Selection of the Functional Currency

Before the financial statements of a foreign branch, division, or subsidiary are translated into U.S. dollars, the management of the U.S. entity must make a decision as to which currency is the functional currency of the foreign entity. Once chosen, the functional currency cannot be changed unless economic facts and circumstances have clearly changed. Additionally, previously issued financial statements are not restated for any changes in the functional currency. The functional currency decision is crucial, because different translation methods are applied which may have a material effect on the U.S. entity's financial statements.

FASB defines functional currency but does not list definitive criteria that, if satisfied, would with certainty result in the identification of an entity's functional currency. Rather, realizing that such criteria would be difficult to develop, FASB listed various factors that were intended to give management guidance in making the functional currency decision. These factors include:

1. Cash flows (Do the foreign entity's cash flows directly affect the parent's cash flows and are they immediately available for remittance to the parent?)
2. Sales prices (Are the foreign entity's sales prices responsive to exchange rate changes and to international competition?)
3. Sales markets (Is the foreign entity's sales market the parent's country or are sales denominated in the parent's currency?)
4. Expenses (Are the foreign entity's expenses incurred primarily in the parent's country?)
5. Financing (Is the foreign entity's financing primarily from the parent or is it denominated in the parent's currency?)
6. Intercompany transactions (Is there a high volume of intercompany transactions between the parent and the foreign entity?).

If the answers to the questions above are predominantly yes, the functional currency is the reporting currency of the parent entity (i.e., the U.S. dollar). If the answers are predominantly no, the functional currency would most likely be the local currency of the foreign entity, although it is possible for a foreign currency other than the local currency to be the functional currency.

Translation Methods

To deal with discrete circumstances, FASB chose two different methods to translate an entity's foreign financial statements into U.S. dollars:

• The current rate method and
• The remeasurement method.

These are not alternatives, but rather are employed as circumstances dictate. The primary distinction between the methods is the classification of assets and liabilities (and their corresponding income statement amounts) that are translated at either the current or historical exchange rates.

Current rate method. The current rate method is the approach mandated by ASC 830 when the functional currency is the foreign currency (e.g., the domestic currency of the foreign subsidiary or operation). All assets and liabilities are translated at the current rates, while stockholders' equity accounts are translated at the appropriate historical rate or rates. Revenues and expenses are translated at rates in effect when the transactions occur, but those that occur evenly over the year may be translated at the weighted-average rate for the year.

Note that weighted-average, if used, must take into account the actual pace and pattern of changes in exchange rates over the course of the year, which will often not be varying at a constant rate throughout the period nor, in many instances, monotonically increasing or decreasing over the period. When these conditions do not hold, it is incumbent upon the reporting entity to develop a weighted-average exchange rate that is meaningful under the circumstances. When coupled with transactions (sales, purchases, et al.) that also have not occurred evenly throughout the year, this determination can become a fairly complex undertaking, requiring careful attention.

The theoretical basis for the current rate method is the “net investment concept,” wherein the foreign entity is viewed as a separate entity in which the parent invested, rather than being considered part of the parent's operations. FASB's reasoning was that financial statement users can benefit most when the information provided about the foreign entity retains the relationships and results created in the environment (economic, legal, and political) in which the entity operates. Converting all assets and liabilities at the same current rate accomplishes this objective.

The rationale for this approach is that foreign-denominated debt is often used to purchase assets that create foreign-denominated revenues. These revenue-producing assets act as a natural hedge against changes in the settlement amount of the debt due to changes in the exchange rate. The excess (net) assets—which are the U.S. parent entity's net equity investment in the foreign operation—will, however, be affected by this foreign exchange risk, and this effect is recognized by the parent.

Remeasurement method. The remeasurement method has also been referred to as the monetary/nonmonetary method. This approach is required by ASC 830 when the foreign entity's accounting records are not maintained in the functional currency (e.g., when the U.S. dollar is designated as the functional currency for a Brazilian subsidiary). This method translates monetary assets (cash and other assets and liabilities that will be settled in cash) at the current rate. Nonmonetary assets, liabilities, and stockholders' equity are translated at the appropriate historical rates. The appropriate historical rate would be the exchange rate at the date the transaction involving the nonmonetary account originated. Also, the income statement amounts related to nonmonetary assets and liabilities, such as cost of goods sold (inventory), depreciation (property, plant, and equipment), and intangibles amortization (patents, copyrights), are translated at the same rate as used for the related statement of financial position translation. Other revenues and expenses occurring evenly over the year may be translated at the weighted-average exchange rate in effect during the period, subject to the considerations discussed above.

Recap. Thus, to summarize, if the foreign entity's local currency is the functional currency, ASC 830 requires use of the current rate method when translating the foreign entity's financial statements. If, on the other hand, the U.S. dollar (or other nonlocal currency) is the functional currency, ASC 830 requires the remeasurement method when translating the foreign entity's financial statements. Both of these methods are illustrated below. All amounts in the following two illustrations, other than exchange rates, are in thousands.

An exchange rate might not be available if there is a temporary suspension of foreign exchange trading. ASC 830-30-55 provides that, if exchangeability between two currencies is temporarily lacking at a transaction date or the date of the statement of financial position, the first subsequent rate at which exchanges could be made is to be used to implement ASC 830.

Cessation of Highly Inflationary Condition

When a foreign subsidiary's economy is no longer considered highly inflationary, the entity converts the reporting currency values into the local currency at the exchange rates on the date of change on which these values become the new functional currency accounting bases for nonmonetary assets and liabilities.

Furthermore, ASC 830-740 states that when a change in functional currency designation occurs because an economy ceases to be highly inflationary, the deferred taxes on the temporary differences that arise as a result of a change in the functional currency are treated as an adjustment to the cumulative translation adjustments portion of stockholders' equity (accumulated other comprehensive income).

Applying ASC 740 to Foreign Entity Financials Restated for General Price Levels

Price-level-adjusted financial statements are preferred for foreign currency financial statements of entities operating in highly inflationary economies when those financial statements are intended for readers in the United States. If this recommendation is heeded, the result is that the income tax bases of the assets and liabilities are often restated for inflation. ASC 830-740 provides guidance on applying the asset-and-liability approach of ASC 740 as it relates to such financial statements. It discusses (1) how temporary differences are to be computed under ASC 740, and (2) how deferred income tax expense or benefit for the year is to be determined.

With regard to the first issue, temporary differences are computed as the difference between the indexed income tax basis amount and the related price-level restated amount of the asset or liability. The consensus reached on the second issue is that the deferred income tax expense or benefit is the difference between the deferred income tax assets and liabilities reported at the end of the current year and those reported at the end of the prior year. The deferred income tax assets and liabilities of the prior year are recalculated in units of the current year-end purchasing power.

On a related matter, ASC 830-10-45 states that, when the functional currency changes to the reporting currency because the foreign economy has become highly inflationary, ASC 740 prohibits recognition of deferred income tax benefits associated with indexing assets and liabilities that are remeasured in the reporting currency using historical exchange rates. Any related income tax benefits would be recognized only upon their being realized for income tax purposes. Any deferred income tax benefits that had been recognized for indexing before the change in reporting currency is effected are eliminated when the related indexed amounts are realized as income tax deductions.

Application of ASC 830 to an Investment to be Disposed of That is Evaluated for Impairment

Under ASC 830, accumulated foreign currency translation adjustments are reclassified to net income only when realized upon sale or upon complete or substantially complete liquidation of the investment in the foreign entity. ASC 830-30-45 addresses whether a reporting entity is to include the translation adjustments in the carrying amount of the investment in assessing impairment of an investment in a foreign entity that is held for disposal if the planned disposal will cause some or all of the translation adjustments to be reclassified to net income. The standard points out that an entity that has committed to a plan that will cause the translation adjustments for an equity-method investment or consolidated investment in a foreign entity to be reclassified to earnings is to include the translation adjustments as part of the carrying amount of the investment when evaluating that investment for impairment. An entity would also include the portion of the translation adjustments that represents a gain or loss from an effective hedge of the net investment in a foreign operation as part of the carrying amount of the investment when making this evaluation.

Measuring Hedge Effectiveness

While any entity may use hedging strategies, under the provisions of ASC 815 the transaction must meet a number of important conditions to qualify for hedge accounting. Among these conditions are the establishment, at inception, of criteria for measuring hedge effectiveness and ineffectiveness. Periodically, each hedge must be evaluated for effectiveness, using the preestablished criteria, and the gains or losses associated with hedge ineffectiveness must be reported currently in earnings and not deferred to future periods. In the instance of foreign currency hedges, ASC 815 states that reporting entities must exclude from their assessments of hedge effectiveness the portions of the fair value of forward contracts attributable to spot-forward differences (i.e., differences between the spot exchange rate and the forward exchange rate).

In practice, this means that reporting entities engaging in foreign currency hedging will recognize changes in the above-described portion of the derivative's fair value in earnings, in the same manner that changes representing hedge ineffectiveness are reported, but these are not considered to represent ineffectiveness. These entities must estimate the cash flows on forecasted transactions based on the current spot exchange rate, appropriately discounted for time value. Effectiveness is then assessed by comparing the changes in fair values of the forward contracts attributable to changes in the dollar spot price of the pertinent foreign currency to the changes in the present values of the forecasted cash flows based on the current spot exchange rate(s).

Observe that in the foregoing example the gain on the forward contract did not precisely offset the loss incurred from the firm commitment. Since a hedge of an unrecognized foreign currency denominated firm commitment is accounted for as a fair value hedge, with gains and losses on hedging positions and on the hedged item both being recorded in current earnings, it may appear that the matter of hedge effectiveness is of academic interest only. However, according to ASC 815, even if both components (that is, the net gain or loss representing hedge ineffectiveness, and the amount charged to earnings that was excluded from the measurement of ineffectiveness) are reported in current period earnings, the distinction between them is still of importance.

With respect to fair value hedges of firm purchase commitments denominated in a foreign currency, ASC 815 directs that “the change in value of the contract related to the changes in the differences between the spot price and the forward or futures price would be excluded from the assessment of hedge effectiveness.” As applied to the foregoing example, therefore, the net credit to income in 20X2 ($118,226) can be further analyzed into two constituent elements: the amount arising from the change in the difference between the spot price and the forward price, and the amount resulting from hedge ineffectiveness.

The former item, not attributed to ineffectiveness, arose because the spread between spot and forward price at hedge inception, (1.44 − 1.40 =) .04, fell to (1.46 − 1.45 =) .01 by December 31, for an impact amounting to (.04 − .01 =) .03 × €4,000,000 = $120,000, which, reduced to present value terms, equaled $118,227. The net credit to earnings in December 2012, ($78,818 + 118,226 =) $197,044, relates to the spread between the spot and forward rates on December 31 and is identifiable with hedge ineffectiveness.