9.6 Changes in an Entity’s Functional Currency

An entity may determine that it needs to change its functional currency as a result of significant changes in economic facts and circumstances. For example, changes in 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.

In addition, when the economy in the country in which a foreign entity operates becomes highly inflationary,2 the entity must change its functional currency to its immediate parent’s reporting currency (e.g., USD). Likewise, when the economy in the country in which a foreign entity operates ceases to be highly inflationary, the entity should discontinue using its immediate parent’s reporting currency as its functional currency, provided that the entity’s facts and circumstances 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).

Regardless of the reason, ASC 830 requires entities to account for the effects of a change in the functional currency by remeasuring the carrying value of their assets and liabilities into the new functional currency. ASC 830-740 addresses the accounting for the income tax effects related to a change in the functional currency, which differs depending on whether the functional currency changed to or from the reporting currency.

9.6.1 Changes From the Local Currency to the Reporting Currency

When the reporting currency is the functional currency, ASC 830-10-45-18 requires that historical exchange rates be used to remeasure nonmonetary assets and liabilities from the local currency into the reporting currency, and therefore the exception in ASC 740-10-25-3(f), as discussed in Section 9.2.1, applies.

ASC 830-10-45-10 states, in part, that “[i]f 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.”

In this case, because the pretax carrying amounts of the subsidiary’s assets and liabilities do not change when the functional currency changes, temporary differences also do not change. Therefore, the subsidiary’s DTAs and DTLs should not be adjusted on the date on which the functional currency changes from local currency to the reporting currency.

However, the guidance in ASC 740-10-25-3(f) would be applied prospectively from the date of the change. Therefore, after the functional currency is changed to the reporting currency, the exception applies and, while the local-currency-equivalent amount of the financial reporting carrying value (for use in determining the temporary difference) is measured by using the spot rate as of the subsequent reporting date, deferred tax on the temporary difference associated with the change in exchange rates is not recognized.

In addition, an entity would continue to recognize deferred taxes for (1) differences related to the effects of exchange rate changes associated with reporting-currency-denominated (or any other nonlocal-currency-denominated) monetary assets and liabilities and (2) other differences between the local-currency financial reporting carrying value and local-currency tax basis of nonmonetary assets (e.g., differences arising when a nonmonetary asset is depreciated over different periods for book and tax purposes), excluding the effects of indexing. As discussed in Section 9.2.2, certain countries (especially those that are considered highly inflationary) permit the tax basis of assets to be indexed. ASC 830-10-45-16 states, in part:

[D]eferred 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.

Therefore, deferred tax effects (either a lesser DTL or a DTA) that were recognized as a result of indexing before the change in functional currency to the reporting currency are not derecognized. Rather, such effects reverse over time as those benefits are realized on the tax return (i.e., previously recognized DTAs should not be reversed when the functional currency is changed to the reporting currency). Going forward, in accordance with ASC 740-10-25-3(f), no new DTAs should be recognized for the effects of indexing that occur after the change in the functional currency.

Because the effects of indexing are ignored for deferred tax accounting purposes when the reporting currency is the functional currency, the current-year tax depreciation of indexation not recognized under ASC 740 (i.e., any indexation after the reporting currency became the functional currency) will result in a current-period tax benefit and a favorable permanent difference. Therefore, the excess tax depreciation (because of unrecognized indexing) will result in a lower ETR in the year in which it is realized on the entity’s tax return. The prohibition in ASC 740-10-25-3(f) causes the timing of recognition of the tax benefit related to indexing to shift from the period in which the indexing occurs to the period in which the additional tax basis is depreciated or amortized (even when the resulting deduction increases an NOL carryforward).

Example 9-8

Entity A, a foreign entity, uses the LC as its functional currency. Entity A’s parent is a U.S. entity that uses USD as its reporting currency. On January 1, 20X5, A acquires a piece of equipment for 1 million LC. The equipment is depreciated on a straight-line basis over four years for both book and tax purposes. The tax laws of the foreign country in which A operates allow for a 15 percent increase in the tax basis at the end of each year (i.e., the depreciable tax basis includes the additional tax basis from indexation), which is depreciated over the remaining tax life of the equipment. Assume that A’s tax rate is 40 percent.

Entity A’s deferred taxes on the temporary difference associated with the equipment are calculated as follows (all amounts are in local currency):

Assume that on January 1, 20X6, the country in which A operates becomes highly inflationary (or that A otherwise determines that its functional currency has changed to the reporting currency). The exchange rate on January 1, 20X6, is 1 USD to 5 LC, the average exchange rate for 20X6 is 1 USD to 12.5 LC, and the exchange rate on December 31, 20X6, is 1 USD to 20 LC. Under ASC 830, A’s functional currency would change to the reporting currency of its parent (USD) in the period in which A determines that the jurisdiction is highly inflationary (or otherwise determines that its functional currency should be the reporting currency). The USD-translated amount for the equipment at the end of the prior period (December 31, 20X5) becomes the accounting basis in the current period and in subsequent periods. The following table illustrates the tax effects when A changes its functional currency from the local currency to the reporting currency (all amounts are in local currency):

On December 31, 20X6, A would recognize a DTA of 30,000 LC (temporary difference of 75,000 LC × 40% tax rate). The change in the local currency DTA from the beginning of the year to the end of the year would be recognized at the average exchange rate (to determine the amount to recognize as an income tax expense) (45,000 LC − 30,000 LC = 15,000 LC ÷ 12.5 = $1,200), and the end-of-year local currency DTA would then be converted at the exchange rate in effect on December 31, 20X6; any difference between the change in the USD beginning-of-the-year DTA ($9,000 = 45,000 LC ÷ 5) and the USD end-of-year DTA ($1,500 = 30,000 LC ÷ 20) and the amount recognized as an income tax expense ($1,200) would be included in the income statement, which is calculated as ($9,000 – $1,500) – $1,200 = $6,300. Under ASC 830-740-45-1, A may present the transaction gain or loss that results from remeasuring the DTA (i.e., $6,300) as deferred tax expense or benefit (rather than as a transaction gain or loss) if such presentation is considered more useful. If reported in that manner, the transaction gain or loss would still be included in the aggregate transaction gain or loss for the period, which would be disclosed in accordance with ASC 830-20-45-1.

Because A’s functional currency changed to USD (i.e., the reporting currency of its parent) in 20X6, it would not recognize any deferred taxes related to the additional indexing that occurred in 20X6 since that adjustment was made after the functional currency changed. Further, A would not immediately reverse the DTA that it previously recorded in connection with the 20X5 indexing adjustments before its functional currency changed. Rather, the DTA would be reversed over time as those benefits (in the form of increased tax depreciation expense) are realized on A’s tax return. In 20X6, A claimed 37,500 LC more tax depreciation than book depreciation. Because this additional depreciation was realized on the return, A reverses the DTA by the corresponding, tax-effected amount (37,500 LC × 40% = 15,000).

In addition, when determining the local-currency-equivalent amount of the USD carrying value of the equipment (for use in measuring the temporary difference related to the equipment), A must use the exchange rate in effect at the time the functional currency changed (i.e., the historical exchange rate).3 The fact that the presumed recovery of the equipment for its USD carrying amount implies a different local-currency-equivalent amount (i.e., 500,000 LC ÷ 5 = $100,000 × 20 = 2 million LC ) as the exchange rate fluctuates is not considered because the equipment is remeasured from the local currency into the functional currency by using historical exchange rates (which is the exception in ASC 740-10-25-3(f)).

Further assume that throughout 20X7, the country in which A operates continues to be highly inflationary and that its functional currency therefore continues to be the reporting currency. The following table illustrates A’s tax effects in 20X7 (all amounts are in local currency):

In 20X7, A realizes total tax depreciation of 330,625 LC on its tax return (the total of the first and second columns in the table above). However, of the total tax depreciation realized, 43,125 LC is related to the effects of the indexing that occurred in 20X6.4 Because the indexing occurred after the functional currency changed to the reporting currency, the excess depreciation realized in 20X7 has no impact on the DTA. Because this amount is realized on the entity’s return, it creates a permanent difference in 20X7, which would lower A’s ETR and current payable (provided that A reported taxable income).

The remainder of the tax depreciation realized in 20X7 (287,500 LC) is related to the tax basis that existed before the functional currency changed to the reporting currency. The amount is the same as the amount calculated in 20X6 and would remain the same in 20X8 (the last year of the asset’s useful life for tax purposes). Because this amount is 37,500 LC higher than the depreciation expense realized for book purposes, A reverses the DTA by the corresponding, tax-effected amount (37,500 LC × 40% = 15,000). The remaining temporary difference of 37,500 LC at the end of 20X7 would be reversed in 20X8.

Lastly, A does not recognize a DTA for the additional indexing that occurred at the end of 20X7 since that adjustment occurred after the functional currency was changed.

9.6.2 Change in the Functional Currency When an Economy Ceases to Be Considered Highly Inflationary

As discussed above, when an entity has a foreign subsidiary operating in an economy that is considered highly inflationary under ASC 830, the reporting currency will be used as the subsidiary’s functional currency to measure foreign nonmonetary assets and liabilities, such as inventory, land, and depreciable assets. If the rate of inflation for the local currency significantly declines, the economy will no longer be considered highly inflationary and the entity will need to account for the change in its subsidiary’s functional currency from the reporting currency to the local currency.

Deferred taxes should be recognized when the new local currency accounting bases are established for the foreign nonmonetary assets and liabilities. ASC 830-740-25-3 concludes that any resulting difference between the new functional currency basis and the tax basis is a temporary difference for which intraperiod tax allocation is required under ASC 740. Since the functional currency book basis generally will exceed the local currency tax basis in this situation, a DTL will be recognized at the time the change occurs. In addition, under ASC 830-740-45-2, the deferred tax expense associated with the taxable temporary difference that arises should be reflected as an adjustment to the cumulative translation component of OCI rather than as a charge to income. The example below illustrates this concept.

Example 9-9

A foreign subsidiary of a U.S. entity operating in a highly inflationary economy purchases equipment with a 10-year useful life for 100,000 LC on January 1, 20X1. The asset is depreciated over 10 years for both book and tax purposes. The exchange rate on the purchase date is 10 LC to $1, so USD-equivalent cost was $10,000. On December 31, 20X5, the equipment has a net book value on the subsidiary’s local books of 50,000 LC (the original cost of 100,000 LC less accumulated depreciation of 50,000 LC) and the current exchange rate is 75 LC to 1 USD. In the U.S. parent’s consolidated financial statements, annual depreciation expense of $1,000 has been reported for each of the last five years, and on December 31, 20X5, a $5,000 amount is reported for the equipment (foreign currency basis measured at the historical exchange rate between USD and the foreign currency on the date of purchase).

At the beginning of 20X6, the economy in which the subsidiary operates ceases to be considered highly inflationary. Accordingly, assuming the functional currency and local currency are now the same, the foreign subsidiary would establish a new functional currency accounting basis for the equipment as of January 1, 20X6, by translating the reporting currency amount of $5,000 into the functional currency at the current exchange rate of 75 LC to 1 USD. The new functional currency accounting basis on the date of change would be 375,000 LC (5,000 × 75).5

A DTL, as measured under the tax laws of the foreign jurisdiction, is recorded in the subsidiary’s local books on January 1, 20X6. This measurement is based on the temporary difference between the new reporting basis of the asset of 375,000 LC and its underlying tax basis, 50,000 LC, on that date. Thus, if a tax rate of 50 percent in the foreign jurisdiction is assumed, a DTL of 162,500 LC (325,000 LC × 50%) would be recorded on the local books of record. That DTL would then be translated at the current exchange rate between USD and the local currency and reported as $2,167 (i.e., 162,500 LC ÷ 75) in the consolidated financial statements with a corresponding charge to the cumulative translation account. The foreign subsidiary would compare the functional currency book basis with the tax basis prospectively to determine the temporary difference and change in the DTL recognized.

Footnotes

The CAQ’s International Practices Task Force (IPTF) has developed a framework for compiling inflation data to help registrants determine whether a particular country has met the definition in ASC 830 of highly inflationary. The IPTF periodically issues discussion documents on this topic.

With respect to assets held at the time the functional currency is changed to the reporting currency, the “historical exchange rate” means the rate in effect on the date of change in the functional currency. With respect to assets acquired after the change in functional currency, the “historical exchange rate” means the rate used to remeasure the local-currency cost of the asset into the reporting-currency amount (generally, the rate in effect when the asset was acquired).

The amount of depreciation expense related specifically to the 20X6 indexing is calculated by dividing the amount of tax basis created as a result of the indexing (86,250 LC) by the number of years remaining on the asset’s useful life for tax purposes at the time the basis increased (two years). This amount can also be calculated by comparing the amounts of tax depreciation expense before and after the change in functional currency.

Note that the redetermination of the new functional currency occurs only in the year in which the economy ceases to be highly inflationary.

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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.