In this video, we walk through 5 BAR practice questions teaching about determining a subsidiary’s functional currency. These questions are from BAR content area 2 on the AICPA CPA exam blueprints: Technical Accounting and Reporting
The best way to use this video is to pause each time we get to a new question in the video, and then make your own attempt at the question before watching us go through it.
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Determining a Subsidiary’s Functional Currency
A key concept in multinational accounting under U.S. GAAP is understanding what the functional currency is and how it affects the way subsidiaries report their financial results. Being able to identify the functional currency and distinguish it from related terms like the reporting currency is essential. This overview breaks down the core concepts through scenario-based questions, with examples to illustrate how the rules apply in practice.
Determining the Functional Currency
The functional currency is defined as the currency of the primary economic environment in which an entity operates. In practical terms, it’s the currency that most directly affects how a subsidiary earns and spends cash. Determining the functional currency is not a subjective choice made by management; it must be based on clear economic indicators.
The most important factors in this determination include the currency that influences sales prices, the currency in which customers pay, the currency of operating expenses such as wages and raw materials, and the broader economic environment in which the company functions. These are considered primary indicators and typically carry the most weight.
For example, if a subsidiary operates in Argentina, earns local revenue in pesos, and pays wages and suppliers in pesos, then the Argentine peso is the functional currency, even if the parent company is based in the U.S. or receives some revenue in U.S. dollars. The fact that the subsidiary’s day-to-day transactions and costs are rooted in the Argentine economy is the deciding factor.
There are also secondary indicators, such as the currency in which financing is conducted or the currency used to keep accounting records. These can support a conclusion, especially in cases where primary indicators are mixed or inconclusive, but they are not decisive on their own.
Functional Currency vs. Reporting Currency
One common area of confusion is the difference between functional currency and reporting currency. The functional currency is what the subsidiary uses to measure its own assets, liabilities, revenues, and expenses. The reporting currency is what the parent company uses to prepare and present its consolidated financial statements.
These currencies are often different. For example, a Brazilian subsidiary may operate in Brazilian reais as its functional currency, while the U.S.-based parent prepares its consolidated financials in U.S. dollars. In this case, the Brazilian financial statements are first measured in reais and then translated into dollars before being included in the consolidated report.
Understanding that a subsidiary must measure its financial statements in its functional currency — not in the reporting currency and not necessarily in the currency of the parent — is critical. This rule holds even if the books are kept in a different currency for local compliance or administrative reasons.
Remeasurement to the Functional Currency
If a subsidiary keeps its books in a currency other than its functional currency, then the financial statements must first be remeasured into the functional currency before they can be translated into the reporting currency. This process is called remeasurement and uses the temporal method.
The temporal method involves remeasuring monetary items such as cash, receivables, and liabilities using current exchange rates, while nonmonetary items like inventory and fixed assets are remeasured using historical rates. Income statement items may be remeasured at average rates or at the rate in effect when the transaction occurred.
What matters most is how the resulting gain or loss is reported. When remeasurement is required, any resulting exchange gains or losses flow through the income statement as part of continuing operations. This is a key distinction: these amounts are not placed in other comprehensive income (OCI), and they affect the company’s reported net income.
For example, suppose Radeon Ltd. operates with the U.S. dollar as its functional currency but keeps its books in dinars. Before consolidation, the company must remeasure its financials into dollars. If exchange rates have fluctuated, the company may recognize a gain or loss — and that amount will appear in continuing operations.
Translation for Consolidation
Once a subsidiary’s financial statements are measured in its functional currency, they may still need to be translated into the parent’s reporting currency for consolidation. This translation step occurs only when the functional currency and the reporting currency are different.
Unlike remeasurement, translation uses the current rate method and does not affect net income. Translation adjustments are reported in the equity section of the balance sheet as part of accumulated other comprehensive income (AOCI), not on the income statement.
This distinction is frequently tested. Candidates must be able to tell when a foreign currency gain or loss goes to continuing operations (as in remeasurement) versus when it is reported in OCI (as in translation). The difference hinges on whether the subsidiary is being remeasured into its functional currency or translated into the parent’s reporting currency.
Key Concepts to Retain
- The functional currency reflects the subsidiary’s primary economic environment — it’s not selected arbitrarily and may differ from the parent’s currency.
- The reporting currency is the currency in which the parent presents its financials and can differ from the functional currency.
- Financial statements are measured in the functional currency, regardless of what currency is used for recordkeeping.
- Remeasurement into the functional currency is required when the books are kept in a different currency, and any gains or losses are recognized in net income under continuing operations.
- Translation into the reporting currency for consolidation purposes results in translation adjustments that are recorded in OCI, not on the income statement.
These distinctions are fundamental to financial reporting for multinational entities. Mastering them means not only being able to choose the correct answer in a multiple-choice question, but also understanding the logic behind currency measurement and how it affects both standalone and consolidated financial statements.
