Factors Indicating the Appropriate Functional Currency
Companies will usually explain in the notes to their annual report how they accounted for foreign currency translation. A typical statement is that found in Dow Chemical’s 1999 Annual Report:
The local currency has been primarily used as the functional currency throughout the world. Translation gains and losses of those operations that use local currency as the functional currency, and the effects of exchange rate changes on transactions designated as hedges of net foreign investments, are included in “Accumulated other comprehensive income.” Where the U.S. dollar is used as the functional currency, foreign currency gains and losses are reflected in income.
The reporting currency is the currency in which the parent firm prepares its own financial statements—that is, U.S. dollars for a U.S. firm. FASB 52 requires that the financial statements of a foreign unit first be stated in the functional currency, using generally accepted accounting principles of the United States. At each balance sheet date, any assets and liabilities denominated in a currency other than the functional currency of the recording entity must be adjusted to reflect the current exchange rate on that date. Transaction gains and losses that result from adjusting assets and liabilities denominated in a currency other than the functional currency, or from settling such items, generally must appear on the foreign unit’s income statement. The only exceptions to the general requirement to include transaction gains and losses in income as they arise are listed as follows:
1. Gains and losses attributable to a foreign currency transaction that is designated as an economic hedge of a net investment in a foreign entity must be included in the separate component of shareholders’ equity in which adjustments arising from translating foreign currency financial statements are accumulated. An example of such a transaction would be a euro borrowing by a U.S. parent. The transaction would be designated as a hedge of the parent’s net investment in its German subsidiary.
2. Gains and losses attributable to intercompany foreign currency transactions that are of a long-term investment nature must be included in the separate component of shareholders’ equity. The parties to the transaction in this case are accounted for by the equity method in the reporting entity’s financial statements.
3. Gains and losses attributable to foreign currency transactions that hedge identifiable foreign currency commitments are to be deferred and included in the measurement of the basis of the related foreign transactions.
The requirements regarding translation of transactions apply both to transactions entered into by a U.S. company and denominated in a currency other than the U.S. dollar and to transactions entered into by a foreign affiliate of a U.S. company and denominated in a currency other than its functional currency. Thus, for example, if a German subsidiary of a U.S. company owed $180,000 and the euro declined from $1.20 to $1.00, the euro amount of the liability would increase from €150,000 (180,000/1.20) to €180,000 (180,000/1.00), for a loss of €30,000. If the subsidiary’s functional currency is the euro, the €30,000 loss must be translated into dollars at the average exchange rate for the period (say, $1.10), and the resulting amount ($33,000) must be included as a transaction loss in the U.S. company’s consolidated statement of income. This loss results even though the liability is denominated in the parent company’s reporting currency because the subsidiary’s functional currency is the euro, and its financial statements must be measured in terms of that currency. Similarly, under FASB 52, if the subsidiary’s functional currency is the U.S. dollar, no gain or loss will arise on the $180,000 liability.
After all financial statements have been converted into the functional currency, the functional currency statements are then translated into dollars, with translation gains and losses flowing directly into the parent’s foreign exchange equity account.
If the functional currency is the dollar, the unit’s local currency financial statements must be remeasured in dollars. The objective of the remeasurement process is to produce the same results that would have been reported if the accounting records had been kept in dollars rather than the local currency. Translation of the local currency accounts into dollars takes place according to the temporal method; thus, the resulting translation gains and losses must be included in the income statement.
A large majority of firms have opted for the local currency as the functional currency for most of their subsidiaries. The major exceptions are those subsidiaries operating in Latin American and other highly inflationary countries; they must use the dollar as their functional currency.
10 The previous translation standard, Statement of Financial Accounting Standards No. 8 (or FASB 8), was based on the temporal method. Its principal virtue was its consistency with generally accepted accounting practice that requires balance sheet items to be valued (translated) according to their underlying measurement basis (i.e. current or historical). Almost immediately upon its adoption, however, controversy ensued over FASB 8. A major source of corporate dissatisfaction with FASB 8 was the ruling that all reserves for currency losses be disallowed. Before FASB 8, many companies established a reserve and were able to defer unrealized translation gains and losses by adding them to, or charging them against, the reserve. In that way, corporations generally were able to cushion the impact of sharp changes in currency values on reported earnings. With FASB 8, however, fluctuating values of pesos, pounds, yen, Canadian dollars, and other foreign currencies often had far more impact on profit-and-loss statements than did the sales and profit margins of multinational manufacturers’ product lines.