Accounting rules on foreign currency continue to trip up plenty of companies, as global mergers and acquisitions gain steam amid volatile currency exchange rates.
Ken Miller, a partner with PwC, said during a recent Webcast that the firm gets many questions these days on how to apply foreign currency accounting rules, as companies navigate emerging global business issues and evaluate their foreign currency risk. M&A activity is resurging following the global financial crisis, yet currency exchange rates are volatile, especially between the U.S. dollar and the Euro, the Japanese yen, and the Australian dollar. Those two trends raise accounting questions about whether and how to tweak determinations about what functional currency a particular business unit is using, and how to adjust financial statements for currency translations properly, he said.
The area requires meticulous attention to detail, says Brian Jobe, a partner with Deloitte & Touche, even though there is nothing particularly new about how to do the accounting and it's not as complex as other areas, such as derivatives or impairments. “You wouldn't think it would cause headaches year after year, but we do see companies that have challenges,” he says.
Companies outside the United States increasingly approach U.S. companies with buyout proposals looking to take advantage of opportunities in the massive U.S. market, says Paul Weisbrich, a senior managing director for McGladrey Capital Markets. European companies especially want ways to “dollarize” their operations, he says, meaning they want to acquire U.S.-dollar-based operations to better match their U.S.-dollar-based revenues. That helps balance the flow of a particular currency moving in and out of the business, he adds, minimizing the volatility that comes with currency translations. “It's a natural accounting hedge,” he says.
As U.S. companies sell or co-mingle their businesses with others overseas, they face those accounting details and find that misapplying them can create problems, says Jobe. According to Miller, mistakes or questions often focus on a few key areas, including how to determine the entity to which the rules apply, and when to use average currency exchange rates.
For starters, Miller says, Accounting Standards Codification Topic 830, Foreign Currency Matters, applies to foreign entities as described in the accounting literature, not legal entities as organized under various business structures. A foreign entity is generally defined in the accounting standard as an operation with financial statements prepared in a currency other than the parent company's reporting currency and consolidated to that parent company's financial statements based on the parent company's equity investment in the operation.
“Once you've made a decision (determining functional currency), it's not easy to change unless there's something overwhelmingly pointing in a different direction.”
—Brian Jobe,
Partner,
Deloitte
“There's a lot of judgment that goes into determining what a foreign entity is,” Miller said. “You could have a foreign entity with multiple legal entities in it, and you could have a legal entity with multiple foreign entities in it.” Sorting that out properly is especially important, because it helps determine whether a company is selling an investment in a business operation versus the assets of an operation. And that has significant implications on how companies might need to unravel any accumulated currency translations adjustments that might be hung up on the balance sheet.
Companies also need to brush up the provisions in the accounting standard for using average exchange rates to translate currencies, says Pete Bible, partner-in-charge of the public company group at audit firm EisnerAmper and a former chief accounting officer at General Motors. The standard generally allows for the use of an average exchange rate as a practical expedient to cover a reporting period, but in periods of significant volatility, the average rate may not give the best depiction of economic reality. “There's a lot of debate right now about how often you look to a marker to compute that average,” he says.
EXCHANGE RATE TIPS
The following information on exchange rate volatility was provided by PwC in a recent Webcast:
Considerations for using an average exchange rate when
there is volatility in rates
ASC 830 specifically allows management to make a practical approximation
of average exchange rates to be used in translating revenues, expenses, gains,
losses, and cash flows.
A simple average of the rates at the beginning and end of the period might
not yield an appropriately weighted average exchange rate, especially for
large and infrequent transactions.
An evaluation should be done to determine whether the average exchange
rates used are appropriate.
Non-recurring transactions, such as intangible asset impairments and long-
lived assets, should be translated at actual prevailing rates on the transaction
date.
Several points are worth remembering regarding how
exchange rate volatility impacts the statement of cash flows
ASC 830 indicates that companies should:
-Prepare a statement of cash flows for each foreign operation in its
functional currency (or for each group of operations that use the same
functional currency).
-Translate (or remeasure) those functional currency statements of cash
flows into the reporting currency.
-Prepare a consolidating statement of cash flows.
Preparing the statement of cash flows using the parent's
consolidated reporting currency balance sheet and income
statement may produce results that are inconsistent with ASC
230, Statement of Cash Flows, and ASC 830 if the foreign
operations or the exchange rate fluctuations are significant.
The effect of exchange rate changes on cash balances held in foreign
currencies is reported as a separate line item in the reconciliation of
beginning and ending balances of cash and cash equivalents.
-This number is not a plug.
-This number can be recomputed using the proof provided in ASC 830-
230-55-15.
Functional currency determination
A foreign entity?s functional currency is basically a question of fact,
that should be documented.
When exchange rates are volatile, customers and suppliers may react
quickly. This may cause an entity to question their functional
currency determination.
-For example, an entity?s European customers may be happy to
purchase its products in U.S. Dollars when the Euro is strong, but
as the Euro weakens, a Company may begin to see its European
customers insist that the Company sell to them in Euro.
› Generally, this type of experience will not result in a functional
currency change.
› Customers are merely reacting to a short-term change in the
relative value of the Euro vs. the U.S. Dollar.
Functional currency changes are expected to be rare.
Source: PwC Webcast: Current Accounting & Reporting Developments.
The standard gives no bright line on when to use an average compared with when companies should do a more expanded calculation to identify a rate that reflects the volatility of the period, Jobe says, but it doesn't give companies an open door to calculate the rate any way they'd like. “It has to be reasonable,” he says.
According to accountants, companies are asking questions these days around whether they can make a change under ASC 830 to the functional currency in which a particular business unit operates. While a change in determination might produce a better outcome in the financial statements, it's not an easy change to make, according to Miller. As an example, a U.S. company's European customers might be content to buy products in U.S. dollars when the euro is strong, but might prefer to pay in euros when the euro weakens. But that's not enough to sway accounting policy on which currency is the functional currency for the business, he said. “The standard says functional currency changes are expected to be very rare,” he said. If the situation persists it can be re-evaluated over time, “but one event itself won't do it.”
Until a few years ago, accounting firms heard few questions about whether changing the functional currency determination was feasible, Jobe says. It's more easily done when a company acquires or sells a particular unit that operates under a different functional currency than for other reasons. “Once you've made a decision [determining functional currency], it's not easy to change unless there's something overwhelmingly pointing in a different direction,” he said.
Steve Burlone, senior managing director at consulting firm FTI, says he sees a troubling number of errors in foreign currency related to intercompany loans, such as a loan from a parent to a subsidiary that crosses from one currency to another. When the subsidiary's financial statements are consolidated to the parent company's results for financial reporting purposes, the balance sheet effect appears to be a wash; it's a receivable, or an asset, for the parent and a payable, or a liability, for the subsidiary.
The analysis, however, needs to go a step further, says Burlone. For income purposes, the payable has to be converted each period from the subsidiary's functional currency to the parent company's, with the difference showing up as a gain or loss in the income statement. “It doesn't have anything to do with M&A or current volatility, but we find errors in this area frequently when we do investigations,” he says.
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