2.2 Definition of a Foreign Entity
ASC 830-10 — Glossary
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.
The first step in the functional-currency approach is to determine which foreign entities make up the reporting entity. To be considered a foreign entity, an operation (or set of operations) should have its own financial statements or be able to produce such statements. Accordingly, a foreign entity most likely would have a management team that uses dedicated resources to run the entity’s operations. The concept of “distinct and separable operations” is important to making this determination.
From a practical standpoint, a reporting entity may begin the determination of
its distinct and separable operations by identifying each legal entity in its
organizational structure. Next, the reporting entity must determine whether any of
those legal entities have two or more distinct and separable operations (e.g.,
divisions, branches, product lines). If a legal entity has more than one distinct
and separable operation, a reporting entity would consider each operation a separate
entity when applying the guidance in ASC 830. Otherwise, the legal entity itself
would generally be considered the entity subject to ASC 830. Judgment must be used
in the determination of whether a single legal entity has more than one separate and
distinct operation, and the reporting entity must thoroughly understand how and
where the legal entity conducts business.
Connecting the Dots
The term “foreign entity,” as used in ASC 830, refers to an entity that prepares
its financial statements in a currency other than the reporting currency but
does not refer to the entity’s geographical location. Therefore, an entity
that is domiciled in the United States would meet the definition of a
foreign entity under ASC 830 if it was consolidated by a reporting entity
that has a reporting currency other than USD. Similarly, an entity that is
domiciled in a foreign country would not meet the definition of a foreign
entity under ASC 830 if it was consolidated by a reporting entity that has
the same reporting currency as the entity. Therefore, the reporting entity
must determine the functional currency of each distinct and separable
operation (i.e., entity) within the consolidated group, regardless of where
that operation is geographically located. The identification of foreign
entities is important, since ASC 830 requires that the financial statements
of each foreign entity be translated into the reporting currency, as
discussed in Section
1.3.
2.2.1 Identifying Distinct and Separable Operations
ASC 830-10
45-5 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.
55-6 In some instances, a foreign entity might have more than one distinct and separable operation. For example, a foreign entity might have one operation that sells parent-entity-produced products and another operation that manufactures and sells foreign-entity-produced products. If they are conducted in different economic environments, those two operations might have different functional currencies. Similarly, a single subsidiary of a financial institution might have relatively self-contained and integrated operations in each of several different countries. In those circumstances, each operation may be considered to be an entity as that term is used in this Subtopic, and, based on the facts and circumstances, each operation might have a different functional currency.
ASC 830-10-45-5 presents the notion of a “distinct and separable operation” but
offers no definition of or qualifying criteria related to such an operation.
Further, a distinct and separable operation may or may not meet the definition
of a business in ASC 805-10. Thus, management will need to use judgment and
consider all facts and circumstances in determining which operations are
distinct and separable. However, the following factors, while not exhaustive,
may indicate that an operation is distinct and separable for purposes of the
functional-currency analysis:
-
The operation has specifically identifiable assets and liabilities (i.e., not shared or commingled with other operations’ assets and liabilities).
-
The operation can be managed separately and apart from other operations of the reporting entity.
-
Accounting records for the operation could be produced.
As noted previously, distinct and separable operations may be identified at a lower level than the legal entity itself. For instance, divisions or branches of the same legal entity (e.g., a subsidiary) may operate in different economic environments, in which case each may be considered a distinct and separable operation.
Example 2-1
Distinct and Separable Operations
Bank IDB is an international development
bank that conducts its operations through various
currency pools. Each pool is self-contained and
integrated within a particular currency. The activities
of each pool are separable, distinct, and conducted in
the economic environment of the foreign country. Within
each pool, funds are raised in a single currency from
borrowings, loan participations, capital, and
accumulated earnings. These funds are for the most part
held, invested, or loaned, and IDB may not convert a
pool’s currency (e.g., the JPY pool may not convert JPY
into USD, GBP, etc.). Loans are denominated in the
currency of the pool. Generally, pools do not convert
currencies or engage in hedging currencies. For example,
a loan denominated in JPY would be funded by JPY
resources from the JPY pool. The loan and interest
thereon would be repaid in JPY as well.
Under ASC 830, each pool may be viewed
as a separate and distinct operation that should have
its own functional currency. The pools described above
operate in separate economic environments, and each has
its own currency in which substantially all of its
activities are executed. The pools do not hedge the
local currency against the parent’s functional currency.
This is an important factor because it demonstrates that
the pool operates in the local currency and does not peg
its operations, or results thereof, to another currency
by using derivatives. If one of the pools were to
liquidate its investments in the cash or loans, IDB
would be required to reclassify into income the amounts
it has recognized in its CTA related to those liquidated
amounts, since the only holdings of the pools are
financial instruments (i.e., financial assets and
financial liabilities instead of operations).
Under ASC 830, a reporting entity is not required to separate the accounting records of its operations if doing so is impracticable. Further, just because certain operations may be separable in some way (e.g., the operations have their own set of accounting records), the operations are not necessarily distinct and separable.
Reporting entities should carefully consider all facts and circumstances, as well as the factors discussed in Section 2.3, when determining whether an operation is distinct and separable. The following are some factors (not all-inclusive) indicating that operations may not be distinct and separable, even if separate accounting records are maintained:
- A legal entity’s foreign division is solely responsible for manufacturing certain product lines for its parent.
- A holding company is essentially an extension of its parent or affiliate (see Section 2.3.1 for additional considerations related to shell and holding companies).
- A subsidiary or division functions only as a foreign sales office for its parent.
- Individual retail stores are managed centrally.
- A foreign subsidiary or division operates only as the treasury or internal administrative function for its parent.
Example 2-2
Operations That Are Not Distinct and Separable
The overall conclusion from Example
2-1 would be different if Bank IDB
engaged in (1) foreign-currency-hedge strategies, (2)
other means of converting a particular foreign currency
into the parent’s functional currency, or (3) activities
to convert a pool’s currency into the currency of
another country, such as USD or JPY. In such cases, the
operations of the pools would not be considered separate
and distinct operations because of the high degree of
intra-entity transactions, which effectively would make
each pool an extension of IDB. Therefore, the
determination of the functional currency would be
evaluated for IDB as a whole, including the operations
of the individual pools.