Chapter 1 — Introduction
Chapter 1 — Introduction
1.1 Overview
Since the issuance of FASB Statement 52 (codified in ASC 830) in
1981, domestic and international economies have become more interdependent. In
addition, the structures of many multinational corporations have become more
intricate. For example, many corporations are organized as a series of holding
companies that have no significant operations and only hold investments in other
entities within the group. Furthermore, certain significant global functions (e.g.,
treasury) that transact in many different currencies are performed entirely outside
the United States.
Despite such changes in the ways companies are organized and operated, the guidance
codified in ASC 830 has not changed significantly over the years. Under ASC 830, it
is assumed that the reporting entity uses the USD as its reporting currency and that
its foreign operations are either (1) self-contained and integrated into a
particular country or economic environment or (2) extensions of the reporting
entity. As a result, companies may encounter challenges in applying such guidance to
their operating structures because their foreign operations may not fit cleanly into
either of the two types contemplated in ASC 830. For example, the treasury function
mentioned above may transact in virtually every currency and operate independently
from the reporting entity. That is, it is neither (1) contained in a particular
economic environment nor (2) an extension of the reporting entity.
1.2 Scope
Although not defined in the ASC master glossary, the term “currency” commonly refers to a generally accepted form of money, including coins and paper notes, issued by a sovereign government and circulated within an economy. Currency is a medium of exchange for goods and services and is the basis for trade.
Cryptocurrencies are not cash and therefore would not be considered
a foreign currency within the scope of ASC 830. While cryptocurrencies may be used
as a medium of exchange, they are not backed by a sovereign government and do not
represent legal tender that must be accepted as a form of payment.
ASC 830-10 — Glossary
Foreign Currency
A currency other than the functional currency of the entity being referred to (for example, the dollar could be a
foreign currency for a foreign entity). Composites of currencies, such as the Special Drawing Rights, used to set
prices or denominate amounts of loans, and so forth, have the characteristics of foreign currency.
Foreign Currency Transactions
Transactions whose terms are denominated in a currency other than the entity’s functional currency. Foreign
currency transactions arise when a reporting entity does any of the following:
- Buys or sells on credit goods or services whose prices are denominated in foreign currency
- Borrows or lends funds and the amounts payable or receivable are denominated in foreign currency
- Is a party to an unperformed forward exchange contract
- For other reasons, acquires or disposes of assets, or incurs or settles liabilities denominated in foreign currency.
Special Drawing Rights on the International Monetary Fund are international reserve assets whose value is
based on a basket of key international currencies.
As indicated in ASC 830-10-15, all entities and all foreign currency
transactions are within the scope of ASC 830 regardless of which currency is
selected as the reporting currency. Reporting entities that engage in foreign
currency transactions should be aware that certain entities, generally multilateral
development banks (e.g., International Bank for Reconstruction and Development, Bank
for International Settlements), engage in foreign currency transactions denominated
in special drawing rights (SDRs).
If a reporting entity uses its local currency as the reporting currency and prepares
its financial statements in accordance with U.S. GAAP, it must apply ASC 830.
However, in these instances, ASC 830 would not apply for purposes “other than
consolidation, combination, or the equity method” (i.e., convenience
translations).
SEC Regulation S-X, Rule 3-20(b), provides guidance on presenting convenience
translations for foreign private issuers and states, in part, “[i]f the reporting
currency is not the U.S. dollar, dollar-equivalent financial statements or
convenience translations shall not be presented, except a translation may be
presented of the most recent fiscal year and any subsequent interim period presented
using the exchange rate as of the most recent balance sheet included in the filing,
except that a rate as of the most recent practicable date shall be used if
materially different.” In addition, SEC rules require foreign private issuers to
disclose prominently, on the face of the financial statements, the currency in which
amounts in the financial statements are stated. Further, if dividends on publicly
held equity securities are declared in a currency other than the reporting currency,
a note to the financial statements should identify that currency.
Footnotes
1
On its Web site, the
International Monetary Fund (IMF) describes SDRs as follows:
The SDR is an international reserve asset,
created by the IMF in 1969 to supplement its
member countries’ official reserves. So far SDR
660.7 billion (equivalent to about US$935.7
billion) has been allocated to members, including
SDR 182.7 billion allocated in 2009 in the wake of
the global financial crisis. The value of the SDR
is based on a basket of five currencies — the U.S.
dollar, the euro, the Chinese renminbi, the
Japanese yen, and the British pound
sterling.
1.3 Objective of ASC 830
The primary objective of ASC 830 is for reporting entities to present their consolidated financial statements as though they are the financial statements of a single entity. Therefore, if a reporting entity operates in more than one currency environment, it must translate the financial results of those operations into a single currency (referred to as the reporting currency). However, this process should not affect the financial results and relationships that were created in the economic environment of those operations.
In accordance with the primary objective of ASC 830, a reporting entity must use a “functional-currency approach” in which all transactions are first measured in the currency of the primary economic environment in which the reporting entity operates (i.e., the functional currency) and then translated into the reporting currency.
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.
Connecting the Dots
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.
Connecting the Dots
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.
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).
Connecting the Dots
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.
Connecting the Dots
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
2
The guidance on foreign currency transactions applies to
all entities.