Question

The proper analysis of foreign operations by financial statement users requires that financial statements of the foreign operations be expressed in a common currency. For a U.S. company with a French subsidiary, this means converting the subsidiary’s financial statements from Euros to U.S. dollars. One of the major issues in translating the financial statements of a foreign branch, division, or subsidiary is determining the functional currency of the foreign entity. The term “functional currency” has been defined by the Financial Accounting Standards Boards (FASB) as the currency of the primary economic environment in which the entity operates; normally, the currency of the environment in which the entity primarily generates and expends cash. Although the definition may seem relatively straightforward, the Financial Accounting Standards Board found it necessary to list various factors to guide management in determining the functional currency. Required: Identify the factors FASB identified that might be helpful in making the functional currency decision.

Answer 1

FASB listed various factors that were intended to give management guidance in making the functional currency decision.

This includes:-

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