Chapter 2 — Determining the Functional Currency

2.3 Definition of Functional Currency and Indicators

ASC 830-10

45-3 It is neither possible nor desirable to provide unequivocal criteria to identify the functional currency of foreign entities under all possible facts and circumstances and still fulfill the objectives of foreign currency translation. Arbitrary rules that might dictate the identification of the functional currency in each case would accomplish a degree of superficial uniformity but, in the process, might diminish the relevance and reliability of the resulting information.

45-4 Multinational reporting entities may consist of entities operating in a number of economic environments and dealing in a number of foreign currencies. All foreign operations are not alike. To fulfill the objectives in paragraph 830-10-10-2, it is necessary to recognize at least two broad classes of foreign operations:

In the first class are foreign operations that are relatively self-contained and integrated within a particular country or economic environment. The day-to-day operations are not dependent on the economic environment of the parent’s functional currency; the foreign operation primarily generates and expends foreign currency. The foreign currency net cash flows that it generates may be reinvested or converted and distributed to the parent. For this class, the foreign currency is the functional currency.
In the second class are foreign operations that are primarily a direct and integral component or extension of the parent entity’s operations. Significant assets may be acquired from the parent entity or otherwise by expending dollars and, similarly, the sale of assets may generate dollars that are available to the parent. Financing is primarily by the parent or otherwise from dollar sources. In other words, the day-to-day operations are dependent on the economic environment of the parent’s currency, and the changes in the foreign entity’s individual assets and liabilities impact directly on the cash flows of the parent entity in the parent’s currency. For this class, the dollar is the functional currency.

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.

45-6 The functional currency of an entity is, in principle, a matter of fact. In some cases, the facts will clearly identify the functional currency; in other cases they will not. For example, if a foreign entity conducts significant amounts of business in two or more currencies, the functional currency might not be clearly identifiable. In those instances, the economic facts and circumstances pertaining to a particular foreign operation shall be assessed in relation to the stated objectives for foreign currency translation (see paragraphs 830-10-10-1 through 10-2). Management’s judgment will be required to determine the functional currency in which financial results and relationships are measured with the greatest degree of relevance and reliability.

Once the distinct and separable operations have been identified, the next step is to determine the “currency of the primary economic environment in which the [distinct and separable operation] operates.” An entity may be required to use significant judgment in making this determination, depending on the nature of the operation being evaluated. The following are two scenarios illustrating the determination of the functional currency:

Entity A, a subsidiary of a U.S. parent, is an operating company located in France that is relatively autonomous. Entity A conducts all of its operations in France, and all of its transactions are denominated in EUR.
Entity B, a subsidiary of a U.S. parent, is a holding company located in Germany and obtains a loan denominated in USD from its U.S. parent. In addition, B borrows additional funds denominated in EUR from an unrelated third party and invests the entire amount, denominated in EUR, in Entity C, an operating company also located in Germany. Entity B intends to use dividends received from its investment in C to remit dividends to the parent in USD.

In the first scenario, the determination of the functional currency is relatively straightforward: A’s functional currency is the EUR. However, in the second scenario, it is not clear whether B’s functional currency is USD or the EUR. Management would need to use judgment in determining B’s functional currency in the second scenario.

Further, it should not be assumed that the functional currency is either that of the parent or that of the jurisdiction in which the distinct and separable operation operates (i.e., the local currency). Management may also conclude, on the basis of the facts and circumstances, that the functional currency is that of another jurisdiction (although such a conclusion is not as common).

In determining the appropriate functional currency, management should consider each of the economic factors in ASC 830-10-55 and thoroughly document the conclusions reached.

ASC 830-10

55-3 The following provides guidance for determination of the functional currency. The economic factors cited here, and possibly others, should be considered both individually and collectively when determining the functional currency.

55-4 This general guidance presents indicators of facts to be considered in identifying the functional currency. In those instances in which the indicators are mixed and the functional currency is not obvious, management’s judgment will be required to determine the functional currency that most faithfully portrays the economic results of the entity’s operations and thereby best achieves the objectives of foreign currency translation set forth in paragraph 830-10-10-2. Management is in the best position to obtain the pertinent facts and weigh their relative importance in determining the functional currency for each operation. It is important to recognize that management’s judgment is essential and paramount in this determination, provided only that it is not contradicted by the facts.

55-5 The following salient economic factors, and possibly others, should be considered both individually and collectively when determining the functional currency:

Cash flow indicators, for example:
1. Foreign currency. Cash flows related to the foreign entity’s individual assets and liabilities are primarily in the foreign currency and do not directly affect the parent entity’s cash flows.
2. Parent’s currency. Cash flows related to the foreign entity’s individual assets and liabilities directly affect the parent’s cash flows currently and are readily available for remittance to the parent entity.
Sales price indicators, for example:
1. Foreign currency. Sales prices for the foreign entity’s products are not primarily responsive on a short-term basis to changes in exchange rates but are determined more by local competition or local government regulation.
2. Parent’s currency. Sales prices for the foreign entity’s products are primarily responsive on a short-term basis to changes in exchange rates; for example, sales prices are determined more by worldwide competition or by international prices.
Sales market indicators, for example:
1. Foreign currency. There is an active local sales market for the foreign entity’s products, although there also might be significant amounts of exports.
2. Parent’s currency. The sales market is mostly in the parent’s country or sales contracts are denominated in the parent’s currency.
Expense indicators, for example:
1. Foreign currency. Labor, materials, and other costs for the foreign entity’s products or services are primarily local costs, even though there also might be imports from other countries.
2. Parent’s currency. Labor, materials, and other costs for the foreign entity’s products or services continually are primarily costs for components obtained from the country in which the parent entity is located.
Financing indicators, for example:
1. Foreign currency. Financing is primarily denominated in foreign currency, and funds generated by the foreign entity’s operations are sufficient to service existing and normally expected debt obligations.
2. Parent’s Currency — Financing is primarily from the parent or other dollar-denominated obligations, or funds generated by the foreign entity’s operations are not sufficient to service existing and normally expected debt obligations without the infusion of additional funds from the parent entity. Infusion of additional funds from the parent entity for expansion is not a factor, provided funds generated by the foreign entity’s expanded operations are expected to be sufficient to service that additional financing.
Intra-entity transactions and arrangements indicators, for example:
1. Foreign currency. There is a low volume of intra-entity transactions and there is not an extensive interrelationship between the operations of the foreign entity and the parent entity. However, the foreign entity’s operations may rely on the parent’s or affiliates’ competitive advantages, such as patents and trademarks.
2. Parent’s currency. There is a high volume of intra-entity transactions and there is an extensive interrelationship between the operations of the foreign entity and the parent entity. Additionally, the parent’s currency generally would be the functional currency if the foreign entity is a device or shell corporation for holding investments, obligations, intangible assets, and so forth, that could readily be carried on the parent’s or an affiliate’s books.

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.

55-7 Foreign investments that are consolidated or accounted for by the equity method are controlled by or subject to significant influence by the parent entity. Likewise, the parent’s currency is often used for measurements, assessments, evaluations, projections, and so forth, pertaining to foreign investments as part of the management decision-making process. Such management control, decisions, and resultant actions may reflect, indicate, or create economic facts and circumstances. However, the exercise of significant management control and the use of the parent’s currency for decision-making purposes do not determine, per se, that the parent’s currency is the functional currency for foreign operations.

ASC 830 does not address how the above economic factors should be applied (e.g., weightings or hierarchy may differ for certain factors) but states that these “factors, and possibly others, should be considered both individually and collectively when determining the functional currency.”

However, because changes in functional currency are expected to be infrequent (see Section 2.4), management should place greater emphasis on long-term considerations related to each factor than it does on short-term considerations. For example, start-up operations may receive significant financing from the parent in the parent’s functional currency but ultimately plan to operate primarily in a foreign economic environment. In such cases, the facts and circumstances may indicate that, while the start-up operation’s financing was in the currency of its parent in the short term, the start-up operation may eventually operate primarily in the foreign economic environment. Therefore, consideration of the factors above would most likely lead to a conclusion that the start-up operation’s functional currency is, in fact, different from the parent’s.

Connecting the Dots

An unconsolidated joint venture or an equity method investment in which a reporting entity invests is subject to the same functional currency assessment that the reporting entity is required to perform for an entity it consolidates (i.e., because the functional currency of such unconsolidated entities may also differ from that of the reporting entity). However, because such entities are not consolidated, the reporting entity may not have access to certain information that it would otherwise have for a consolidated entity. Accordingly, a reporting entity would most likely need to exercise greater judgment when determining the functional currency for an unconsolidated joint venture or equity method investment.

Example 2-3

Functional Currency Is the Same as the Parent’s

Company X, which is incorporated in the United States, is a subsidiary of a U.S.-based parent whose reporting currency is USD. Company X maintains branches, including marketing and manufacturing, in several countries. Belgium is the predominant manufacturing location, and Canada is the predominant research and development location. In addition, X has operations in two other countries. Management has determined that none of X’s foreign branches are distinct and separable. Therefore, the functional currency has been determined for X as a whole.

Management of X uses USD when preparing its company-wide budget and internal reports. Salaries and other general expenses are paid in the local currencies of the countries in which X operates. Sales are invoiced in USD, but local customers frequently pay in the local currency at the current exchange rate. All intercompany sales are denominated and paid in USD. About 80 percent of X’s borrowings are denominated in USD.

Company X

Several of the indicators in ASC 830-10-55-5 demonstrate that X’s functional currency is USD. Because X transacts business in several countries, one local currency is not considered more dominant than another. Sales invoicing, financing, and intercompany transactions are predominantly in USD, and this currency is dominant in management’s budgeting and pricing process. While selling and general expenses are paid in other currencies, doing so is a function of X’s business transactions in those countries. For example, a worker in the Belgian manufacturing plant would expect his or her salary to be paid in the local currency (i.e., EUR), not in USD. Further, net cash flows appear to be in USD.

Example 2-4

Subsidiaries With Different Functional Currencies

Company Z, a U.K.-based entity whose functional currency is the GBP, has two operating subsidiaries, Company A and Company B, which are distinct and separable operations under ASC 830. Both A and B obtain financing from Z, which is denominated in GBP (i.e., neither subsidiary maintains third-party debt). See Example 2-5 for discussion related to B.

Company A is located in Spain, where most of its products are manufactured and sold. Sales prices charged by A are denominated in EUR and determined on the basis of local conditions (i.e., market competition or government regulations in Spain). Similarly, selling and administrative expenses are paid in EUR. Any excess cash flows are retained by A and reinvested in the Spain-based operations. Company A does not have intercompany transactions other than payments made to the parent entity in GBP in connection with its outstanding intercompany debt, which is not material to A’s balance sheet.

Company A

Company A’s functional currency is the EUR. Although financing is entirely in GBP, the majority of the remaining economic indicators are in EUR. Sales are invoiced, selling and general expenses are paid in EUR, and excess cash flows are retained by A and reinvested in the Spanish operations.

Example 2-5

Subsidiaries With Different Functional Currencies

Company B is located in Mexico, but its products are manufactured primarily in the United Kingdom and purchased from Z at a transfer price set to cover both production costs and research and development; these intercompany sales are invoiced in GBP. Sales prices charged by B are denominated in MXN and determined on the basis of local conditions (i.e., market competition or government regulations in Mexico). Similarly, selling and administrative expenses are paid in local currency. Any excess cash flows generated by B are distributed to and invested by Z in the United Kingdom.

Company B

Company B’s functional currency is GBP. Financing is entirely in GBP, and intra-entity transactions, which include significant inventory transfers, are predominantly in GBP. Further, excess cash flows are repatriated to the United Kingdom, where they are invested by the parent entity. Although sales are invoiced and selling and general expenses are paid in MXN, doing so is a function of conducting business in Mexico, and it appears that these are the only cash flows not denominated in GBP. In this case, group management most likely views B as a local sales branch integral to the parent.

Example 2-6

Functional Currency of a Start-Up Operation

Newco is a U.K.-based, newly formed, wholly owned subsidiary of Company A, a U.S.-based entity whose functional currency is USD. Because of a series of legal transactions associated with the creation of Newco, cash received from A as part of initial equity financing and a note due from another subsidiary of A (the “note”) are Newco’s only assets, both of which are denominated in USD; it has no significant liabilities. Newco does not currently have any operational activities or any employees of its own since A’s employees currently manage and operate the entity. In considering Newco’s functional currency, A’s management focuses on longer-term considerations rather than shorter-term considerations, including intentions for Newco to (1) establish local manufacturing operations, (2) recruit and hire locally based management and a general workforce, and (3) create a sales force to develop a local customer base. In addition, management’s intention is for Newco to retain the initial cash financing and retain and accumulate the repaid principal and interest earned on the note (all denominated in USD). The accumulated USD-denominated funds will be used to fund the start-up operations and consummate potential future acquisitions of U.K.-based entities. Management has no intention to repatriate any funds held by Newco to A.

Newco

On the basis of Newco’s current structure and operations, it seems to have the same functional currency as its parent (i.e., USD). However, management’s long-term intention is for Newco to act as a distinct and separate entity within the United Kingdom. Newco, therefore, will have the characteristics of an entity that is integrated into a particular economic environment (i.e., the United Kingdom) and that has a currency different from the one that currently represents most of Newco’s operations. Although intra-entity transactions are denominated in USD, they are limited to payments received in connection with the note. Upon formation, therefore, Newco’s functional currency is GBP rather than USD.

2.3.1 Considerations for Shell and Holding Companies

2.3.1.1 Subsidiaries Formed as Shell or Holding Companies

Although ASC 830 does not assign weight to or provide a specific hierarchy for the indicators discussed above, it stipulates that if a shell or holding company was formed primarily to hold assets or liabilities (e.g., investments, debt, intangible assets) that could “readily be carried on the parent’s or an affiliate’s books,” the functional currency for that shell or holding company would generally be that of its immediate parent. This could be the case, for example, when a holding company is established to conduct a narrow transaction or set of transactions (e.g., borrowing) that could have easily been performed by the parent. In listing factors that may indicate that the parent’s currency should be the entity’s functional currency, ASC 830-10-55-5(f)(2) states:

There is a high volume of intra-entity transactions and there is an extensive interrelationship between the operations of the foreign entity and the parent entity. Additionally, the parent’s currency generally would be the functional currency if the foreign entity is a device or shell corporation for holding investments, obligations, intangible assets, and so forth, that could readily be carried on the parent’s or an affiliate’s books.

Example 2-7

Functional Currency for Holding Companies

Company A, which has identified the USD as its functional currency, establishes two wholly owned subsidiary holding companies, Company B and Company C. Company B is incorporated in the United States, and C is incorporated in the United Kingdom. Company A loans 5 million GBP (£) to each company; B and C both record the transaction as an intercompany payable. Company B has no other assets, liabilities, or operations besides the cash received and the corresponding intercompany payable. In addition, C borrows an additional £2 million from an unrelated third party; A guarantees this loan. Company C invests the entire £7 million in Company D, an operating company in the United Kingdom, and intends to use dividends received from its investment in D to repay the loan to the third party.

The functional currency of B should be USD, the same functional currency as that of its parent company. Although B’s loan transaction results in a payable denominated in a foreign currency, it is a shell company. It has no substantive operations of its own and is not conducting any operations that the parent could not otherwise conduct itself. Therefore, its functional currency should be USD.

Company C also appears to be a shell company. However, C must consider additional indicators in determining its functional currency; these indicators demonstrate that C is “integrated within a particular country or economic environment.” Specifically, C is incorporated in the United Kingdom and has an investment in a substantive operating company that is also incorporated in the United Kingdom; has borrowed money from a third party that is denominated in GBP instead of USD; and intends to repay its third-party loan by using dividends from its investment in D. Thus, C’s functional currency appears to be GBP.

2.3.1.2 Parent Formed as a Shell or Holding Company

There may be cases in which the parent entity itself is a holding company (e.g., when a company is trying to access a particular market, such as the U.S. market, a holding company may be established to facilitate market access). There is no explicit guidance on how to determine the functional currency of such entities. In such circumstances, entities are encouraged to consult with their accounting advisers.

Connecting the Dots

To facilitate their access to the U.S. or other global capital markets, Chinese operating companies commonly establish holding companies in a foreign territory or country (e.g., the Cayman Islands) that serve as the ultimate parent of the consolidated group. In such cases, questions have arisen regarding what the functional currency of the ultimate parent holding company should be.

ASC 830 does not directly address the determination of the functional currency of the ultimate parent holding company. However, in practice, entities have used one of the two approaches discussed below to determine the ultimate parent holding company’s functional currency in such situations.

Approach 1 (“Top-Down” Approach)

Under the top-down approach, the functional currency is assessed on the basis of the ultimate parent holding company’s activities. In this context, the ultimate parent holding company generally does not carry out any substantive business operations; rather, its main purpose is to hold the investments in Chinese operating entities and earn a return through dividends to be received from those entities. Further, the ultimate parent holding company, in addition to serving as a listing vehicle, is generally responsible for financing and raising capital in USD, as well as paying dividends to its own investors in USD. These activities may be considered relevant to assessing economic factors in the determination of the functional currency. That is, “the financing indicator” in ASC 830-10-55-5(e) may be considered the most relevant indicator and may lead management to conclude that USD would be the appropriate functional currency of the ultimate parent holding company.

Approach 2 (“Bottom-Up” Approach)

Under the bottom-up approach, the ultimate parent holding company is deemed to be an extension of the operating subsidiaries in China. The ultimate parent holding company does not have substantive business operations, and its principal purpose is to raise capital to fund the Chinese operating entities. Therefore, it would be acceptable to look through the legal form and consider the ultimate parent to be an “extension” of the Chinese operating subsidiaries rather than as a self-sustained parent entity with substantive operations. ASC 830-10-55-5(f)(2) indicates that in the determination of the functional currency, “the parent’s currency generally would be the functional currency if the foreign entity is a device or shell corporation for holding investments, obligations, intangible assets, and so forth that could readily be carried on the parent’s or an affiliate’s books.” However, because the ultimate parent in this scenario does not have substantive operations, the ultimate parent holding company under this approach could be viewed as nonsubstantive and as a device or shell corporation for holding investments, obligations, etc., that could readily be carried on the Chinese operating company’s books. Accordingly, in such circumstances, the functional currency of the ultimate parent holding company could be considered the same as that of its Chinese operating entities.

The bottom-up approach provides for a reasonable framework when substantially all of the company’s operations are concentrated within a specific foreign jurisdiction and the functional currency is the same for all those subsidiaries. Additional consideration would be required when subsidiaries’ operations span multiple foreign jurisdictions (i.e., multiple operating subsidiaries with different functional currencies). In these instances, it may prove challenging to conclude that the ultimate parent holding company is an extension of subsidiaries in a single jurisdiction when no individual operations are significantly larger than others.

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.