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3.3 Change in functional currency
Publication date: 31 May 2022
us Foreign currency guide
Functional currency is a matter of fact, not a policy election. As discussed in ASC 830-10-45-7, once the functional currency is determined, a subsequent change can be made only if it is justified by significant changes in facts and circumstances; thus, changes in functional currency are rare.
Once the functional currency for a foreign entity is determined, that determination shall be used consistently unless significant changes in economic facts and circumstances indicate clearly that the functional currency has changed. Previously issued financial statements shall not be restated for any change in the functional currency.
As discussed in FX 2.3.1, the determination of distinct and separable operations is not static. Management should periodically reassess its operations to determine if its previous conclusions are still valid. Similarly, management should consider whether changes in its distinct and separable operations warrant a change in functional currency.
ASC 830 does not provide guidance on what would represent sufficient changes in facts and circumstances to indicate that the functional currency of a distinct and separable operation has changed. Generally, a change is warranted only when an operation encounters a significant and permanent change to its operating paradigm.
A change could result from a discrete event, such as an acquisition or reorganization of a reporting entity, or it could occur over time. For example, a foreign operation may initially be determined to have the same functional currency as its parent because it is a direct and integral extension of its parent; however, over time it may evolve into a self-contained distinct and separable operation that should identify its functional currency based on its own operations. When a change occurs over time, management should carefully assess the facts to determine not only whether a significant change has occurred, but also when the change occurred. Management should consider disclosing the potential for a change in functional currency when a change is expected to occur over time. Changes in the currency of transactions with third parties are a stronger indicator that a change in functional currency has occurred than changes in the currency of intercompany transactions.
Management should periodically reassess its distinct and separable operations to determine if a change in functional currency has occurred or if new distinct and separable operations have developed, placing more emphasis on the entity’s long-term, rather than short-term economic indicators.
See FX 6 for information on a change in an entity’s functional currency when an economy becomes, or ceases to be, highly inflationary.
Example FX 3-5 illustrates how to determine if a change in functional currency is warranted.
EXAMPLE FX 3-5
Change from an extension of the parent to an autonomous entity
Change from an extension of the parent to an autonomous entity
USA Corp is a US registrant that uses the US dollar as its reporting currency.
In September 20X1, USA Corp establishes a wholly-owned subsidiary, Turkish Inc, located in Turkey. Turkish Inc serves as the sales arm of USA Corp in Eastern Europe. Products are designed and produced by USA Corp and shipped directly to customers identified by Turkish Inc. USA Corp funds the expenses of Turkish Inc on a monthly basis. USA Corp management concludes that Turkish Inc is an extension of the operations of USA Corp and that the functional currency of Turkish Inc is USD, the functional currency of its parent, USA Corp.
In 20X3, Turkish Inc completes construction of a manufacturing facility, which is intended to produce products designed solely for the European markets. Turkish Inc will continue to import products from USA Corp, but will now take ownership of this inventory pursuant to an at-market transfer pricing agreement. Turkish Inc also hired numerous executives responsible for general management of the European market.
Should Turkish Inc reassess its functional currency?
Analysis
Yes. Turkish Inc should reassess its functional currency because it has migrated from an entity that was fully integrated with its parent to an autonomous entity that is now considered a distinct and separable operation.
EXAMPLE FX 3-6
Change in functional currency as result of business expansion over time
Change in functional currency as result of business expansion over time
USA Corp is a US registrant that uses the US dollar as its reporting currency.
In March 20X1, USA Corp establishes a wholly-owned subsidiary, Royalty Inc, located in the United Kingdom. Royalty Inc designs and produces products similar to those sold by USA Corp, but are adapted to customer tastes in the United Kingdom. Royalty Inc ships directly to customers in the United Kingdom.
USA Corp establishes this subsidiary to conduct all business in the United Kingdom and hires an executive team to ensure success. Royalty Inc is determined to be a distinct and separable foreign operation. All of Royalty Inc’s sales and the predominance of its costs are denominated in GBP at inception and are expected to remain that way long-term. As a result, USA Corp management concludes that the functional currency of Royalty Inc is GBP.
In 20X3, Royalty Inc launches an extension of its original product line that was not anticipated in March 20X1. This extension generates significant demand in Spain, Portugal, Italy, and other parts of Europe. As such, Royalty Inc sales transactions with third parties transition from being all in GBP to 75% in EUR and 25% in GBP. Royalty Inc expects its EUR sales to continue to increase. Should Royalty Inc reassess its functional currency?
Analysis
Royalty Inc should reassess its functional currency because the unexpected extension of the original product line may represent a significant change in facts and circumstances. Because changes in functional currency are expected to be rare, in performing its functional currency evaluation, Royalty Inc must have significant confidence that the change in facts and circumstances are expected to be other than temporary. As a result, the timing of any change in functional currency will require significant judgment.
3.3.1 Accounting for a change in functional currency
The accounting for a change in functional currency depends on the currency it is changing from and the currency it is changing to. The table below summarizes the accounting treatment for the various types of changes. In this discussion, we have assumed that the immediate parent of the foreign operation is the consolidated reporting entity (i.e., the foreign operation is a first-tier entity). If the foreign operation is a second-tier entity (or lower), the “reporting currency” would be the currency of its immediate parent, not the currency of the consolidated reporting entity.
All changes in functional currency are accounted for currently and prospectively from the date of the change. Since the exact date a change in functional currency occurred may be hard to determine, it is often recognized at the beginning of the reporting period that approximates the date of the change. As discussed in ASC 830-10-45-7, previously released financial information should not be restated for a change in functional currency.
Figure FX 3-1 summarizes the accounting for a change in functional currency at the consolidated level.
Figure FX 3-1
Accounting for a change in functional currency at the consolidated level
Accounting for a change in functional currency at the consolidated level
Change |
Accounting summary |
From the currency of the reporting entity to a local currency
|
Nonmonetary assets and liabilities, as stated in the local currency (i.e., the new functional currency), are translated using the exchange rate in effect at the date of the change. The difference between the consolidated historical carrying values (which would have been a function of the exchange rate that existed when the assets or liabilities arose), and the new translated values using the current exchange rate, is recorded to the cumulative translation adjustment (CTA) account.
Monetary assets and liabilities not denominated in the reporting currency are translated at the current exchange rate at the date of the change. This process will produce the same carrying values produced from the measurement process that was performed prior to changing the functional currency. To the extent that the distinct and separable operation has monetary assets and liabilities denominated in the reporting currency, such balances will create transaction gains and losses subsequent to the change in functional currency.
|
From a local currency to the currency of the reporting entity (including changes due to a highly inflationary economy)
|
The translated balances of monetary and nonmonetary assets and liabilities recorded in the reporting entity’s consolidated financial statements as of the end of the prior reporting period become the new accounting basis for those assets and liabilities in the period of the change. To the extent that the distinct and separable operation has monetary assets and liabilities denominated in the old functional currency, such balances will create transaction gains and losses subsequent to the change in functional currency.
The balance recorded in the CTA account for prior periods is not reversed upon the change in functional currency.
|
From a local currency to a new local currency
|
Nonmonetary assets and liabilities should be remeasured into the new functional currency, using the exchange rate on the date the asset or liability arose. These amounts should then be translated into the reporting entity’s reporting currency based on current exchange rates. The difference between this amount and the prior translated balance should be recorded in CTA.
Monetary assets and liabilities not denominated in the new local currency should be remeasured into the new functional currency, based on the exchange rate at the date of the change in functional currency. These amounts should then be translated into the reporting entity’s reporting currency based on current exchange rates. To the extent that the distinct and separable operation has monetary assets and liabilities not denominated in the new local currency, such balances will create transaction gains and losses subsequent to the change in functional currency.
The balance recorded in the CTA account for prior periods is not reversed upon the change in functional currency.
|
See FX 6 for information on a change in functional currency due to an economy becoming, or ceasing to be, highly inflationary.
3.3.1.1 Change from the reporting currency of the reporting entity to a foreign currency
When the functional currency of a distinct and separable operation changes from the reporting currency of the reporting entity to a local currency, the foreign operation should record its account balances in its new functional currency and then translate those balances into the reporting currency. See FX 4.4.1 for a discussion of nonmonetary and monetary assets and liabilities.
Even when a foreign operation has a functional currency that is the same as the reporting entity’s reporting currency, it will often maintain its books and records in its local currency. As such, local currency balances are generally available. Upon a change in functional currency, these local currency balances should be translated into the reporting entity’s reporting currency using current exchange rates; the difference between (1) the translated value using the current exchange rate, and (2) the historical values (in the reporting currency) should be recognized as an adjustment to the cumulative translation adjustment account. By measuring nonmonetary items in this manner, the foreign operation is accounting for the items as if the new functional currency had always been its functional currency.
Monetary assets and liabilities should be translated at the current exchange rate at the date of the change.
Example FX 3-7 illustrates the accounting for a change in functional currency of a foreign entity from the currency of the reporting entity to a foreign currency.
EXAMPLE FX 3-7
Change in functional currency – currency of the reporting entity to a foreign currency
USA Corp has the following organizational structure.
USA Corp is a US registrant that uses the US dollar as its reporting currency.
Britannia PLC is a wholly-owned operating subsidiary of USA Corp located in the United Kingdom. The functional currency of Britannia PLC was initially determined to be the US dollar. Due to significant changes in facts and circumstances, in January 20X4, management determined that the functional currency of Britannia PLC should be changed to British pound sterling (GBP).
Consider these facts about a fixed asset purchase by Britannia PLC:
Fixed assets were purchased for GBP 500,000 on January 1, 20X1 when the exchange rate was GBP 1 = USD 1.3. The fixed assets were recorded in the US dollar financial statements of Britannia PLC at USD 650,000.
GBP purchase price |
Exchange rate |
USD balance |
GBP 500,000
|
GBP 1 = USD 1.3
|
USD 650,000
|
The fixed assets had a useful life of five years. Annual depreciation is USD 130,000.
On December 31, 20X3, the functional currency net book value of the fixed assets was USD 260,000 (the fixed assets measured at the historical exchange rate less three years of depreciation expense [USD 650,000 – 3 x USD 130,000 = USD 260,000]).
The exchange rate on January 1, 20X4 is GBP 1 = USD 1.5.
How should Britannia PLC measure the carrying value of the fixed assets when it changes its functional currency from US dollars to British pound sterling?
Analysis
When the functional currency changes, Britannia PLC should measure the fixed assets using the historical exchange rate in effect at the date the fixed assets were purchased.
USD balance |
Exchange rate |
GBP balance |
USD 260,000
|
GBP 1 = USD 1.3
|
GBP 200,000
|
In addition, the difference between the carrying value of the fixed assets calculated using the historical exchange rate, and the carrying value of the fixed assets calculated using the current exchange rate is recorded to the CTA account.
GBP balance |
Exchange rate |
USD balance |
GBP 200,000
|
GBP 1 = USD 1.3
|
USD 260,000
|
GBP 200,000
|
GBP 1 = USD 1.5
|
USD 300,000
|
The adjustment recorded to the CTA account is a credit of USD 40,000 (USD 300,000 – USD 260,000).
3.3.2 Change in functional currency-other considerations
The SEC staff has stated in their Division of Corporation Finance: Frequently Requested Accounting and Financial Reporting Interpretations and Guidance, dated March 31, 2001, that registrants with foreign operations in economies that have recently experienced economic turmoil should evaluate whether significant changes in economic facts and circumstances have occurred that warrant reconsideration of their functional currencies. Reconsideration of the functional currency is also required when the economy in which a foreign operation is located ceases to be highly inflationary.
The SEC staff would expect a registrant's analysis to focus on factors that affect the specific foreign operation's cash flows. For example, problems in an Asian economy could cause local currency cash flow sources to severely diminish (on an other than short-term basis) for a self-contained foreign operation and clearly indicate a different functional currency. Conversely, these problems generally would not indicate a change in functional currency for a foreign operation that is an integral component or extension of the parent company's operations. The SEC staff generally will be skeptical that currency exchange rate fluctuations alone would cause a self-contained foreign operation to become an extension of the parent company. Remeasurement of assets and results using the registrant's reporting currency in lieu of determining the functional currency is appropriate only when the foreign operations are in a highly inflationary economy as defined by ASC 830-10-45-11.
The SEC staff has also indicated that ASC 830 does not prescribe specific disclosures about a change in functional currency. However, the SEC staff believes that disclosures in the financial statements and MD&A may be necessary to permit an investor to understand the foreign operations and their impact on the registrant's results of operations, liquidity, and cash flows. Registrants should consider the need to disclose the nature and timing of the change, the actual and reasonably likely effects of the change, and the economic facts and circumstances that led management to conclude that the change was appropriate. The effects of those underlying economic facts and circumstances on the registrant's business should also be discussed in MD&A.
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