There are guidelines to determine the functional currency of a foreign operation. The ‘‘benchmarks’’ apply to selling price, market, cash flow, financing, expense, and inter-company transactions. A detailed discussion follows:
Selling price – The functional currency is the foreign currency when the foreign operation’s selling price of products or services arises primarily from local factors such as government law. It is not caused by changes in exchange rate. The functional currency is the parent’s currency when foreign operation’s sales prices apply in the short run to fluctuation in the exchange rate emanating from international factors (e.g., worldwide competition).
Market – The functional currency is the foreign currency when the foreign activity has a strong local sales market for products or services even though a significant amount of exports may exist. The functional currency is the parent’s currency when the foreign operation’s sales market is mostly in the parent’s country.
Cash flow – The functional currency is the foreign currency when the foreign operation’s cash flows are predominately in foreign currency not directly impacting the parent’s cash flow. The functional currency is the parent’s currency when the foreign operation’s cash flows affect the parent’s cash flows. They are typically available for remittance via inter-company accounting settlement.
Financing – The functional currency is the foreign currency if financing the foreign activity is in foreign currency and funds obtained by the foreign activity are adequate to satisfy debt payments. The functional currency is the parent’s currency when financing foreign activity is provided by the parent or occurs in U.S. dollars. The funds obtained by the foreign activity are inadequate to meet debt requirements.
Expenses – The functional currency is the foreign currency when a foreign operation’s production costs or services are usually incurred locally. However, there may be some foreign imports. The functional currency is the parent’s currency when a foreign operation’s production and service costs are mostly component costs obtained from the parent’s country.
Inter-company transactions – The functional currency is the foreign currency when minor interrelationships exist between the activities of the foreign entity and parent except for competitive advantages (e.g., patents). There are a few inter-company transactions. The functional currency is the parent’s currency when significant interrelationships exist between the foreign entity and parent. There are many inter-company transactions.
Consistent use should be made of the functional currency of the foreign entity over the years unless a significant change in circumstances takes place. If a change in the functional currency occurs, it is treated as a change in estimate.
Local currency – The currency of the foreign country.
Measure – A translation into a currency other than the original reporting currency. The foreign financial statements are measured in U.S. dollars by using the appropriate exchange rate.
Reporting currency – The currency in which the business prepares its financial statements is typically U.S. dollars.
Spot rate – The exchange rate for immediate delivery of currencies exchanged.
Transaction gain or loss – Transaction gains or losses arise from a change in exchange rates between the functional currency and the currency in which a foreign currency transaction is denominated. They represent an increase or decrease in (a) the actual functional currency cash flows realized upon settlement of foreign currency transactions and (b) the expected functional currency cash flows on unsettled foreign currency transactions.
Translation adjustments – Translation adjustments arise from translating financial statements from the entity’s functional currency into the reporting one.
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