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Foreign currency accounting – Determining functional currency · PwC's accounting podcast

0:00
SPEAKER_00: Thought Leadership from PWC's National Office.
0:06
SPEAKER_03: Hello and welcome to PWC's Accounting Podcast.
0:10
SPEAKER_03: I'm Heather Horn.
0:12
SPEAKER_03: Today we begin a new series on trending topics from one of our most popular guides, the Foreign Currency Guide.
0:19
SPEAKER_03: In today's episode, we dive into the determination of functional currency.
0:24
SPEAKER_03: This determination is made at each distinct and separable operation of the reporting entity.
0:29
SPEAKER_03: And depending on the economic environment of those operations, it can get very complicated very quickly.
0:36
SPEAKER_01: Business and companies in general are just increasingly global.
0:40
SPEAKER_01: You know, these foreign currency topics have probably affect the vast majority of our clients in some way.
0:45
SPEAKER_01: Think of it whether it's through foreign currency sales or like we're talking about today, foreign operations.
0:56
SPEAKER_03: That was Brett Julie, Deputy Chief Accountant in PWC's National Office, who leads our financial instruments team.
1:02
SPEAKER_03: Brett's joined by John Haran, a managing director, also in the national office.
1:07
SPEAKER_03: Brett and John address these and other matters with our clients every day and share that knowledge and their insights on the podcast.
1:15
SPEAKER_03: And if you stay tuned all the way until the end of the episode, you'll even hear me crack a very bad dad joke.
1:22
SPEAKER_03: Let's listen to the episode now.
1:24
SPEAKER_03: So, Brett John, so nice to have you guys back on the podcast.
1:28
SPEAKER_03: And as our listeners know, this is one of our uh podcasts in the series covering our most popular guides.
1:34
SPEAKER_03: And for our next two episodes, we're going to be covering foreign currency, which is a great topic.
1:39
SPEAKER_03: And I think, John, one, you've probably been on the podcast to discuss at least five times, maybe more than that.
1:45
SPEAKER_02: Quite a few over the years.
1:46
SPEAKER_03: Yes, quite a few over the years.
1:47
SPEAKER_03: But it's still always good to have a refresher and to kind of look at things from a new angle.
1:52
SPEAKER_03: So maybe with that backdrop, Brett, going to you first, why functional currency as one of our two topics?
2:00
SPEAKER_01: Yeah, sure, Heather.
2:01
SPEAKER_01: You know, I think the short answer to that question is that business and companies in general are just increasingly global.
2:07
SPEAKER_01: You know, these foreign currency topics have probably affect the vast majority of our clients in some way.
2:12
SPEAKER_01: Think of it whether it's through foreign currency sales or like we're talking about today, foreign operations.
2:18
SPEAKER_01: Um we're going to do a couple podcasts of these.
2:20
SPEAKER_01: And it's a complicated topic because it's sort of intertwined.
2:24
SPEAKER_01: And I think it's to understand why we're talking about functional currency, you have to have an understanding of the consolidation process at a high level.
2:32
SPEAKER_01: So each reporting period, companies obviously consolidate all their operations, both domestic and foreign, into a single set of financial statements with the objective of giving an overall snapshot of their financial health.
2:45
SPEAKER_01: So that process of consolidation starts with each legal entity remeasuring all of its monetary assets and liabilities that are denominated in other than its functional currency into its functional currency.
2:57
SPEAKER_01: So you have to start this consolidation process with the starting point at a foreign operation level.
3:03
SPEAKER_01: And then with changes in functional currency amounts are going to be reported through earnings.
3:08
SPEAKER_01: And that entity's functional currency financial statements are then translated into the reporting currency of the ultimate parent.
3:15
SPEAKER_01: So all of the operations are then shown in the context of a single currency.
3:21
SPEAKER_01: And so that's why this determination of functional currency is so important, because it has an immediate and direct impact on the consolidated financial statements through that remeasurement through earnings.
3:31
SPEAKER_01: But like I said, all of this is intertwined.
3:34
SPEAKER_01: And so we'll have another podcast talking about re-that whole remeasurement process.
3:38
SPEAKER_01: I encourage listeners to listen to this one, listen to that next one, and then come back to this because you'll understand this functional currency process once you understand this whole, the, the bigger picture of the whole remeasurement process, too.
3:52
SPEAKER_03: All right.
3:52
SPEAKER_03: So Brett, that's helpful and good background.
3:54
SPEAKER_03: And so then just at a high level at least, how do you go about figuring out what is the functional currency?
4:01
SPEAKER_01: Yeah.
4:01
SPEAKER_01: So I think there's a there's several steps to go through in doing that.
4:05
SPEAKER_01: And the first is to identify what your foreign entities are.
4:10
SPEAKER_01: And so this is one of the things we often deal with with clients and engagement teams.
4:14
SPEAKER_01: They think, well, this is easy.
4:16
SPEAKER_01: I'm talking about foreign entity.
4:17
SPEAKER_01: So I look for my legal entities that are located in a foreign location.
4:22
SPEAKER_01: But that's not what foreign entity means.
4:25
SPEAKER_01: And it's actually a defined term in ASC 830.
4:29
SPEAKER_01: And in that definition, it starts out talking about a foreign entity as an operation.
4:35
SPEAKER_01: For example, a subsidiary, division, branch, joint venture, and so forth.
4:41
SPEAKER_01: And so when you think of anchoring this to the definition of and starts with an operation, it may be a subsidiary, but it may not be.
4:50
SPEAKER_01: And we think that a foreign entity doesn't necessarily need to meet the definition of a business like we use in general accounting, but it needs to be somewhat close.
4:59
SPEAKER_01: And so we think of a consolidated operation must be distinct and separable from other from the reporting entities' other foreign operations in order to be considered a separate foreign entity.
5:11
SPEAKER_01: So this concept of distinct and separable operations, you know, think of it as operations that can be managed independently and can be separated both operationally and for financial reporting purposes from other operations.
5:25
SPEAKER_01: So you need to start with thinking about what are your distinct and separable operations.
5:31
SPEAKER_01: And a reporting entity should start by analyzing the business purpose and activities of each legal entity.
5:37
SPEAKER_01: So I do suggest that the legal entity is a starting point, but it's not going to be an ending point.
5:43
SPEAKER_01: So and begin with the lowest level of the legal structure.
5:47
SPEAKER_01: Determine whether each legal entity is a distinct and separable operation.
5:51
SPEAKER_01: And this process can often involve significant judgment.
5:56
SPEAKER_03: And then Brett, maybe before we dig more into that, just one question on the definition of a foreign entity.
6:02
SPEAKER_03: And to be clear for our listeners, even though you can't hear this, foreign entity is capital.
6:08
SPEAKER_03: So that's a defined term and gap, as Brett did say.
6:12
SPEAKER_03: But so Brett, when we're talking about either the subsidiary division, branch, et cetera, are there any other criteria we need to think about with that before we kind of jump into identifying if we have the foreign entities?
6:24
SPEAKER_01: There are.
6:26
SPEAKER_01: The financial statements for that foreign entity need to have two characteristics.
6:30
SPEAKER_01: One, they're prepared in a currency other than the reporting currency of the reporting entity.
6:35
SPEAKER_01: So you're going to have preparation in a foreign currency or different than the parent.
6:43
SPEAKER_01: And then they're combined or consolidated with, or they could be on the equity method in the financial statements of the reporting entity.
6:50
SPEAKER_01: So I think the critical thing is probably that first one.
6:53
SPEAKER_01: Because we're all we're always dealing with these consolidated statements, but you've got to think about there that you have financial statements that are prepared in a foreign currency.
7:25
SPEAKER_02: So typically that structure was a US parent with foreign operations.
7:30
SPEAKER_02: It's possible today to have, you know, US parent, foreign operation, US operation, foreign operation underneath that.
7:40
SPEAKER_02: And so we refer, it's possible that even though it's not in a currency other than the reporting currency, assuming the reporting currency is the US dollar, you still have to think about your separate and distinct operations.
7:52
SPEAKER_02: One of the reasons we use that term rather than foreign entity that may be US dollar functional that report to entities that are foreign entities that you don't have a functional currency other than the US dollar.
8:06
SPEAKER_03: And then that entity is, if that entity is reporting in other than okay.
8:11
SPEAKER_03: And so, John, to be clear, then well, two questions follow up.
8:15
SPEAKER_03: The first one I think is straightforward.
8:17
SPEAKER_03: So we talked about this US parent and then foreign, et cetera.
8:21
SPEAKER_03: If I'm a US gap reporter that is headquartered in, for example, the UK, then it would be UK parent from that point of view.
8:29
SPEAKER_03: So this we're gonna use US throughout.
8:31
SPEAKER_03: So the US is the ultimate parent, but it's equally, it's depends where you're headquartered.
8:36
SPEAKER_02: Absolutely.
8:36
SPEAKER_02: We have clients, US gap reporters that have other than you know, US dollar reporting currencies.
8:41
SPEAKER_03: Okay.
8:42
SPEAKER_03: So I think that's a key point.
8:43
SPEAKER_03: And then I guess the other point, then going back to where Brett was going, is you're saying, okay, yes, you have to make sure you meet this criteria about the financial statements, but that doesn't change the fact that you need to identify these distinct and separable operations.
8:58
SPEAKER_03: And that's really the starting point.
9:00
SPEAKER_03: And then it's almost like this is almost like a check to make sure once you've identified these.
9:05
SPEAKER_03: Is that fair?
9:06
SPEAKER_03: That's right.
9:06
SPEAKER_03: All right, John's nodding at me, but I needed that confirmation.
9:10
SPEAKER_03: So all right.
9:10
SPEAKER_03: So then Brett, let's go back.
9:12
SPEAKER_03: So, what are some of the examples as you start thinking about identifying these distinct inseparable operations?
9:19
SPEAKER_01: Yeah.
9:19
SPEAKER_01: Maybe start with by giving a few examples where you do this legal entity-based analysis and you find some that won't be considered to be foreign entities.
9:30
SPEAKER_01: I'll give you three examples.
9:32
SPEAKER_01: One is a sales office.
9:34
SPEAKER_01: Um, what's a sales office?
9:36
SPEAKER_01: A sales office can be primarily responsible for identifying potential customers and servicing those customers by educating them about products, ensuring delivery, responding to complaints, but it really just consists of a few salespersons, um, computers, and administrative staff.
9:54
SPEAKER_01: There's no real operations going on there.
9:57
SPEAKER_01: Um another example, maybe the flip of that, is just a manufacturing facility.
10:02
SPEAKER_01: Um, we often find that these are not considered to be foreign entities.
10:06
SPEAKER_01: A parent may send a host of materials, you know, a kit or raw materials to a facility in a foreign country, um, and that facility is responsible for assembling or producing the product and just shipping it back to the parent or directly to customers.
10:21
SPEAKER_01: But there's no sales, marketing, research, strategy or other, or other function, and it's just funded on a cost plus basis.
10:29
SPEAKER_03: And I guess, Brett, this is where you go to that there's can be this idea that doesn't have to be a business, but you have to have some of the characteristics.
10:38
SPEAKER_03: I guess this is where the judgment comes in, right?
10:40
SPEAKER_01: Aaron Powell I I think that's right.
10:41
SPEAKER_01: Um, it's it's probably clear in a situation where literally this foreign entity or this this foreign operation, I should say, I'm gonna catch myself, right?
10:51
SPEAKER_01: This this facility is just manufacturing.
10:53
SPEAKER_01: It receives a kit of materials and just assembles it and then sends it right back.
10:59
SPEAKER_01: They're not doing anything, they don't have any strategy, they don't have any customer facing.
11:05
SPEAKER_01: When you have a couple more of those characteristics, it may blur the lines a little bit, and that's where the I think the judgment's gonna come in.
11:12
SPEAKER_02: Aaron Powell If it for the poker players out there, if the the the tell in my mind is if an entity is cost plus, they're not generating a profit to fund their own operations, probably not a separate and distinct operation.
11:25
SPEAKER_03: All right, that's helpful.
11:26
SPEAKER_03: Any other examples then?
11:28
SPEAKER_01: The third example I give is a is a treasury center.
11:31
SPEAKER_01: So parents may op may establish a legal entity, but the sole responsibility is to manage um cash and or maybe financial risk exposures.
11:41
SPEAKER_01: Maybe that that treasury center is responsible for issuing debt and then is going to fund um other other parts of the operation.
11:48
SPEAKER_01: Again, to John's point, this these are often funded on a cost plus basis.
11:53
SPEAKER_01: And a lot of times in practice, we find that that these types of legal entities are not considered to be foreign operations themselves.
12:00
SPEAKER_03: And then I the immediate question that comes to mind before we get into some further examples and discussion, obviously business changes over time.
12:09
SPEAKER_03: And so I could picture a scenario where you start with you're just the manufacturing facility, and then you start doing procurement, and then you start doing sales, and then you start, you know, and you keep adding on.
12:21
SPEAKER_03: And so from a, and I'm sorry if I'm jumping too far ahead, but if as these changes are happening, then are you each quarter saying, okay, does this meet the definition?
12:32
SPEAKER_03: And I guess back maybe John's your point of the tell, how do you know when you've, quote, crossed the line?
12:38
SPEAKER_01: Let's talk about that in a little more detail.
12:40
SPEAKER_01: I think you're right that this is an ongoing evaluation.
12:44
SPEAKER_01: You can't, you don't set up a an entity or an operation and think you're never going to revisit it again.
12:49
SPEAKER_01: Right.
12:50
SPEAKER_01: That being said, changes in functional currency are expected to be rare.
12:54
SPEAKER_01: And so it is true that as a business evolves and as you restructure operations or entities, those are good points that you need to revisit the functional currency of it.
13:05
SPEAKER_01: But it's not necessarily something that you'd expect to see just evolving every quarter and making different decisions.
13:13
SPEAKER_01: It's you kind of take a longer-term view of what that operation is intended to do over a longer period of time.
13:19
SPEAKER_03: All right.
13:20
SPEAKER_03: This is very helpful.
13:21
SPEAKER_02: Yeah, we're going to talk about that longer term view a little bit more later, but that's exactly right.
13:25
SPEAKER_02: You know, maybe when you establish the entity, it's an extension of the parent, and then it becomes more autonomous as time goes on.
13:33
SPEAKER_02: Um, and it it it makes change.
13:35
SPEAKER_02: Sometimes that happens if there's a change in management.
13:37
SPEAKER_02: They have a different philosophy as to how run businesses, those types of things.
13:40
SPEAKER_03: So they you could change it, but it's not you're going to change it back and forth, basically, or you wouldn't expect to.
13:45
SPEAKER_03: So all right.
13:46
SPEAKER_03: So then Pratt, let's go back to, I know you were talking about sort of starting from the bottom up in the org chart, but how should we then?
13:53
SPEAKER_03: So I've gone through, you gave a few examples of things that are uh would not likely have a different functional currency, but then how do I think about all, you know, my entire org chart in this example?
14:06
SPEAKER_01: Yeah.
14:06
SPEAKER_01: So I think you have to start by accepting that you could have a couple different scenarios.
14:11
SPEAKER_01: And one is where you've got multiple legal entities but a single foreign entity for functional currency purposes.
14:18
SPEAKER_01: I just went through some examples of things that of operations that themselves may not be considered to be a foreign entity.
14:26
SPEAKER_01: Then it's possible sometimes that you have a single foreign entity for functional currency purposes that's actually made up of multiple legal entities.
14:35
SPEAKER_01: Um There are many cases where a company operates similar types of business through multiple legal entities.
14:41
SPEAKER_01: Like think of a chain restaurant operation.
14:44
SPEAKER_01: You may have an entity that has five restaurants in a single country.
14:48
SPEAKER_01: Often we see those structured as having separate legal entities for each restaurant.
14:55
SPEAKER_01: But the restaurants are managed together from product development, advertising, strategy, they're all managed together.
15:01
SPEAKER_01: And a result, your reporting entity may determine that, in my example, those five separate legal entities form together a single foreign entity for functional currency purposes.
15:13
SPEAKER_01: You can have the flip side, too, where you have one single legal entity but two separate foreign entities, because one legal entity could have separate two separate and distinct operations in them.
15:27
SPEAKER_01: And this is, you think this is very unusual in practice, but it's actually talked about in the standard.
15:32
SPEAKER_01: The standard specifically notes that you can have this situation.
15:37
SPEAKER_01: Um if you have separate operations that are conducted in very different economic environments, they could have different functional currencies.
15:45
SPEAKER_01: Let me give you an example of something we see that could potentially have two separate um foreign entities within a single legal structure.
15:54
SPEAKER_01: And it's something we see in Mexico where a U.S.
15:58
SPEAKER_01: reporting entity establishes a manufacturing facility that's located in Mexico.
16:02
SPEAKER_01: And that facility receives a kit, like I talked about before, of raw materials from the U.S.
16:07
SPEAKER_01: parent.
16:08
SPEAKER_01: It's going to assemble that product and then deliver it back to the parent for sale to customers.
16:13
SPEAKER_01: That entity is often called a maculadora in the local markets.
16:18
SPEAKER_01: And sometimes that's that same legal entity, the maculadora, has a separate business where it produces and sells products locally in Mexico as well.
16:27
SPEAKER_01: So it's possible in that case that the single legal entity could have two separate foreign entities because they're operating in separate economic environments.
16:36
SPEAKER_01: That manufacturing operation could be deemed just to be an extension of the parent because it's receiving the kit and sending it back to the U.S.
16:44
SPEAKER_01: parent.
16:45
SPEAKER_01: And the operation that's producing and selling in the local market could be considered a separate and distinct entity that's operating in the Mexican economic environment and therefore could have the peso as its functional currency.
17:00
SPEAKER_01: But the key here is that in order to justify that as having two operations as separate foreign entities, each separate foreign entity has to produce its own complete set of standalone financial statements.
17:13
SPEAKER_01: And although this is possible, in practice, we often see that the operations are somewhat intertwined still.
17:21
SPEAKER_01: They're not completely separate between this manufacturing operation and the and the sales operation.
17:28
SPEAKER_01: And so although it's possible, it's fairly infrequent in practice.
17:32
SPEAKER_01: Um, but in that case, you're then stuck with having one foreign entity with split indicators, and you're gonna have to use more judgment to identify what the functional currency of that entity is because it's gonna have multiple different operations in it, and you've got to select one functional currency.
17:50
SPEAKER_02: Yeah, but in the in the all the years I've been doing this, I've seen it a couple of times, and it's for the reason that you cited, they really don't have the ability to separate all of the assets and liabilities into two separate entities, if you will, to consolidate.
18:05
SPEAKER_02: Because they would all have to be consolidated separately if they have different functional currencies.
18:09
SPEAKER_02: Trevor Burrus, Jr.
18:09
SPEAKER_03: Right, right.
18:10
SPEAKER_03: And I guess maybe to the that point, John, before we get into understanding how this fits in with the functional currency determination, especially in that first case when Brett was talking about you could have like multiple legal entities.
18:24
SPEAKER_03: I think your example, there was like five restaurants all in one management, but that could be one single foreign entity.
18:31
SPEAKER_03: Does it matter if you treat them as one or if you treat them as five?
18:36
SPEAKER_02: You just assign them all the same functional currency.
18:39
SPEAKER_02: Usually a consolidation is done by legal structure.
18:42
SPEAKER_02: Yeah.
18:43
SPEAKER_02: But you know, it's sort of like you draw a box around the legal structure and say, oh, these five entities are a single foreign entity.
18:50
SPEAKER_02: They all have the same um functional currency.
18:53
SPEAKER_03: Okay, so it can be helpful from that point of view.
18:55
SPEAKER_03: I can see in the second scenario, well, obviously it's very important because you know it's it's going to impact the determination.
19:01
SPEAKER_03: But maybe that's a good lead-in then, because obviously the reason you are figuring out these foreign entities is to determine then if there's a different functional currency.
19:12
SPEAKER_03: So, John, can you weigh in on that?
19:14
SPEAKER_02: Yeah, absolutely.
19:15
SPEAKER_02: The the standard refers to two types of entities.
19:18
SPEAKER_02: The first are those that are an extension of the parent and those that are um self-contained.
19:25
SPEAKER_02: Self-contained.
19:26
SPEAKER_02: I'm sorry.
19:26
SPEAKER_02: Those that are self-contained.
19:28
SPEAKER_02: Um in our terminology, those that are separate and distinct.
19:31
SPEAKER_02: So uh entities that, you know, what what I always say is entities that are separate and distinct have the right to their own functional currency.
19:39
SPEAKER_02: Those entities that are not separate and distinct are the part of some other foreign entity, and the process is to figure out what foreign entity that is.
19:48
SPEAKER_02: And that's that's what Brett was talking about as you kind of go through your legal structure.
19:53
SPEAKER_02: So uh right now we're talking about entities that we're saying are separate and distinct.
19:57
SPEAKER_02: And so the standard points out um multiple indicators that we should use in order to figure out what the functional currency of that entity is.
20:07
SPEAKER_02: Sometimes the entity is fully integrated in a single country or currency, and all of their revenues, all of their expenses, um, all of their financing is done in that currency, determination of functional currency is easy in that case.
20:23
SPEAKER_02: Sometimes, you know, honestly, today, most of the time, that's not the case.
20:27
SPEAKER_02: Um and so the indicators that um the standard um focuses on is it talks about just generally cash flow indicators, and those are cash flows related to their assets and liabilities.
20:42
SPEAKER_02: But the definition of functional currency basically says the functional currency of an entity is the currency of the primary economic environment that that entity operates, operates being the key word.
20:56
SPEAKER_02: So we when we are looking at functional currency determination, even though the standard says that all of these indicators should be considered in conjunction, there's no one indicator more important than the others.
21:08
SPEAKER_02: I think when we evaluate it, we focus on the operating indicators.
21:13
SPEAKER_02: And so primarily that's the sales market, sales price, and expense indicators.
21:20
SPEAKER_02: So think about an environment, for example, the oil industry, for example.
21:25
SPEAKER_02: If let's you're in the exploration and production business in oil, most oil today is um bought and sold in US dollars.
21:34
SPEAKER_02: So typically, even if an oil, uh an exploration and production operation is in a country other than the US, often those entities are US dollar functional because all of their revenues or the primary amount of their revenues are in US dollars.
21:48
SPEAKER_02: Contrast that, and I know you know a little bit about this market, um Heather, um, to the natural gas markets tend to be more local.
21:56
SPEAKER_02: Um and so those, you know, sales.
22:00
SPEAKER_02: Sales price and sales markets tend to be determined locally.
22:03
SPEAKER_02: And so therefore the driver in in a natural gas market would be a local sales price as opposed to outside of that.
22:13
SPEAKER_03: So, John, before you go on though, so let's go back to your oil entity.
22:17
SPEAKER_03: So its sales are in US dollars, but if it's located outside of the US, then its expenses likely are in the local currency.
22:26
SPEAKER_03: And so then I guess there could be judgment, but you're saying that the in that scenario, likely if its sales are predominantly in US dollars, then you would wind up with that functional currency.
22:37
SPEAKER_02: Yeah, the way I always think about it is hopefully the company is thinking that they're going to make money, which is which means that their revenues are going to exceed their expenses.
22:46
SPEAKER_03: So then, okay.
22:47
SPEAKER_03: That's a good way.
22:48
SPEAKER_02: The predominance of uh of their operating cash flows are in US dollars.
22:53
SPEAKER_03: Okay.
22:53
SPEAKER_02: And there's other businesses I think that chip, you know, like computer chips and things like that.
22:58
SPEAKER_02: I think that's mostly um dollar around the world, at least for now.
23:02
SPEAKER_02: I know there's, you know, some of that is changing.
23:05
SPEAKER_02: But um I think there are, you know, industries like that, you know, revenues are not determined locally or by sales prices and sales markets locally.
23:13
SPEAKER_02: It's more of a global market.
23:14
SPEAKER_03: All right.
23:15
SPEAKER_03: But to your point then, you're really looking at the predominant uh currency, basically, when you're determining this.
23:21
SPEAKER_02: Yeah, and that's kind of where I was gonna go next is when I think about how to um evaluate the functional currency, I think about the income statement.
23:32
SPEAKER_02: And assuming you have a classified income statement, I think about everything above the operating income line in that income statement.
23:39
SPEAKER_02: And then think about the currencies of those different line items on an absolute value basis and kind of look at what is the predominant currency that you're um considering.
23:51
SPEAKER_03: All right, and the fact then that to your point it's above the line, we would say at least in utilities.
23:56
SPEAKER_03: Um so then the fact you're paying taxes likely in maybe in a local currency that's kind of left out of this equation.
24:04
SPEAKER_02: Well, it's not left out.
24:06
SPEAKER_02: I just think that we think about the operating indicators first.
24:10
SPEAKER_02: And you know, I would say, you know, you're always going to be paying taxes in the local jurisdiction.
24:16
SPEAKER_02: That's, you know, but you're you're probably paying payroll in the local jurisdiction as well.
24:21
SPEAKER_02: Now, raw materials can be coming, you know, from different markets.
24:25
SPEAKER_02: You know, you could have various currencies in terms of that you're paying for your raw materials in, depending on what it is and you know what the primary market is for those materials.
24:36
SPEAKER_02: I guess the last thing to talk about is the financing indicators.
24:40
SPEAKER_02: And again, we don't disregard the financing indicators, but again, this comes back to the standard was written in 1981.
24:49
SPEAKER_02: In 1981, it wasn't as easy to finance in any currency you want and swap it back to any currency you want.
24:56
SPEAKER_02: And particularly when you're talking about intercompany financing, which sometimes you're talking about that can be denominated in any currency the company wants to denominate it in.
25:05
SPEAKER_02: So it's not that we disregard it.
25:07
SPEAKER_02: You know, sometimes it's a tiebreaker.
25:10
SPEAKER_02: Um, but to make a functional currency determination based on an intercompany loan that can be denominated any currency the company wants to denominate it in.
25:22
SPEAKER_02: Um, I'm not sure that we would say that's the right way to think about it.
25:27
SPEAKER_03: And I guess I mean you made the point on financing with swaps, but also you could be swapping other currency exposures.
25:33
SPEAKER_03: But again, that would be outside of this consideration.
25:37
SPEAKER_02: Well, I mean, I guess we'd have to look at why they were doing that, you know.
25:40
SPEAKER_02: But yeah, um I I think that's a good point, though.
25:44
SPEAKER_03: Yeah.
25:44
SPEAKER_03: Okay, that's a fair point.
25:45
SPEAKER_03: And I guess maybe Brett, that's a great lead-in to them.
25:47
SPEAKER_03: What are some of the pitfalls when you're thinking about this?
25:50
SPEAKER_03: Like what are some of the things we look for?
25:52
SPEAKER_01: Yeah, I'd start with a simple one, um, which is when you're evaluating the functional currency, you're often doing that when you establish that entity.
26:01
SPEAKER_01: Don't just assume that how you capitalize that entity is going to be its functional currency.
26:06
SPEAKER_01: You see, people, well, I I just sent down euro as my initial equity investment, so this thing must be euro functional, right?
26:14
SPEAKER_01: John talked about a whole host of indicators and put financing at the end of the list.
26:19
SPEAKER_01: And even in financing, you're generally looking to long-term indicators of financing, not just what currency you decided to capitalize or your put your initial investment uh in that entity.
26:32
SPEAKER_01: And that leads me to this, we've talked about a little bit this long-term concept of it.
26:37
SPEAKER_01: Uh you know, we I mentioned before, we expect that changes in functional currency are going to be rare.
26:43
SPEAKER_01: Uh, and we'll cover that more, but all of these indicators should be assessed on a long-term view of the operations and the strategy of a business.
26:51
SPEAKER_01: We often deal with this in startup companies.
26:54
SPEAKER_01: Um, you think of this as your expected economic environment over the long term.
27:00
SPEAKER_01: You may have startup operations with a lot of expenses in the local currency, but you have a longer-term view of generating US dollar sales.
27:09
SPEAKER_01: Um it could it could go it could go other ways.
27:12
SPEAKER_01: So we encourage people to not focus on just the near term, what's happening in the next several months and several years, but the long term and what are their business plans, what's their core strategy, and take that long-term view when you're establishing the functional currency of that.
27:28
SPEAKER_01: Um keep in mind that there's gonna be a lot of judgment here.
27:30
SPEAKER_01: We have a lot of legal entities that are going to have different indicators.
27:35
SPEAKER_01: And the indicators, like John mentioned, aren't gonna go all in one direction.
27:38
SPEAKER_01: You're gonna have transactions in multiple currencies, but at the end of the day, each distinct and separable operation can have only one functional currency that you've got to identify, you know, using all of these factors.
27:50
SPEAKER_03: Yeah, and it's interesting.
27:51
SPEAKER_03: I was just thinking when you said thinking over the long term.
27:54
SPEAKER_03: So now I have like high hopes for this business and I'm expecting something to happen in five years.
28:00
SPEAKER_03: I get five years out.
28:01
SPEAKER_03: It didn't pan out the way I wanted it to.
28:04
SPEAKER_03: Like, do we see I could see if I was the entity making that assessment on day one.
28:09
SPEAKER_03: It's a little uncomfortable, right, to be determining the functional currency based on predictions.
28:14
SPEAKER_03: So I'm guessing that does come into the conversation that people sometimes prefer to focus on what's right in front of them.
28:21
SPEAKER_03: But you're saying no, you really need to make your best assessment.
28:25
SPEAKER_01: Yeah.
28:26
SPEAKER_01: I mean, and obviously when you do that, you have to differentiate between hopes and dreams and reasonable expectations and plans.
28:33
SPEAKER_01: You know, you don't you don't want to to to establish this functional currency on kind of the the wildest expectations that could happen.
28:41
SPEAKER_01: Um, but at the end of the day, it's gonna require some judgment if you are in that kind of startup operation where you think that your operations are gonna evolve significantly over time.
28:51
SPEAKER_03: Okay.
28:51
SPEAKER_03: So, John, how about from your point of view, what are some of the areas to judgment that you'd think about?
28:56
SPEAKER_02: You know, Heather, one of the one of the areas we have lots of conversations about is when you're dealing with entities that are not separate and distinct.
29:04
SPEAKER_02: And trying, remember, we talked about if if an entity is not separate and distinct, you have to figure out which separate and distinct operation it's a part of.
29:12
SPEAKER_02: So this happens all the time.
29:13
SPEAKER_02: We have these conversations all the time with respect to holding companies.
29:17
SPEAKER_02: Holding company is a is a legal entity established.
29:20
SPEAKER_02: Primarily, it just holds um investments in other operating entities.
29:26
SPEAKER_02: It may have financing, you know, intercompany financing going through that entity as well.
29:31
SPEAKER_02: Sometimes you see that.
29:32
SPEAKER_02: Or they could have separate shell companies that um they have their intercompany financing run through.
29:40
SPEAKER_02: The standard basically says that for an entity that's just a shell corporation, they are just to hold investments or particular assets.
29:49
SPEAKER_02: For example, you see a lot of time intellectual property being held in companies that don't do anything except for hold the intellectual property.
29:56
SPEAKER_02: That the um functional currency generally is the word used in the standard, should take the functional currency of its immediate parent.
30:04
SPEAKER_02: Uh right.
30:05
SPEAKER_02: And so uh kind of think of it like, yeah, the default is the immediate parent.
30:13
SPEAKER_02: Maybe that's a too strong a word, but but sometimes it's not always the case that you would just default to the immediate parent.
30:21
SPEAKER_02: I'm not sure you get in trouble for doing that, given the the words and the standard.
30:25
SPEAKER_02: But think about a holding company that's just holding investments in other operations.
30:29
SPEAKER_02: And let's say that holding company gets most of its financing through the parent, but it also goes out and borrows from a third-party bank portion of its proceeds to fund the operations.
30:42
SPEAKER_02: Let's just say it's European operations.
30:44
SPEAKER_02: We may, you know, you know, you have to kind of go through all the facts and circumstances, but you may say in a situation like that, well, maybe that's really integrated with the European operations and not really with the parent.
30:56
SPEAKER_02: There's there's a lot of judgment involved in those, in those decisions.
31:00
SPEAKER_02: Another example would be that certain assets are dropped down into a legal entity.
31:06
SPEAKER_02: So think about a UK operation, for example, that is purchasing raw materials in Euroland, you know, from Euroland.
31:13
SPEAKER_02: And so they're purchasing those raw materials in Euro.
31:16
SPEAKER_02: When they do that, they create certain current, you know, currency exposures.
31:20
SPEAKER_02: If their functional currency is the sterling, they're purchasing in euro.
31:24
SPEAKER_02: They have payables in euro.
31:25
SPEAKER_02: That can create some foreign currency volatility.
31:29
SPEAKER_02: So somebody at the organization gets a brilliant idea to say, here, here's what we're going to do.
31:35
SPEAKER_02: We're going to establish a separate legal entity that's just going to hold the procurement operations for the materials that we're purchasing in in Europe.
31:43
SPEAKER_02: And that way we'll establish it.
31:46
SPEAKER_02: Its business will be that of purchasing uh raw materials in Europe, and we'll establish it as a eurofunctional entity, and voila, the foreign currency exposure goes away.
31:56
SPEAKER_02: Well, you can't just wish away foreign currency exposure.
32:00
SPEAKER_02: So we would probably look at that entity and say, is it separate and distinct?
32:04
SPEAKER_02: Well, no, because all it's doing is procuring raw materials for the sterling parent.
32:10
SPEAKER_02: So therefore it's part of that UK foreign entity, and it should assume the functional currency of that parent.
32:17
SPEAKER_02: So those are some of the things that we run into with holding companies and shell companies.
32:23
SPEAKER_02: It requires some judgment and um and a little bit of logic.
32:28
SPEAKER_01: I give I give listeners two rules of thumb when they're dealing with this.
32:32
SPEAKER_01: One is when you have a holding a shell company, don't just think you're gonna stop at these traditional cash flow indicators.
32:41
SPEAKER_01: Because you're really gonna have to dig into what the business purpose of that entity is and figure out its alignment between, like John said, the parent and the subsidiary.
32:50
SPEAKER_01: And the second rule of thumb I'd say is anytime that you think you have a situation where you've created a legal entity that has a different functional currency that's going to change the currency exposure, think twice and think very hard about it.
33:06
SPEAKER_01: Because generally, I I can't think of many situations where you can just create an entity and eliminate currency exposure.
33:15
SPEAKER_01: If it's just done for that purpose, it's probably aligned somewhere and needs to have a different functional currency.
33:20
SPEAKER_01: Trevor Burrus, Jr.
33:20
SPEAKER_02: Brett, I just want to reiterate your point on, and this is something that comes up all the time on consultations.
33:26
SPEAKER_02: The first thing that clients engagement teams, in my experience, want to talk about is the indicators.
33:32
SPEAKER_02: The first question, and this is why Brett started with foreign entities, the first question is is this a separate and distinct operation?
33:39
SPEAKER_02: Um and so then, you know, after you make that decision, yes it is or no, it's not, then you go to the indicators.
33:46
SPEAKER_02: Remember, I, you know, I always use the term in order to earn the right to have your own functional currency, that entity has to be separate and distinct.
33:54
SPEAKER_03: All right.
33:54
SPEAKER_03: That's helpful.
33:55
SPEAKER_03: And I guess one point of clarification, because we're talking here about foreign currency exposure.
34:00
SPEAKER_03: And if you think holistically about foreign currency exposure, the parent company still has that exposure.
34:07
SPEAKER_03: We're really talking here about accounting, right?
34:09
SPEAKER_03: Because if you're a US dollar parent, ultimately you are exposed to Euros or sterling or whatever else.
34:17
SPEAKER_03: It's just the accounting for the exposure.
34:20
SPEAKER_03: Is that right?
34:22
SPEAKER_01: I think that's right.
34:22
SPEAKER_01: And but it's gonna the accounting is obviously gonna matter whether it goes through earnings or through CTA, is we're gonna talk about it.
34:29
SPEAKER_02: Yeah, it's the type of exposure though.
34:31
SPEAKER_02: Yes.
34:31
SPEAKER_02: So maybe I think you and I did a risk management thing at one point.
34:36
SPEAKER_02: But the the uh I think about economic exposure and translation exposure.
34:43
SPEAKER_03: Yes, yes.
34:43
SPEAKER_02: So if I've got an operation in Euroland and they're procuring goods in US dollars, that entity is exposed to change in the US dollar.
34:53
SPEAKER_02: Their cash flows, their actual cash in their bank account could change based on the exchange rate difference between the time they ordered the product and the time they took delivery of the product and paid the bill, right?
35:06
SPEAKER_02: Whereas once you've measured all of your monetary assets and liabilities, we're gonna speak about this in a little bit, yeah, in into your functional currency, um, then you're talking about translation exposure.
35:19
SPEAKER_02: And that's really just an accounting exposure.
35:23
SPEAKER_02: Now, presumably the parent will ultimately distribute some of those earnings to the parent so they'll recognize some there.
35:31
SPEAKER_02: But the accounting exposure is, yeah, it shows up in our financial statements, but it doesn't show up in our bank account.
35:38
SPEAKER_03: Right.
35:39
SPEAKER_03: Okay, that's an important distinction.
35:41
SPEAKER_03: All right.
35:41
SPEAKER_03: And then, John, any other areas that you'd want to highlight in terms of where there could be issues?
35:47
SPEAKER_02: Yeah, I I think one of the things we deal with quite often is when a company goes out and buys another foreign operation, acquisitions of companies.
35:58
SPEAKER_02: And, you know, I guess the mantra there is don't just assume the functional currency that the seller had established for those operations that you've that you've just purchased.
36:09
SPEAKER_02: Um, usually when you buy a business, you're thinking about synergies.
36:13
SPEAKER_02: How are we going to create synergies and merge this with our operations?
36:17
SPEAKER_02: You need to think about all those things because the prior owner may have treated the business um like uh an extension of the parent.
36:27
SPEAKER_02: You may have um a different view that you want to operate that business autonomously, or you're gonna combine it with your operations locally, and then you know it'll be an autonomous operation.
36:38
SPEAKER_02: And so, you know, it's very possible that the way that the acquirer plans to manage the business could be very different from what the prior owner was doing, and that could have an impact on the functional currency determination.
36:51
SPEAKER_02: Maybe you're gonna um merge it with other products that are complementary and you're gonna manage it as the same business, but that's going to change the cash flows that that business has.
37:03
SPEAKER_02: And so you need to think about all of those things when you acquire a business.
37:07
SPEAKER_02: And you know, that's something we see quite often is you know, um, clients and engagement teams, you know, speaking to us about hey, we're we're planning to buy these operations.
37:17
SPEAKER_02: This is how we're planning to change it.
37:19
SPEAKER_02: How do we think about functional currency determination for those businesses?
37:22
SPEAKER_03: Well, and I think the best part of that question was that they're planning to buy.
37:26
SPEAKER_03: They didn't say we've bought this operation.
37:29
SPEAKER_03: Well, then always that happens too.
37:36
SPEAKER_03: So, all right.
37:37
SPEAKER_03: And then I already asked about changing functional currency.
37:40
SPEAKER_03: I jumped straight to that.
37:42
SPEAKER_03: But I do want to make sure we cover that specifically.
37:46
SPEAKER_03: And again, John, maybe going to you.
37:49
SPEAKER_03: I know we said it should be rare, but are there circumstances that we see that it is appropriate or that we it's more common to make a change?
37:57
SPEAKER_02: We do.
37:58
SPEAKER_02: We do.
37:59
SPEAKER_02: You know, they are supposed to be rare.
38:00
SPEAKER_02: The standard uses the term rare, you know, generally in gap rare means never.
38:05
SPEAKER_02: You know, I wouldn't say it's never, it's infrequent.
38:08
SPEAKER_02: Okay.
38:09
SPEAKER_02: You know, it's probably very infrequent.
38:11
SPEAKER_02: Um, but there's there's really two types of changes in functional currency when we think about it.
38:18
SPEAKER_02: The first is we're changing from the reporting currency to the local currency.
38:23
SPEAKER_02: And the second is we're changing from the functional currency being the local currency to being the reporting currency.
38:31
SPEAKER_02: Now, interestingly enough, the easier change from a, I'm just talking about man hours, how hard it is to do to make the change.
38:40
SPEAKER_02: The easier change is when you're going from the functional currency with the local currency to the parents' currency, the reporting currency.
38:49
SPEAKER_02: And the reason is because presumably all along we've been translating that um, you know, that you know, local currency to the um reporting currency.
39:00
SPEAKER_02: So my new accounting basis when I make that functional currency change is it's my last as translated balances that I had.
39:07
SPEAKER_02: So I I have that information readily available, hopefully.
39:12
SPEAKER_02: And um it's easy to make that change, easier to make that change in functional currency.
39:17
SPEAKER_02: The harder change to make is when you're when you're going from reporting currency to the local currency.
39:23
SPEAKER_02: Now, this would be a situation that we talked about where, hey, this operation, we used to think about it as an extension of the parent, but we've changed the business for whatever reason.
39:32
SPEAKER_02: It's going to operate more autonomously, it's going to assume the local currency as the functional currency.
39:38
SPEAKER_02: That change is harder.
39:39
SPEAKER_02: And the reason it's harder is because you have to go back um to, you know, and look at the really the dates all of your non-monetary assets and liabilities were purchased and assume that um the local currency was the functional currency all along, which means you're going to be creating CTA as of the date of the change, as if you had always translated it to uh US dollars, as opposed to accounting for everything as if it was, again, we're assuming US dollars.
40:08
SPEAKER_02: I, you know.
40:09
SPEAKER_03: Which is fine.
40:10
SPEAKER_03: Uh we we gave that copy out of front.
40:12
SPEAKER_02: But uh, so that's the harder change in functional currency to do.
40:15
SPEAKER_02: It requires, you know, more work, in my experience.
40:19
SPEAKER_03: All right.
40:19
SPEAKER_03: And then I know also um one of the things that's popped up a few times over the past couple of years is dealing with highly inflationary economies.
40:28
SPEAKER_03: So what is the rule there?
40:30
SPEAKER_02: Yeah.
40:30
SPEAKER_02: Um the account, you know, US GAAP assumes that the unit of measure that you're using for your financial statements is stable.
40:38
SPEAKER_02: And so the the idea behind changing your functional currency when an economy becomes highly inflationary is because the view is that currency is no longer stable.
40:49
SPEAKER_02: And therefore the financial statements that you're generating are less meaningful if because that currency is not stable.
40:55
SPEAKER_02: So under US GAAP, what they say is if the three-year cumulative inflation rate exceeds 100%, then that currency is no longer stable.
41:06
SPEAKER_02: And you need to change the functional currency of that entity, assuming it was the local currency before, to the reporting currency of the immediate parent of that entity, is the way that I think all you know most folks interpret the guidance.
41:21
SPEAKER_02: Um, and that change needs to be made the first day of the reporting period after the reporting period that the determination was made that the um the economy was highly inflationary.
41:34
SPEAKER_02: So we've seen that a few times.
41:36
SPEAKER_02: You know, this you know, we've had a high interest rate environment, high inflation environment in all countries, including the United States.
41:43
SPEAKER_02: Um, and so we have seen some pretty large economies go highly inflationary, Venezuela and Argentina being two of the biggest.
41:52
SPEAKER_02: Um Turkey, I think, also went tightly inflationary a year or two ago.
41:56
SPEAKER_02: So some pretty decent sized economies that we're now accounting for as highly inflationary economies.
42:01
SPEAKER_03: And then, John, two questions on that.
42:03
SPEAKER_03: So I think first of all, you made the point that it's the first reporting period after you make the determination.
42:09
SPEAKER_03: But from a practical point of view, for individual company, they're likely not making this determination, right?
42:17
SPEAKER_02: Or is it Well, I mean, uh every every company should have controls in place to evaluate, you know, the inflationary status of their significant operations.
42:30
SPEAKER_02: There is a group called the International Practices Task Force, and they meet twice a year in May and November, and they evaluate, you know, virtually all the economies in the world based on data from the International Monetary Fund and put out a report.
42:47
SPEAKER_02: For the November meeting, it's usually out in January at some point, in the May meaning, you know, July-ish.
42:53
SPEAKER_02: But that may not be frequent enough.
42:55
SPEAKER_03: Yes, I just realized that when you said that to help.
42:58
SPEAKER_02: But there is a little bit of, you know, nobody wants to be the first one to say that this is a highly inflationary economy.
43:07
SPEAKER_02: So there's kind of a little bit of looking around to see what the next person is doing as well.
43:13
SPEAKER_02: Um typically you see most companies go to the at the same time.
43:18
SPEAKER_03: And then the related question would be that hopefully you would see with these economies that they are highly inflationary and then they move back and they are no longer highly inflationary.
43:29
SPEAKER_03: So, in that circumstance, then, do you reassess the functional currency?
43:33
SPEAKER_02: Yeah, I mean, that's the harder decision.
43:34
SPEAKER_02: Like I think of the company, the countries I've just mentioned, like they're all still highly inflationary.
43:40
SPEAKER_02: It's a little bit stickier on the way out.
43:42
SPEAKER_02: Like US GAAP basically says if you hit that three year 100% cumulative inflation number, you're highly inflationary.
43:51
SPEAKER_02: There's no judgment there.
43:53
SPEAKER_02: It does provide that, you know, let's say you're at 90% over three years.
43:57
SPEAKER_02: You know, maybe you want to say that it's highly inflation.
44:00
SPEAKER_02: Inflationary based on trend.
44:01
SPEAKER_02: So you know the standard does seem to provide some judgment, that situation.
44:06
SPEAKER_02: But if you're a hundred, you're in.
44:07
SPEAKER_02: You're highly inflationary.
44:09
SPEAKER_02: On the way out, it's a little stickier, right?
44:11
SPEAKER_02: So I don't know.
44:12
SPEAKER_02: I don't know if you go down a 99% three year inflation, you're gonna erase to go out of highly inflationary status.
44:20
SPEAKER_02: And again, I think there's a little bit of weight, look.
44:23
SPEAKER_02: Yeah.
44:23
SPEAKER_03: Yeah.
44:24
SPEAKER_03: All right.
44:24
SPEAKER_03: Well, definitely an era of judgment, hopefully one that we won't see more countries entering.
44:29
SPEAKER_03: So not something, you know, too many companies will have to deal with.
44:32
SPEAKER_03: So um maybe last question, and I I think John, you know, I've talked about this on a prior podcast, but you made a point at the beginning, you know, the standard was issued in the early 80s.
44:43
SPEAKER_03: It's kind of built on that, and we've even talked about some scenarios that are in the standard that we don't think maybe are as common.
44:51
SPEAKER_03: Obviously, we saw with segments that the FASB said, hey, we had an old standard, maybe wasn't sort of fit for purpose in current times.
44:58
SPEAKER_03: They have a new standard.
44:59
SPEAKER_03: Is foreign currency similar to that, or if the model works well enough, the the factors haven't changed that much.
45:06
SPEAKER_03: So we wouldn't think that there would be a change.
45:10
SPEAKER_03: And again, I know you're speculating.
45:11
SPEAKER_02: So there's been very few uh over the last, you know, 15 or 20 years, times when the FASB was introducing a new standard where maybe it created a little bit of, you know, hey, the standard doesn't work and play that well with ASC 830 anymore.
45:29
SPEAKER_02: And so they've had to change some subtle things.
45:33
SPEAKER_02: Um we're gonna do a we're going to do a um podcast on CTA, including CTA release.
45:40
SPEAKER_02: That was one of the areas.
45:41
SPEAKER_02: There was a BizCom standard that came out and there was a a little bit of interplay there.
45:45
SPEAKER_02: So they had to step in and modify A3 a little bit there.
45:49
SPEAKER_02: There was something in the um foreign um, you know, if you have investments in debt securities there in foreign currency, there was some changes there.
45:56
SPEAKER_03: So they're kind of keeping it fresh around the edges then.
46:00
SPEAKER_02: I would call them like patches.
46:01
SPEAKER_03: Yeah.
46:02
SPEAKER_03: Which I mean, which is good though, right?
46:04
SPEAKER_03: Because then it continues to work.
46:06
SPEAKER_03: And I mean, again, you guys described uh a model that seems very functional.
46:12
SPEAKER_03: So um, with that said, I know I'm sorry.
46:15
SPEAKER_01: Um Are we gonna let you get away with that?
46:17
SPEAKER_01: The lips that's for wow.
46:20
unknown: I'm sorry.
46:20
SPEAKER_01: And they call these dad jokes flying.
46:23
SPEAKER_03: I'm sorry, listeners benefits the looks on their faces, but honestly, there's like it was the perfect word.
46:28
SPEAKER_03: So, anyway, with that, on that note, thank you.
46:30
SPEAKER_03: It's always such a pleasure to talk to you.
46:32
SPEAKER_03: Thanks so much for joining me today.
46:34
SPEAKER_01: Thanks.
46:35
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46:37
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46:40
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46:43
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46:48
SPEAKER_03: And to stay up to date on all our latest accounting and reporting news, sign up for our newsletter at viewpoint.pwc.com.
46:57
SPEAKER_03: From Thought Leadership at PwC, I'm Heather Horn.
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SPEAKER_03: Thanks for tuning in.
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SPEAKER_00: PwC refers to the U.S.
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SPEAKER_00: member firm or one of its subsidiaries or affiliates, and they sometimes refer to the PWC network.
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SPEAKER_00: Each member firm is a separate legal entity.
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SPEAKER_00: Please see www.pwc.com slash structure for further details.
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SPEAKER_00: This podcast is for general information purposes only and should not be used as a substitute for consultation with professional advisors, including accountants and lawyers.