Chapter 7 — Highly Inflationary Economies

7.3 Accounting Effects When an Economy Becomes Highly Inflationary

If the cumulative inflation calculation demonstrates that the economy has become highly inflationary, the entity should commence the requisite accounting on the first day of the next reporting period. In such scenarios, entities should consider whether disclosures are warranted in the reporting period before commencing highly inflationary accounting, as discussed further in Section 9.2.3.

Example 7-2

Designation as Highly Inflationary

Company X is a calendar-year-end entity that has quarterly reporting requirements. In the first quarter, X determines that its local economy (whose currency is X’s functional currency) has become highly inflationary on the basis of the inflationary data from the past 36 months. Company X therefore should begin applying the accounting for highly inflationary economies as of the beginning of the second quarter, or April 1. For first-quarter reporting purposes, X should continue to use the local currency as its functional currency but should disclose the adoption of highly inflationary accounting commencing in the next quarter.

As noted above, an entity with interim reporting requirements should not wait until the end of its fiscal year to record the effects of this designation. An entity that does not have interim reporting requirements should perform the cumulative-rate calculation as of its fiscal year-end and apply the effects of becoming highly inflationary to its financial statements at the beginning of the following year.

Local Currency to the Reporting Currency as a Result of Economy Being Highly Inflationary
Nonmonetary Assets and Liabilities	Monetary Assets and Liabilities	Equity Balances	Effect on Currency Translation Adjustment
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	Remeasure by using historical exchange rates	No effect

As summarized in the table above, when an economy is considered highly inflationary, an entity must remeasure its financial records in its parent’s reporting currency as of the first day of the next reporting period. The accounting treatment is the same as that described in Section 2.4.2 for changes from the local currency to the reporting currency related to a significant change in facts and circumstances.

In subsequent periods, if the underlying transactions of the entity continue to be denominated in the currency of the highly inflationary economy, an entity would recognize foreign currency exchange gains and losses in the income statement in connection with the remeasurement of local-currency-denominated monetary balances. Performance of such remeasurement is a result of the required change in functional currency that, in prior periods, would have been recognized as part of the translation adjustment in OCI when the local currency was the functional currency. Similarly, for monetary balances denominated in the new functional currency, the entity would no longer recognize remeasurement gains or losses in the income statement. Therefore, foreign currency gains and losses recognized in the income statement may materially differ from those recognized in prior periods.

Example 7-3

Effects of a Change in Functional Currency to the Reporting Currency

Company A, a public business entity, is a calendar-year-end entity that has operations in Country B such that B’s local currency is A’s functional currency. The functional currency of A’s parent, which is also the reporting currency of the consolidated entity, is USD. During the first quarter of 20X1, B’s economy is determined to be highly inflationary. In accordance with the guidance on highly inflationary economies in ASC 830, A reports its first-quarter results by using the local currency as its functional currency and translates its results into its parent’s reporting currency (i.e., USD) for consolidation purposes. As of April 1, 20X1, the translated balances (i.e., the balances stated in the reporting currency) as of March 31, 20X1, become the new accounting bases for all monetary and nonmonetary assets and liabilities. Company A’s equity accounts should be remeasured at the historical rates. Further, the CTA is not adjusted as a result of this change. Going forward, A will use the historical exchange rate on March 31, 20X1, when remeasuring A’s nonmonetary assets and liabilities.

Because a change in functional currency due to an economy’s designation as highly inflationary results from changes in economic factors (i.e., inflation), such a change is not considered a change in accounting policy and therefore should not be accounted for as a change in accounting principle in accordance with ASC 250. Therefore, previously issued financial statements should not be restated. An entity’s management should, however, consider whether the change will have a material impact on future operations and, if so, disclose the change in the notes to its financial statements.

When an entity operates in a multitiered organization, the entity generally should use the reporting currency of its most immediate parent and not that of the ultimate parent, provided that the entity’s immediate parent does not operate in a highly inflationary economy. (However, this topic is not addressed in ASC 830.)

Connecting the Dots

If an entity believes that its facts and circumstances are such that it should use the reporting currency of an entity other than its immediate parent when becoming highly inflationary, the entity is encouraged to consult with its accounting advisers.

Example 7-4

Identification of an Entity’s Parent

Company E is a third-tier entity within Company A’s multitiered international organization. Company A is headquartered in the United States, and its reporting currency is the USD; however, A globally has subsidiaries with multiple functional currencies. Company E has operations in Venezuela and is a direct subsidiary of Company B, which has operations in Mexico and a functional currency of MXN. Company A has determined that E’s functional currency is the BsF.2 At period-end, E’s financial statements are consolidated into B’s financial statements (i.e., translated into MXN), before being translated into A’s ultimate reporting currency (the USD).

As of December 31, 20X1, Venezuela’s economy is determined to be highly inflationary. As of January 1, 20X2, therefore, E’s financial statements should be remeasured into MXN (i.e., B’s functional currency), which will become its new functional currency. This is the case even though the USD is the ultimate reporting currency of the consolidated entity.

7.3.1 Effects of Remeasuring Financial Statements

When an entity must remeasure its financial statements because an economy becomes highly inflationary, the entity must consider several implications in conjunction with the remeasurement. For example, an entity generally will continue to maintain its books and records in the local currency. In these cases, remeasurement in the “new” functional currency (i.e., the reporting currency of its immediate parent) is required in each reporting period. Monetary assets and liabilities should be remeasured by using current rates. However, nonmonetary assets and liabilities (including related income statement items such as depreciation), should be remeasured by using the exchange rate that was in effect on the date on which the entity began implementing the accounting related to highly inflationary economies. In addition, transaction gains and losses recognized in the local currency will need to be adjusted upon remeasurement if they are related to monetary items denominated in currencies other than the local currency.

See Chapter 4 for an example illustrating the application of these remeasurement requirements in situations in which the foreign currency is not the functional currency.

7.3.1.1 Income Taxes

ASC 830-10

45-16 When the functional currency is the reporting currency, paragraph 740-10-25-3(f) prohibits recognition of deferred tax benefits that result from indexing for tax purposes assets and liabilities that are remeasured into the reporting currency using historical exchange rates. Thus, deferred tax benefits attributable to any such indexing that occurs after the change in functional currency to the reporting currency shall be recognized when realized on the tax return and not before. Deferred tax benefits that were recognized for indexing before the change in functional currency to the reporting currency are eliminated when the related indexed amounts shall be realized as deductions for tax purposes.

For more information about tax-related considerations related to foreign currency accounting, see Chapter 8 of this Roadmap and Chapter 9 of Deloitte’s Roadmap Income Taxes.

7.3.1.2 Monetary Assets and Liabilities Denominated in Multiple Currencies

Another implication that entities should consider is the effect of a change in functional currency on monetary assets and liabilities that are denominated in multiple currencies.

Example 7-5

Effects of Multiple Currencies on Monetary Items

If Company E from Example 7-4 has trade payables that are denominated in MXN, it would not need to remeasure those payables; rather, their actual value in MXN should become their accounting basis when E’s functional currency changes to the MXN because Venezuela becomes highly inflationary.

If E has trade payables dominated in CAD, those payables would be translated directly from CAD to MXN (i.e., there would be no remeasurement in the BsF before consolidation into the Mexican parent).

7.3.1.3 Considerations Related to Classified Balance Sheets

Entities with classified balance sheets should consider whether classifying certain foreign-currency-denominated monetary assets as current is still appropriate in light of the present economic environment. For example, an entity’s classification of assets as current may be inappropriate when such assets will be used to pay USD-denominated liabilities or dividends (rather than foreign-currency-denominated liabilities) and the entity encounters difficulties in converting such assets into USD. Such a determination will depend on an entity’s facts and circumstances and its ability to obtain necessary approvals to convert such balances at an appropriate exchange rate in the volume it needs to operate over the course of one year or its operating cycle, if longer.

7.3.2 Deconsolidation Considerations

ASC 810-10

15-10 A reporting entity shall apply consolidation guidance for entities that are not in the scope of the Variable Interest Entities Subsections (see the Variable Interest Entities Subsection of this Section) as follows:

All majority-owned subsidiaries — all entities in which a parent has a controlling financial interest — shall be consolidated. However, there are exceptions to this general rule.
1. A majority-owned subsidiary shall not be consolidated if control does not rest with the majority owner — for instance, if any of the following are present: . . .
  
  iii. The subsidiary operates under foreign exchange restrictions, controls, or other governmentally imposed uncertainties so severe that they cast significant doubt on the parent’s ability to control the subsidiary. . . .

ASC 830-20

30-2 . . . If the lack of exchangeability is other than temporary, the propriety of consolidating, combining, or accounting for the foreign operation by the equity method in the financial statements of the reporting entity shall be carefully considered.

In determining whether foreign exchange restrictions, controls, and other governmentally imposed uncertainties are severe enough to result in a lack of control by a parent entity, a reporting entity must exercise significant judgment and consider factors including, but not limited to, the following:

Volume restrictions on currency exchange activity (either explicit or in-substance), in conjunction with uncertainties about the reporting entity’s or subsidiary’s ability to obtain approval for foreign currency exchange through the established exchange mechanisms.
The ability, currently and historically, to access available legal currency exchange mechanisms in volumes desired or needed by the reporting entity or subsidiary.
Recent economic developments and trends in the foreign jurisdiction that might affect expectations about the future direction of restrictions on currency exchanges.
The extent and severity of restrictions imposed by the government on a subsidiary’s operations and whether those restrictions demonstrate the reporting entity’s inability to control its subsidiary’s operations. The reporting entity must use considerable judgment in making this determination since many governments, including the U.S. federal government, require companies to adhere to a framework of laws and regulations that govern operational matters. Examples of government intervention might include restrictions on (1) labor force reductions, (2) decisions about product mix or pricing, and (3) sourcing of raw materials or other inputs into the production process.

The mere fact that currency exchangeability is lacking does not in and of itself create a presumption that a reporting entity should not consolidate its foreign subsidiary, nor does the ability to exchange some volume of currency create such a presumption. In addition, in situations in which government control exists, the reporting entity should consider such control in its VIE assessment when evaluating whether the reporting entity has power. The existence of the above factors represents negative evidence in the determination of whether consolidation is appropriate on the basis of the reporting entity’s specific facts and circumstances. At the 2015 AICPA Conference on Current SEC and PCAOB Developments, an SEC staff member, Professional Accounting Fellow Chris Semesky, stated the following:

In the past year, OCA has observed registrant disclosures indicating a loss of control of subsidiaries domiciled in Venezuela. Disclosures indicate that these conclusions have been premised on judgments about lack of exchangeability being other than temporary and, also in some instances, the severity of government imposed controls. The application of U.S. GAAP in this area requires reasonable judgment to determine when foreign exchange restrictions or government imposed controls or uncertainties are so severe that a majority owner no longer controls a subsidiary. In the same way, a restoration of exchangeability or loosening of government imposed controls may result in the restoration of control and consolidation. In other words, I would expect consistency in a particular registrant’s judgments around whether it has lost control or regained control of a subsidiary. In addition, I would expect registrants in these situations to have internal controls over financial reporting that include continuous reassessment of foreign exchange restrictions and the severity of government imposed controls.

Further, to the extent a majority owner concludes that it no longer has a controlling financial interest in a subsidiary as a result of foreign exchange restrictions and/or government imposed controls, careful consideration should be given to whether that subsidiary would be considered a variable interest entity upon deconsolidation because power may no longer reside with the equity-at-risk holders. As a result, registrants should not only think about clear and appropriate disclosure of the judgments around, and the financial reporting impact of, deconsolidation but also of the ongoing disclosures for variable interest entities that are not consolidated.

If a reporting entity ultimately concludes that nonconsolidation of a foreign subsidiary is appropriate, the reporting entity must determine the appropriate date for any deconsolidation, including the appropriate currency exchange rate to use for remeasuring its deconsolidated investment and any other outstanding monetary balances that are no longer eliminated in consolidation (if they are not considered fully impaired). Furthermore, a reporting entity should clearly disclose the basis for its consolidation/nonconsolidation conclusion about an investment in a foreign subsidiary for which there is negative evidence regarding whether it controls the foreign subsidiary. A reporting entity that continues to consolidate may wish to consider disclosing its intention to continue monitoring developments, along with a description of the possible financial statement impact, if estimable, if deconsolidation were to occur. In addition, if a reporting entity concludes that nonconsolidation of a foreign subsidiary is appropriate, the reporting entity should continue to monitor developments in each reporting period to determine whether it has regained control and thus should reconsolidate the foreign subsidiary.

For more information about deconsolidation implications related to an economy’s designation as highly inflationary, see Deloitte’s Roadmap Consolidation — Identifying a Controlling Financial Interest.

Footnotes

This currency is no longer used in Venezuela.

7.4 Accounting Effects When an Economy Ceases to Be Highly Inflationary

ASC 830-10

Functional Currency Changes From Reporting Currency to Foreign Currency Because Foreign Economy Is No Longer Highly Inflationary

45-15 If an entity’s subsidiary’s functional currency changes from the reporting currency to the local currency because the economy ceases to be considered highly inflationary, the entity shall restate the functional currency accounting bases of nonmonetary assets and liabilities at the date of change as follows:

The reporting currency amounts at the date of change shall be translated into the local currency at current exchange rates.
The translated amounts shall become the new functional currency accounting basis for the nonmonetary assets and liabilities.

Example 1 (see paragraph 830-10-55-12) illustrates the application of this guidance.

Example 1: Functional Currency Changes From Reporting Currency to Foreign Currency Because Foreign Economy Is No Longer Highly Inflationary

55-12 This Example illustrates the application of paragraph 830-10-45-15.

55-13 A foreign subsidiary of a U.S. entity operating in a highly inflationary economy purchased equipment with a 10-year useful life for 100,000 local currency (LC) on January 1, 19X1. The exchange rate on the purchase date was LC 10 to USD 1, so the U.S. dollar equivalent cost was USD 10,000. On December 31, 19X5, the equipment has a net book value on the subsidiary’s local books of LC 50,000 (original cost of LC 100,000 less accumulated depreciation of LC 50,000) and the current exchange rate is LC 75 to the U.S. dollar. In the U.S. parent’s financial statements, annual depreciation expense of USD 1,000 has been reported for each of the past 5 years, and at December 31, 19X5, the equipment is reported at USD 5,000 (foreign currency basis measured at the historical exchange rate).

55-14 As of the beginning of 19X6, the economy of the subsidiary ceases to be considered highly inflationary. Under paragraph 830-10-45-15, a new functional currency accounting basis for the equipment would be established as of January 1, 19X6, by translating the reporting currency amount of USD 5,000 into the functional currency at the current exchange rate of LC 75 to the U.S. dollar. The new functional currency accounting basis at the date of change would be LC 375,000. For U.S. reporting purposes, pursuant to this Subtopic, the new functional currency accounting basis and related depreciation would subsequently be translated into U.S. dollars at current and average exchange rates, respectively.

When an economy ceases to be designated as highly inflationary, an entity should discontinue using its parent’s reporting currency as its functional currency, provided that the entity’s facts and circumstances (as described in Chapter 2) have not changed in such a way that its functional currency should now be the same as the reporting currency used for highly inflationary accounting (e.g., analysis of the economic indicators described in ASC 830-10 results in the determination that the entity’s functional currency should be that of its parent regardless of the inflationary status of its local economy). When the economy ceases to be highly inflationary,3 the nonmonetary assets and liabilities are converted at the exchange rate in effect on the date of change. (This treatment is different from that for changes in the functional currency that are not inflation-related.)

The table below summarizes the effects of the change in these specific circumstances.

Reporting Currency to Local Currency as a Result of Economy Ceasing to Be Highly Inflationary
Nonmonetary Assets and Liabilities	Monetary Assets and Liabilities	Equity Balances	Effect on Currency Translation Adjustment
Remeasure by using exchange rate as of the date of change. Remeasured balance becomes the new basis. Subsequent translations to reporting currency (e.g., at future period-ends) are performed by using current exchange rates, with effects of exchange rate fluctuations recorded as a currency translation adjustment.	Remeasure by using exchange rate as of the date of change.	Remeasure by using historical exchange rates.	No adjustment.

As when an entity changes its functional currency because an economy becomes highly inflationary, when an entity changes its functional currency because an economy is no longer highly inflationary, the change is not considered a change in accounting principle in accordance with ASC 250. Therefore, in such circumstances, previously issued financial statements should not be restated. An entity’s management should, however, consider whether the change will have a material impact on future operations and, if so, disclose the change in the notes to its financial statements.

Example 7-6

Accounting for a Change in Functional Currency When an Economy No Longer Is Highly Inflationary

This example addresses the accounting records of Company X, a foreign entity operating in a highly inflationary economy whose parent company’s reporting currency is the USD. Because X’s local economy is deemed highly inflationary, it has been using the USD as its functional currency for a number of years. During the fourth quarter of 20X5, X’s local economy ceased being considered highly inflationary; therefore, X’s functional currency has changed from the USD (its reporting currency) back to its local currency (LC). The change was accounted for on January 1, 20X6. Assume the following:

Company X purchased all of its PP&E for 100,000 LC on December 31, 20X0, when the LC-to-USD exchange rate was 5:1. The PP&E has a 10-year life, and depreciation is calculated on a straight-line basis.
Company X’s local economy became highly inflationary in the fourth quarter of 20X2; therefore, X changed its functional currency to the USD on January 1, 20X3, when the LC-to-USD exchange rate was 15:1.
The LC-to-USD exchange rate on the date on which the local economy ceased being highly inflationary (i.e., January 1, 20X6) was 10:1.

If it is assumed that the PP&E was purchased for 100,000 LC on December 31, 20X0, when the LC-to-USD exchange rate was 5:1, and that its useful life is 10 years (depreciation is calculated on a straight-line basis), the nonmonetary asset basis would have been 50,000 LC on January 1, 20X6, if the functional currency never changed to USD. However, as shown above, there is a 16,670 decrease in the LC basis because the functional currency changed as a result of the economy’s ceasing to be highly inflationary. While ASC 830 does not provide guidance on how to recognize this adjustment in the local books, an acceptable approach is to recognize the adjustment to opening retained earnings on the date of the change in functional currency.

Alternative Fact Pattern

Assume the same facts as above except that Company X is changing its functional currency from the USD (its reporting currency) to its local currency (LC) because of a significant change in economic facts and circumstances rather than because its local economy ceases to be highly inflationary. As explained in Chapter 2, when such a change is made, the reporting-currency accounting basis for nonmonetary assets and liabilities, such as the PP&E in this example, is adjusted for the difference between the exchange rates when the asset or liability arose and those when the entity’s functional currency changes. The change was accounted for in January 20X6. Assume the following:

Company X purchased all of its PP&E for 100,000 LC on December 31, 20X0, when the LC-to-USD exchange rate was 5:1. The PP&E has a 10-year life, and depreciation is calculated on a straight-line basis.
The LC-to-USD exchange rate on the date on which the change in functional currency was accounted for was 10:1.

In this case, the local-currency basis of the nonmonetary asset does not change as a result of the change in functional currency. (This scenario is different from that above, in which the LC basis is adjusted because of the change associated with the economy’s ceasing to be highly inflationary.) Rather, the USD-denominated bases (i.e., the reporting-currency accounting bases) change, resulting in a decrease of $5,000 in the amount of PP&E. As explained in Chapter 2, this decrease, which is due to the difference between the carrying value of the PP&E in the reporting currency (i.e., USD) at the historical exchange rate and that at the current exchange rate, is recorded as a currency translation adjustment.

An entity should also be aware of several implications related to an economy’s ceasing to be highly inflationary. One of the most significant effects is that on deferred taxes, as discussed in Chapter 8 of this Roadmap and Chapter 9 of Deloitte’s Roadmap Income Taxes.

As explained in Chapter 2, a change in functional currency may have a number of other effects on an entity, a few examples of which are depicted in Section 2.4.2. An entity should carefully consider the impact of the change in functional currency on all of its 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. Changes in functional currency may also affect the local subledgers the entity maintains in its local currency (such as the adjustment to retained earnings described above).

Further, for consolidated entities that determined deconsolidation was necessary for a subsidiary in a highly inflationary economy, such conclusions should be revisited.

Footnotes

When an entity changes its functional currency from the reporting currency to a foreign currency for reasons other than an economy’s ceasing to be highly inflationary, nonmonetary assets and liabilities are converted in a manner that results in a difference between the historical reporting-currency basis and the new reporting-currency basis. As a result, the account balances would be reflected in the reporting currency as if the new functional currency had always been the functional currency; these differences would be recorded in a CTA. See Chapter 2 for additional details.