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6.3 Accounting for a foreign entity in a highly inflationary economy
Publication date: 31 May 2022
us Foreign currency guide
As discussed in ASC 830-10-45-11, once a reporting entity determines that it has a foreign entity operating in a highly inflationary economy, the reporting currency should be considered the foreign entity’s functional currency on a prospective basis. To the extent that the foreign entity’s books and records are not maintained in its new functional currency, remeasurement into the functional currency is required.
Excerpt from ASC 830-10-45-11
The financial statements of a foreign entity in a highly inflationary economy shall be remeasured as if the functional currency were the reporting currency.
Because of the wording in ASC 830-10-45-11, many US preparers assume that the functional currency of a foreign entity operating in a highly inflationary economy must always be the US dollar. As discussed in FX 1.2, ASC 830 has a US dollar bias that reflects the simplistic structure of multinational companies that existed at the time of its issuance. As a result, some preparers instead interpret ASC 830-10-45-11 to mean that the functional currency of a foreign entity operating in a highly inflationary economy should be changed to the reporting currency of its most immediate parent, which is also likely the immediate parent’s functional currency. We believe that this “bottom up” approach (i.e., looking to the most immediate parent) is more representationally faithful to the conceptual underpinnings of ASC 830 and consolidation theory. However, we recognize that practice with respect to this issue is mixed. For the purpose of this chapter, “parent’s currency,” as used in this context, will be that of the immediate parent.
Question FX 6-2
Should a foreign entity located in a highly inflationary economy apply the guidance for foreign entities in highly inflationary economies in ASC 830-10-45-11 if its functional currency is not the local currency?
Should a foreign entity located in a highly inflationary economy apply the guidance for foreign entities in highly inflationary economies in ASC 830-10-45-11 if its functional currency is not the local currency?
PwC response
No. If a foreign entity has determined that its functional currency is something other than the local currency of the country in which it is located, it would not be considered to be operating in a highly inflationary economy.
6.3.1 Change in functional currency from a foreign currency to the parent's currency
When accounting for a change in functional currency resulting from a highly inflationary determination, the new accounting basis of monetary and nonmonetary assets and liabilities should be the last translated balances prior to the designation as highly inflationary. Equity accounts should be measured at the historical exchange rate in effect when the balances were established. For example, the exchange rate in effect when common stock was issued should be used to measure the common stock outstanding. Retained earnings will reflect an aggregation of the translated amounts of prior and current period undistributed net income. The balance recorded in the cumulative translation adjustment account, which was created from the translation process in prior periods, is not reversed when a foreign entity changes its functional currency because it is operating in a highly inflationary economy.
Example FX 6-1 illustrates the accounting for a change in the functional currency of a foreign entity from the local currency to its parent’s reporting currency.
EXAMPLE FX 6-1
Change in functional currency as a result of operating in a highly inflationary economy
Change in functional currency as a result of operating in a highly inflationary economy
USA Corp has the following organizational structure:
Effective 1/1/20X2, USA Corp deemed Argentina to be a highly inflationary economy. Therefore, Iguazu Inc changed its functional currency from the Argentine peso (ARS), the local currency, to the US dollar (USD), the reporting currency of its immediate parent (USA Corp).
The exchange rate on 12/31/20X1 was USD 1 = ARS 800.
Iguazu Inc has a US dollar denominated loan of USD 1,000 from USA Corp which is recorded in the Iguazu Inc financial statements prepared in Argentine pesos at ARS 800,000.
All other balances and transactions are denominated in Argentine pesos.
How should the Iguazu Inc account balances that will be used for consolidation purposes be determined when Argentina is deemed to be a highly inflationary economy?
Analysis
At transition, all accounts should be recorded in Iguazu Inc’s financial statements at the prior period translated balances in USA Corp’s financial statements. The prior period translated balances were calculated using the exchange rates listed in the following table.
Account type |
Exchange rate type |
Exchange rate |
Monetary assets and liabilities
|
Current exchange rate
|
USD 1 = ARS 800
|
Nonmonetary assets and liabilities
|
Current exchange rate
|
USD 1 = ARS 800
|
Common stock and APIC
|
Aggregated balance based on the exchange rate in effect at the date common stock was issued
|
USD 1 = ARS 500
|
Retained earnings
|
Calculated rate based on an aggregation of the translated amounts of prior and current period undistributed net income
|
USD = ARS 625
|
The following table shows: (1) prior period Iguazu Inc balances, (2) prior period translated balances at USA Corp, and (3) Iguazu Inc balances upon transition to the US dollar.
Account |
Prior period balance (Iguazu Inc) |
Exchange rate |
Prior period translated balance (USA Corp) |
Balance upon adoption of USD as functional currency (Iguazu Inc) |
|
Cash |
ARS 310,000 |
USD 1 = ARS 800 |
USD 388 |
USD 388 |
|
Accounts receivable |
ARS 720,000 |
USD 1 = ARS 800 |
USD 900 |
USD 900 |
|
Inventory |
ARS 640,000 |
USD 1 = ARS 800 |
USD 800 |
USD 800 |
|
Fixed assets |
ARS 1,000,000 |
USD 1 = ARS 800 |
USD 1,250 |
USD 1,250 |
|
Total assets |
ARS 2,670,000 |
USD 3,338 |
USD 3,338 |
||
Accounts payable |
ARS 400,000 |
USD 1 = ARS 800 |
USD 500 |
USD 500 |
|
Accrued expenses |
ARS 100,000 |
USD 1 = ARS 800 |
USD 125 |
USD 125 |
|
Loan from USA Corp |
ARS 800,000 |
USD 1 = ARS 800 |
USD 1,000 |
USD 1,000 |
|
Total liabilities |
ARS 1,300,000 |
USD 1,625 |
USD 1,625 |
||
Common stock |
ARS 100,000 |
USD 1 = ARS 500 |
USD 200 |
USD 200 |
|
APIC |
ARS 420,000 |
USD 1 = ARS 500 |
USD 840 |
USD 840 |
|
Cumulative translation adjustment (CTA) |
(USD 687) |
(USD 687) |
|||
Retained earnings |
ARS 850,000 |
USD 1 = ARS 625 |
USD 1,360 |
USD 1,360 |
|
Total shareholder’s equity |
ARS 1,370,000 |
USD 1,713 |
USD 1,713 |
||
Total liabilities and equity |
ARS 2,670,000 |
USD 3,338 |
USD 3,338 |
Note that in this example, CTA resides at the parent level, but is shown here for illustrative purposes. In Iguazu Inc’s stand-alone financial statements, this balance would be part of retained earnings. This amount represents the difference between translating the ARS balances for common stock, APIC, and retained earnings at the historical exchange rates indicated, compared to translating these same ARS balances at the current rate.
6.3.2 Financial statement remeasurement
Even when a foreign entity’s functional currency is changed for consolidation purposes, it will typically continue to transact in the local currency and maintain its financial records in the local currency (i.e., the general ledger balances remain in the local currency).
Excerpt from ASC 830-10-45-17
If an entity’s books of record are not maintained in its functional currency, remeasurement into the functional currency is required. That remeasurement is required before translation into the reporting currency.
Based on the guidance in ASC 830-10-45-18, nonmonetary assets and liabilities and the related expenses (e.g., depreciation) should be remeasured at historical exchange rates. Monetary assets and liabilities denominated in a currency other than the new functional currency should be remeasured using current exchange rates. The resulting gains and losses on these monetary assets and liabilities should be reported in net income. Any transaction gains and losses recognized by the foreign entity in its local currency books and records related to monetary assets and liabilities denominated in its new functional currency (or other currencies) should be reversed (or adjusted) in the remeasurement process.
When the immediate parent of the foreign entity is the reporting entity (i.e., the foreign entity is a first-tier entity), only remeasurement into the functional currency is required. It is not necessary to translate the financial statements because they are already in the parent’s reporting currency. However, if the foreign entity is a second-tier entity (or lower), the financial statements should first be remeasured into the functional currency of the immediate parent and then translated into the currency of the next highest entity, or the reporting entity, whichever comes next in the organizational structure of the reporting entity.
Example FX 6-2 illustrates the remeasurement of financial statements when an entity maintains its books and records in a currency other than its functional currency.
EXAMPLE FX 6-2
Remeasurement of financial statements when books and records are maintained in a currency other than the functional currency
This example is a continuation of Example FX 6-1. Iguazu Inc continues to maintain its books and records in the local currency, Argentine pesos.
At the end of the period following Iguazu Inc’s adoption of the US dollar as its functional currency, the spot exchange rate is USD 1 = ARS 900. In addition, Iguazu Inc:
- Did not produce any additional inventory; therefore, inventory sold during the period was recorded at the exchange rate in effect at the date Iguazu Inc transitioned to a functional currency of US dollars (USD 1 = ARS 800).
- Did not have any changes in the balance of its USD 1,000 loan from USA Corp. The loan is recorded on the Iguazu Inc balance sheet (prepared in Argentine pesos) at ARS 900,000 (USD 1,000 at the period end exchange rate of USD 1 = ARS 900).
- Did not have any fixed asset additions during the period. Depreciation expense was ARS 100,000 and was recognized in the USD income statement using the exchange rate upon adoption of highly inflationary accounting.
How should Iguazu Inc remeasure its financial statements into US dollars for the period ended 12/31/X2?
Analysis
- Monetary account balances should be remeasured at the current exchange rate (USD 1 = ARS 900).
- Nonmonetary accounts should be measured using the historical exchange rate, which is the rate that was in place when the new accounting basis was established at the time Argentina’s economy became highly inflationary (USD 1 = ARS 800). The income tax expense impact created by using the historical rate instead of the average rate for purposes of preparing the USD financial statements has been ignored.
- Equity accounts, with the exception of retained earnings, should be measured at the historical exchange rate in effect when the balances were established (e.g., when common stock was issued).
- The retained earnings generated prior to the point of changing the functional currency should be calculated based on an aggregation of the translated amounts of prior and current period undistributed net income. Retained earnings generated after changing the functional currency will not need to be remeasured.
- The income statement was remeasured using the average rate for the period (USD 1 =ARS 870) with the exception of those accounts that relate to nonmonetary assets or liabilities (cost of goods sold, depreciation expense) which should be recorded at the exchange rate in effect when the asset or liability was established. In this example, no inventory was produced and no fixed assets were acquired in the current period; therefore, these expenses are recorded at the exchange rate in effect when Iguazu Inc adopted USD as its functional currency (USD 1 = ARS 800).
- The foreign currency gain or loss recorded in Iguazu Inc’s Argentine peso income statement is calculated by comparing the change in the balance of the USD denominated loan from the beginning of the period (ARS 800,000) to the end of the period (ARS 900,000). This loss will be reversed in the remeasurement process to create the USD functional financial statements because the loan is denominated in USD. The $103 transaction loss recorded in the USD income statement is created by the ARS denominated net monetary asset which was ARS 530,000 at the beginning of the year and increased by ARS 766,880 during the year. The $103 transaction loss can be recomputed as follows. The income tax expense impact related to these foreign currency losses has been ignored in the USD financial statements.
(ARS 530,000/900) – (ARS 530,000/800) = |
($74) |
|||
(ARS 766,880/900) – (ARS 766,880/870) = |
($29) |
|||
($103) |
Iguazu Inc balance sheet
Account |
ARS balance at 12/31/X2 |
Exchange rate |
USD balance at 12/31/X2 |
Cash |
ARS 474,800 |
USD 1 = ARS 900 |
USD 528 |
Accounts receivable |
ARS 1,000,000 |
USD 1 = ARS 900 |
USD 1,111 |
Inventory |
ARS 340,000 |
USD 1 = ARS 800 |
USD 425 |
Fixed assets |
ARS 900,000 |
USD 1 = ARS 800 |
USD 1,125 |
Total assets |
ARS 2,714,800 |
USD 3,189 |
|
Accounts payable |
ARS 100,000 |
USD 1 = ARS 900 |
USD 111 |
Accrued expenses |
ARS 77,920 |
USD 1 = ARS 900 |
USD 87 |
Loan from USA Corp |
ARS 900,000 |
USD 1 = ARS 900 |
USD 1,000 |
Total liabilities |
ARS 1,077,920 |
USD 1,198 |
|
Common stock |
ARS 100,000 |
USD 1 = ARS 500 |
USD 200 |
APIC |
ARS 420,000 |
USD 1 = ARS 500 |
USD 840 |
Cumulative translation adjustment (CTA) |
(USD 687) |
||
Retained earnings |
ARS 1,116,880 |
USD 1,638 |
|
Total shareholder’s equity |
ARS 1,636,880 |
USD 1,991 |
|
Total liabilities and equity |
ARS 2,714,800 |
USD 3,189 |
Iguazu Inc income statement
Account |
ARS amount for period |
Exchange rate |
USD amount for period |
Revenue |
ARS 1,000,000 |
USD 1= ARS 870 |
USD 1,149 |
Cost of goods sold |
ARS 300,000 |
USD 1= ARS 800 |
USD 375 |
Expenses: |
|||
General and administrative |
ARS 3,000 |
USD 1= ARS 870 |
USD 3 |
Depreciation |
ARS 100,000 |
USD 1= ARS 800 |
USD 125 |
Interest |
ARS 52,200 |
USD 1= ARS 870 |
USD 60 |
Total expenses |
ARS 455,200 |
USD 563 |
|
Foreign currency transaction gain or (loss) |
(ARS 100,000) |
(USD 103) |
|
Income before taxes |
ARS 444,800 |
USD 483 |
|
Income taxes |
ARS 177,920 |
USD 1= ARS 870 |
USD 205 |
Net income |
ARS 266,880 |
USD 278 |
6.3.3 Remeasuring when multiple exchange rates exist
When a foreign entity has a monetary asset or liability denominated in its parent’s reporting currency, the existence of multiple exchange rates prior to a highly inflationary determination can produce differences between the parent translated balance and the items’ underlying denominated values. This can occur when different rates are used to measure the monetary asset or liability in the foreign entity’s functional currency from those used to translate the balance back to the reporting currency.
As discussed in FX 6.3.1, when a foreign entity changes its functional currency due to its local economy being deemed highly inflationary, the “as translated” balances in the financial statements of its parent at the end of the prior period become the accounting basis for the foreign entity’s assets and liabilities. If there is a difference between a foreign entity’s balance and the translated balance in its parent’s financial statements, ASC 830-30-S99-1 states that the difference should be recognized in net income.
Excerpt from ASC 830-30-S99-1
Impact of Highly Inflationary Accounting on Differences between Amounts Recorded for Financial Reporting Purposes versus the Underlying U.S. Dollar Denominated Values
Accordingly, upon the application of highly inflationary accounting requirements, a U.S. reporting currency parent and subsidiary effectively utilize the same currency (U.S. dollars) and accordingly there should no longer be any differences between the amounts reported for financial reporting purposes and the amount of any underlying U.S. dollar denominated values that are held by the subsidiary. Therefore, the staff believes that any differences that may have existed prior to applying highly inflationary accounting requirements between the reported balances for financial reporting and the U.S. dollar denominated balances should be recognized in the income statement, unless the registrant can document that the difference was previously recognized as a cumulative translation adjustment (in which case the difference should be recognized as an adjustment to the cumulative translation adjustment).
Furthermore, the staff believes that these differences should be recognized at the time of adoption of highly inflationary accounting.
In our experience, there are very limited circumstances where the difference between the “as translated” balance and the actual US dollar balance can be adequately documented as having been previously recognized through the cumulative translation adjustment. As such, in most cases this difference would be recognized in the income statement when the foreign entity changes its functional currency.
See FX 5.5.3 for additional information on multiple exchange rates and FX 7.6 for information on the effect of multiple exchange rates on intercompany transactions.
Example FX 6-3 illustrates the timing of the recognition of gains and losses in the income statement under the application of highly inflationary accounting, when those gains and losses were not previously recognized as a cumulative translation adjustment.
EXAMPLE FX 6-3
Venezuelan foreign entity that holds US dollars
USA Corp is a US multinational company with a wholly-owned subsidiary in Venezuela, VZ Inc. USA Corp’s functional and reporting currency is the US dollar (USD). VZ Inc’s functional currency prior to transition to highly inflationary accounting is the Venezuelan bolivar (BSF).
Effective February 1, 20X2, USA Corp deemed Venezuela to be a highly inflationary economy, and as a result, VZ Inc changed its functional currency from BSF to USD. Based on its facts and circumstances, USA Corp believes it should continue to use the official rate to translate the financial statement of VZ Inc on December 31, 20X1.
VZ Inc had previously exchanged excess BSF cash into USD in a US bank account using a parallel exchange rate that was higher than the official exchange rate at the time. Because VZ Inc had the intent and the ability to convert the USD cash back into BSF at the parallel market exchange rate, prior to commencement of highly inflationary accounting, the parallel exchange rate was used to remeasure the USD cash balance in VZ Inc’s BSF financial statements. The remeasured balance was then translated into USD using the official rate. This mechanical process created an “as translated” balance of USD cash that was in excess of the cash balance in the subsidiary’s bank account, as shown below.
USD held by VZ Inc |
USD 1,000,000 |
||
Parallel rate |
5 BSF = 1USD |
||
BSF as converted |
BSF 5,000,000 |
||
Official rate |
2.15 BSF = 1 USD |
||
USD in consolidation (as translated) |
USD 2,326,000 |
What is VZ Inc’s USD cash balance upon adopting the USD as its functional currency under highly inflationary accounting?
Analysis
Typically, the “as translated” balance of USD cash (USD 2,326,000) would become VZ Inc’s accounting basis of its USD 1,000,000 cash on a prospective basis. However, at the time highly inflationary accounting is adopted and the functional currency is changed to USD, USA Corp would be required to recognize the difference between the “as translated” balance and the actual USD balance in the income statement. Since this difference (USD 1,326,000) was not previously recognized as a cumulative translation adjustment, the adjustment should be recognized in the income statement.
6.3.4 Effect on deferred tax benefits
ASC 830-10-45-16 provides guidance related to the recognition of deferred tax benefits when a foreign entity in a highly inflationary economy adopts the reporting currency of its parent as its functional currency.
When the functional currency is the reporting currency, paragraph 740-10-25-3(f) prohibits recognition of deferred tax benefits that result from indexing for tax purposes assets and liabilities that are remeasured into the reporting currency using historical exchange rates. Thus, deferred tax benefits attributable to any such indexing that occurs after the change in functional currency to the reporting currency shall be recognized when realized on the tax return and not before. Deferred tax benefits that were recognized for indexing before the change in functional currency to the reporting currency are eliminated when the related indexed amounts are realized as deductions for tax purposes.
For more information, see TX 3.6.1.
6.3.5 CTA balances that existed prior to highly inflationary accounting
The highly inflationary guidance in ASC 830 should be applied prospectively. Prior period translation adjustments associated with a foreign entity in a highly inflationary economy should not be reversed from the parent company’s CTA account upon commencement of highly inflationary accounting. Absent a derecognition event as described in FX 8, once a foreign entity in a highly inflationary economy changes its functional currency, there should be no changes to the historical CTA.
PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
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