Chapter 2 — Determining the Functional Currency
Chapter 2 — Determining the Functional Currency
2.1 Overview
ASC 830-10
45-2 The assets, liabilities, and operations of a foreign entity shall be measured using the functional currency of that entity. An entity’s functional currency is 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.
To comply with the measurement and translation requirements in ASC 830, a reporting entity must identify the appropriate functional currency to use in measuring the financial position and operations of each of its foreign entities. A reporting entity may need to use significant judgment both in identifying foreign entities and in determining the “currency of the primary economic environment,” or functional currency, for each of these entities.
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.
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:
- 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.
- 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:
- 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.
- 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:
- Foreign currency. There is an active local sales market for the foreign entity’s products, although there also might be significant amounts of exports.
- 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:
- 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.
- 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:
- 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.
- 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:
- 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.
- 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.
2.4 Change in Functional Currency
ASC 830-10
Changes in the Functional Currency
45-7 Once the functional currency for a foreign entity is determined, that determination shall be used consistently unless significant changes in economic facts and circumstances indicate clearly that the functional currency has changed. Previously issued financial statements shall not be restated for any change in the functional currency.
45-8 See paragraph 250-10-45-1 for guidance on adoption
or modification of an accounting principle necessitated by transactions or
events that are clearly different in substance from those previously occurring.
Paragraphs 830-10-45-15 through 45-16 discuss changes related to highly
inflationary economies.
Functional Currency Changes From Reporting Currency to Foreign Currency
45-9 If the functional currency changes from the reporting currency to a foreign currency, the adjustment attributable to current-rate translation of nonmonetary assets as of the date of the change shall be reported in other comprehensive income.
Functional Currency Changes From Foreign Currency to Reporting Currency
45-10 If the functional currency changes from a foreign currency to the reporting currency, translation adjustments for prior periods shall not be removed from equity and the translated amounts for nonmonetary assets at the end of the prior period become the accounting basis for those assets in the period of the change and subsequent periods. This guidance shall be used also to account for a change in functional currency from the foreign currency to the reporting currency when an economy becomes highly inflationary.
ASC 830-10-45-7 indicates that there must be “significant changes in economic
facts and circumstances” to justify a change in functional currency. Except when an economy
is identified as highly inflationary (see Chapter 7), ASC 830 does not define or provide examples related to what
constitutes a significant change in facts and circumstances. An entity must therefore use
judgment in determining whether significant changes in facts and circumstances have
occurred. However, such changes are expected to be rare.
Changes in the functional currency may result from one-time transactions,
such as a merger or acquisition, or from a longer-term shift in an entity’s operations.
Regardless of the reason, it is important that management carefully consider whether such an
event is significant enough to warrant a change in the functional currency. Because ASC 830
does not provide guidance on how to determine whether a change is “significant,” preparers
may find it helpful to compare the indicators before and after the change in making the
determination. Entities are encouraged to consult with their accounting advisers in such
situations.
Example 2-8
Significant Changes in Facts and Circumstances That Justify a Change in
Functional Currency
Company H, located in Ireland, is a wholly owned subsidiary of
Company K, whose functional currency is USD. Company H has identified the EUR as
its functional currency because, among other indicators, its sales and
purchases, as well as its labor costs, have primarily been denominated in this
currency. During the fourth quarter, H’s operations begin to change. The sales
composition of H changes because it loses some sizable contracts and gains some
significant new contracts. Company K begins using H’s manufacturing facility to
complete its sales orders. Because more than 80 percent of H’s sales will come
from K’s operations, H will no longer need to generate its own sales; therefore,
H terminates its sales force. Company K builds a new facility to produce the
materials needed in its manufacturing processes. As of the end of the fiscal
year, H begins receiving all materials from K instead of from outside vendors.
On the basis of the changes in its business, H expects cash inflows and
outflows, except for wages, to be primarily denominated in USD.
These circumstances collectively justify a change in H’s
functional currency from EUR to USD. For example, the denomination of revenues
has changed from primarily EUR to USD. This change does not appear to be
temporary since H has terminated its sales force. In addition, the denomination
of cash outflows for materials also has changed to USD. Because K has built a
new facility to make these materials, this change does not appear to be
temporary either. Further, the philosophy behind H’s operations has changed: in
K’s overall operating strategy, H has changed from a self-supporting,
stand-alone operating company to a manufacturing facility of K.
Example 2-9
Impact of Significant Borrowings on Determination of Functional
Currency
Company O’s functional currency is USD, and O uses the equity
method to account for its 43 percent investment in Company M, a Mexican company
whose functional currency is the MXN. During the current year, M enters into a
$200 million third-party borrowing denominated in USD. Most of M’s operations,
labor costs, and purchases are denominated in MXN.
Despite the significant borrowing denominated in USD, it is
not appropriate for M to change its functional currency from MXN to USD. Because
most of M’s operations, sales, purchases, and labor cost are denominated in MXN,
M should continue using the MXN as its functional currency. Although a large
third-party financing in O’s functional currency may constitute some evidence of
a change in the functional currency from MXN to USD, there is insufficient
evidence of such a change in this example.
Example 2-10
Effects of an Acquisition on Functional Currency
Company W is a manufacturing entity whose primary operations
(e.g., headquarters, manufacturing operations, majority of sales contracts) are
located in the United States and whose functional currency is USD. Company W is
acquired by Company L, a similar manufacturing entity that is based in
Luxembourg and whose functional currency is the EUR, as part of L’s efforts to
expand into the North American market. Company L plans to cease manufacturing
operations in the United States, since it has adequate capacity within its
existing facilities in Europe, and to manage W’s operations from its European
headquarters in Luxembourg. These changes result in the conversion of W into a
foreign sales office for L. Therefore, W’s functional currency changes to the
EUR when it is acquired by L.
If significant changes had not been made to W’s operations
after the acquisition, W’s functional currency most likely would have remained
the USD.
SEC Considerations
The SEC’s Frequently Requested Accounting and Financial Reporting Interpretations and Guidance, released by the Division of Corporation Finance (the “Division”), provides an additional example in which a change in functional currency may be appropriate. This guidance states that “[r]egistrants with foreign operations in economies that have recently experienced economic turmoil should evaluate whether significant changes in economic facts and circumstances have occurred that warrant reconsideration of their functional currencies.” The Division warns, however, that it may be difficult to conclude that “currency exchange rate fluctuations alone would cause a self-contained foreign operation to become an extension of the parent company.” Regardless of the underlying reason for the change in functional currency, the Division suggests that, although ASC 830 does not require them to do so, “[r]egistrants should consider the need to disclose the nature and timing of the change, the actual and reasonably likely effects of the change, and economic facts and circumstances that led management to conclude that the change was appropriate. The effects of those underlying economic facts and circumstances on the registrant’s business should also be discussed in MD&A.”
2.4.1 Determining When to Change the Functional Currency
In accordance with ASC 830-10-45-7, a change in functional currency should be
reported as of the date on which it is determined that “significant changes in economic
facts and circumstances” have occurred. Although such a change could occur on any date
during the year, it is acceptable to use a date at the beginning of the most recent
reporting/accounting period.
2.4.2 Accounting for a Change in the Functional Currency
ASC 250-10-45-1 states that the “[a]doption or modification of an accounting
principle necessitated by transactions or events that are clearly different in substance
from those previously occurring” is not considered a change in accounting principle.
Because a change in functional currency is necessitated by a significant change in facts
and circumstances that are “clearly different in substance from those previously
occurring,” such a change does not meet the definition of a change in accounting principle
and therefore should not be accounted for as such (i.e., previously issued financial
statements should not be restated).
The accounting effects of a change in functional currency depend on (1) the type
of change being made (e.g., foreign currency [likely the local currency] to reporting
currency or reporting currency to foreign currency) and (2) the nature of the assets or
liabilities being restated (i.e., monetary or nonmonetary). The following table summarizes
the consolidated accounting treatment of a change in functional currency as of the first
day of a reporting period and assumes that the foreign entity is a direct subsidiary of
the parent:
Effect of Changes in Functional Currency on the Consolidated
Financial Statements
|
Type of Change
|
Nonmonetary Assets and Liabilities
|
Monetary Assets and Liabilities
|
Effect on CTA
|
|---|---|---|---|
|
Reporting currency to foreign currency1
|
Translate at the rate in effect on the date of change.
Causes a difference between historical carrying value (based
on rate at time of asset or liability’s inception) and new carrying value
(based on current rate).
|
Translate at the rate in effect on the date of change.
Causes no difference between historical carrying value and
new carrying value.
|
Difference between historical basis of nonmonetary assets
and liabilities and new basis is recorded in CTA.
|
|
Foreign currency to reporting currency
|
Translated balances at the end of the prior period become
the new accounting basis.
|
Translated balances at the end of the prior period become
the new accounting basis.
|
No effect.
|
|
Foreign currency to other foreign currency
|
Remeasure into the new functional currency at the rate in
effect on the date of the asset or liability’s inception.
Then translate into reporting currency based on current
exchange rate.
|
Remeasure into the new functional currency at the rate in
effect on the date of change.
Then translate into reporting currency based on current
exchange rate.
|
Difference between historical basis of nonmonetary assets
and liabilities and new basis is recorded in CTA.
|
In all scenarios, the rate on the date of change becomes the historical rate at which nonmonetary assets and liabilities are translated in subsequent years. Previously recorded CTA balances are not reversed.
For additional information on accounting for monetary and nonmonetary assets and liabilities, see Chapter 4.
Example 2-11
Accounting for a Change in Functional Currency
The table below represents the accounting records of Company
X, a foreign entity whose parent company’s reporting currency is USD. As a
result of a significant change in facts and circumstances, X’s functional
currency has changed from USD (its reporting currency) to EUR (its local
currency). The change occurs on January 1, 20X5. This example assumes the
following:
-
All nonmonetary assets and liabilities arise on the same date, January 1, 20X0, when the EUR-to-USD exchange rate is 1 to 2. Assume that no depreciation is taken on the PP&E.
-
Company X maintains its books and records in EUR, its local currency.
-
The EUR-to-USD exchange rate on the date of the change in functional currency is 1 to 1.5.
-
The reporting currency of the consolidated entity is USD.
Connecting the Dots
Considerations When Functional Currency Changes
A change in functional currency can have a number of effects on an entity, a few examples of which are depicted above. An entity should carefully consider the impact of the change in functional currency on all account balances. For example, the lower-of-cost-or-market analysis required by ASC 330-10 would have to be performed in the new functional currency. In addition, an entity should revisit its various investing and hedging positions to determine whether changes in methods or strategies are warranted.
Footnotes
1
This guidance does not apply to situations in which an
entity is changing its functional currency from the reporting currency to
a foreign currency (likely the local currency) because an economy ceases
to be highly inflationary. See Chapter 7 for guidance on such
situations and Example
7-6 for an illustration of the differences.
2.5 Change in Reporting Currency
ASC 830 does not specifically address a change in reporting currency (i.e., the currency in which the financial statements are presented). The FASB staff has said that it would permit some sort of “convenience translation” (i.e., the translation of an entity’s financial statements from its reporting currency into another currency for the convenience of readers) if the change in reporting currency was necessitated by a change in the parent’s functional currency. However, the FASB staff prefers a restatement of the prior periods as though the information originally had been presented in the new reporting currency.
SEC Considerations
In accordance with SEC Regulation S-X, Rule 3-20(e), if an SEC registrant changes its reporting currency, it is required to “recast its financial statements as if the newly adopted currency had been used since at least the earliest period presented in the filing.” In addition, the registrant should disclose the “decision to change and the reason for the change in the reporting currency” in the period in which the change occurs.