How to Determine Functional Currency Following New Guidance

ASC 830 provides guidelines on how to determine the functional currency of an entity. This is typically an election made by management based on the economic environment in which the company operates — but the process is more complex than that.

First, a company identifies its entity type — self-contained (stand alone) or an extension of parent operations — Sounds easy, but the line between these two entity types can often be blurred. Therefore, the guidance also provides six economic indicators to help companies figure it out.

Here’s how to determine functional currency following the ASC 830 guidance.

Step #1: Identify Entity Type

The first step in determining the functional currency of a subsidiary is to evaluate whether the entity is self-contained or an extension of parent operations.

A self-contained entity generates and spends its own cash. It does not depend on the parent’s functional currency for operations and integrates fully with the local foreign economy. These types of entities have the local currency as their functional currency.

On the other hand, foreign operations that receive assets from the parent that are then sold into the local market with subsequent cash flows flowing back to the parent are considered extensions of parent operations. These entities provide a local presence to do business in lieu of the parent but would not exist at all without the parent’s support. For these types of entities, the parent currency is the functional currency.

Many companies jump immediately to the local functional decision. As you can imagine, an entity may have some characteristics of both types of entities, so FASB has provided management with a framework to evaluate each entity further. It is very common for entities to default to accepting local currency as the functional currency. We invite you to review the FASB indicators from a different perspective to determine if any of these criteria support USD functional for your entity.

Step #2: Assess 6 Economic Indicators

FASB describes six salient economic indicators in ASC 830-10-55-5. These indicators assist management in making the right functional currency decision. The guidance explains that this is a management decision as long as the decision doesn’t contradict the facts.

When assessing functional currency consider the indicators from this fresh perspective:

#1 Cash Flow: 

• Does the cash flow of the subsidiary impact the parent’s cash flows currently?
  • Yes = USD
  • No = Local Currency
• Are most of the cash flows between subsidiary and parent dividend payments?
  • Yes = Local Currency
  • No = USD

#2 Sales Price:

• Is the local sale price derived from a corporate USD list starting point or does pricing start with local market analysis?
  • USD Price List = USD
  • Local Market Analysis = Local Currency

#3 Sales Market

• Is there substantive competition from local market participants? Are there many active buyers and sellers
  • Yes = Local Currency
  • No = USD

#4 Expenses

• Are the key costs (manufacturing/R&D/cost of sales) for the product/services in the local currency?
  • Yes = Local Currency
  • No = USD
• Are corporate strategy, marketing and legal managed centrally from the parent?
  • Yes = USD
  • No = Local Currency

#5 Financing 

• Does or would the entity borrow locally from local financial institutions to meet working capital requirements? Do or could they borrow without parent guarantee?
  • Yes = Local Currency
  • No = USD

#6 Intercompany Relationships 

• Are the third party transactions of the subsidiary mirrored by intercompany activity (or, do third party sales and/or purchases impact intercompany activity)?
  • Yes = USD
  • No = Local Currency

We invite you to consider these approaches to the FASB’s six economic indicators.

The indicators, especially when considered in the above light, may result in a split decision. So, the next task is to weight the importance of each indicator in terms of your operations.

For example, the local entity may not need to borrow funds — therefore, the financing indicator would carry less weight compared to others. Product margins may be very high, making the sales indicator more relevant than the expense indicator.

This may seem like an easy exercise without too many ramifications, but determining the correct functional currency can be one of the most significant decisions a corporation can make in regards to managing currency risk.

Some companies have been stymied in effectively managing currency risk into USD by a combination of functional currency and tax structure decisions. Changing functional currency is generally not permitted unless there is a material change in facts and circumstances impacting the indicators, so a decision made today can have lasting effects.

Contact Hedge Trackers consulting for more reasons why the functional currency decision is so impactful — and what can be done to get it right.