. Management must use judgment in making each of these decisions before the reporting entity can apply the recognition and measurement guidance in ASC 830. As further discussed below, the terms “distinct and separable operation” and “foreign entity” are used interchangeably in this Roadmap.
“Mechanics of ASC 830” — This section summarizes the processes for remeasuring foreign currency transactions into the functional currency and translating foreign currency statements into the reporting currency. While some judgment may be required (e.g., selecting exchange rates, assessing intra-entity transactions that are of a long-term investment nature), the accounting for foreign currency transactions and financial statement translation is largely a mechanical exercise once the functional currency has been determined.

1.4.1 Decision Points

The first step in applying the functional-currency approach under ASC 830 is to identify each distinct and separable operation within the consolidated group. While ASC 830 does not explicitly define “distinct and separable operation,” ASC 830-10-45-5 states:

An entity might have more than one distinct and separable operation, such as a division or branch, in which case each operation may be considered a separate entity. If those operations are conducted in different economic environments, they might have different functional currencies.

ASC 830-10-45-5 highlights that the functional currency could be different for each distinct and separable operation, even if those operations are part of the same entity. Therefore, to correctly determine the functional currency under ASC 830, reporting entities must evaluate whether a single entity contains two or more distinct operations. See Chapter 2 for further guidance on determining distinct and separable operations.

After identifying the distinct and separable operations, the reporting entity must determine the functional currency of each one. This step is critical to the successful application of ASC 830 since the functional currency directly affects the identification and measurement of foreign currency transactions and the translation of the financial statements (discussed in Section 1.4.2).

ASC 830 defines functional currency as “the currency of the primary economic environment in which the entity operates; normally, that is the currency of the environment in which an entity primarily generates and expends cash.” ASC 830-10-45-6 further states that “the functional currency of an entity is, in principle, a matter of fact.” That is, the functional currency of an entity is not simply an election that the reporting entity makes but a determination that is made on the basis of facts.

It can be challenging to determine an entity’s functional currency, depending on the nature of the entity’s operations. Therefore, to help reporting entities determine the functional currency of their entities, ASC 830 provides the following indicators, which must be assessed both individually and collectively:

Once an entity has determined the functional currency on the basis of evaluating the indicators above, it is generally rare that this currency would change in the future. ASC 830-10-45-7 indicates that there must be “significant changes in economic facts and circumstances” to justify changing an entity’s functional currency. However, ASC 830 also requires an entity to change its functional currency to the reporting currency of its immediate parent if the economy in which the entity operates becomes highly inflationary.

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ASC 830-10-45-5 clarifies that each distinct and separable operation of the reporting entity is considered a separate “entity” when the requirements of ASC 830 are applied. Furthermore, ASC 830-10-20 defines a “foreign entity” and “reporting entity” as follows:

Foreign Entity

An operation (for example, subsidiary, division, branch, joint venture, and so forth) whose financial statements are both:

Prepared in a currency other than the reporting currency of the reporting entity
Combined or consolidated with or accounted for on the equity basis in the financial statements of the reporting entity.

Reporting Entity

An entity or group whose financial statements are being referred to. Those financial statements reflect any of the following:

The financial statements of one or more foreign operations by combination, consolidation, or equity accounting
Foreign currency transactions.

Accordingly, each “distinct and separable operation” whose financial statements are prepared in a currency other than the reporting currency of the reporting entity (i.e., the direct parent entity) would be considered a “foreign entity.” Therefore, throughout this Roadmap, the terms “distinct and separable operation” and “foreign entity” are used interchangeably.

A distinct and separable operation whose financial statements are prepared in the same currency as the reporting currency of the reporting entity (e.g., a USD-denominated subsidiary of a USD-denominated parent entity) may be referred to as a “domestic entity.” While the guidance on foreign currency translation does not apply in such circumstances, it may still be necessary to identify such distinct and separable operations because doing so could affect the determination of the distinct and separable operations that constitute a foreign entity.2

For the remainder of this Roadmap, an “entity” refers to a distinct and separable operation, which would constitute either a foreign entity or a domestic entity.

For more information about determining the functional currency, see Chapter 2. For a discussion of highly inflationary economies, see Chapter 7.

1.4.2 Mechanics of ASC 830

The mechanics of ASC 830 include the processes for remeasuring foreign currency transactions into the functional currency and translating foreign currency financial statements into the reporting currency.

1.4.2.1 Measuring Foreign Currency Transactions

Under the functional-currency approach in ASC 830, the financial information of each distinct and separable operation of the reporting entity must be measured in its respective functional currency. Therefore, if an entity enters into a transaction that is denominated in a currency other than its functional currency (i.e., a foreign currency transaction), it must initially measure that transaction in its functional currency by using the exchange rate in effect when the transaction was recognized in its financial statements.

While all foreign currency transactions are initially measured in the functional currency at the then-current exchange rate, the subsequent measurement (i.e., remeasurement) of a foreign currency transaction for monetary assets and liabilities is different from that for nonmonetary assets and liabilities, as illustrated below.

Monetary assets and liabilities — The exchange rate in effect on the reporting date must be used to remeasure monetary assets and liabilities (e.g., receivables or payables in a foreign currency) as of each reporting date in the functional currency. Therefore, fluctuations in the exchange rate between the date the foreign currency transaction was recognized and the date on which it is settled will cause the carrying amount of the monetary asset or liability to increase or decrease. That increase or decrease in the carrying amount of the asset or liability will result in a foreign currency transaction gain or loss (“transaction gain or loss”) in the period in which the exchange rate changes. With certain exceptions, transaction gains and losses should be presented in earnings in the period in which they arise.
Nonmonetary assets and liabilities — The exchange rate that was in effect when the transaction was recognized (i.e., the historical exchange rate) must be used to remeasure, in the functional currency, nonmonetary assets and liabilities that are denominated in a foreign currency. Therefore, unlike the carrying amount of monetary assets and liabilities, the carrying amount of nonmonetary assets and liabilities will not increase or decrease as a result of fluctuations in exchange rates (and therefore no transaction gains and losses will arise). By using the historical exchange rate to remeasure nonmonetary assets and liabilities, an entity effectively achieves the same results it would have achieved if it had entered into the related transaction in its functional currency.

See Chapter 4 for more information about foreign currency transactions.

1.4.2.2 Translating Financial Statements

After all foreign currency transactions have been measured in the functional currency, the reporting entity must translate the financial statements of each foreign entity into the reporting currency. The purpose of the translation process is to state all amounts that are denominated or measured in a different currency in a single reporting currency (in a manner consistent with the primary objective of ASC 830 — see Section 1.3).

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While the requirements in ASC 830 related to determining the functional currency and measuring all transactions in this currency apply to all distinct and separable operations within the reporting entity, the translation process is only relevant to foreign entities. This is because the financial statements of distinct and separable operations that are not foreign entities (i.e., domestic entities) are already measured in the reporting currency.

The graphic below summarizes which exchange rates are used to translate each account type.

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Equity accounts are not remeasured in the functional currency each reporting period; rather, equity accounts (excluding changes in retained earnings due to current-year net income) are translated by using the historical exchange rate on the date of recognition. (See Section 3.2.1 for additional discussion of translation exchange rates.) Although nonmonetary assets and liabilities are not remeasured in the functional currency each reporting period, they must still be translated into the reporting currency by using the current exchange rate. (See Section 1.4 for an explanation of the difference between remeasurement and translation.) The table below summarizes the exchange rates that are used in the remeasurement and translation processes for monetary and nonmonetary assets and liabilities.

Account Type	Exchange Rate for Remeasurement	Exchange Rate for Translation
Monetary assets and liabilities	Current exchange rate	Current exchange rate
Nonmonetary assets and liabilities	Historical exchange rate	Current exchange rate

Translation gains or losses, which result from the process of translating a foreign entity’s financial statements into the reporting currency, are recorded in a cumulative translation adjustment (CTA), a separate component of other comprehensive income (OCI). See Chapter 5 for more information about the translation process.

Footnotes

The guidance on foreign currency transactions applies to all entities.

Confidential and Proprietary — for Use Solely by Authorized Personnel

This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.