Today I want to explore the accounting rules around determining an entity’s functional currency and think about these rules in the context of Brexit. How could Brexit impact decisions around setting an entity’s functional currency? Could Brexit cause a change in an existing entity’s functional currency?
To kick off, let’s take a look at what the accounting standards say about determining an entity’s functional currency. The relevant guidance is found under ASC 830 and IAS 21 for US GAAP and IFRS respectively.
Under both sets of accounting standards, the functional currency is a key concept that will have a number of downstream impacts. It determines what foreign exchange rates will impact earnings as income in foreign currencies are translated back to the functional currency. That said, selecting the appropriate functional currency can be more involved than simply using the currency local to an entity’s location. For example, because oil products are often priced off of US Dollar based indices, energy companies sometimes select the US Dollar as their functional currency, even though they may be located outside of the US.
Both accounting standards recognize these nuances and as such avoid proscriptive guidance. Accountants recognise that management may need to exercise significant judgment when setting functional currency. Further, while it would be unusual, accounting guidance suggests that there may be situations where a change in functional currency is warranted. For example, significant changes in economic facts and circumstances would be an indication that a functional currency change is appropriate. Again, the guidance isn’t proscriptive and judgment is necessary.
Companies may find that existing hedge accounting relationships may no longer be valid if functional currency were to change.
Functional Currency and Brexit
An entity may be based in the UK, but serve as a regional headquarters for a European business, in this case, if most of the entity’s transactions are primarily denominated in EUR, the EUR may have been selected as the entity’s functional currency. A key concern regarding Brexit is that companies based in the UK may no longer freely trade across Europe. If a UK based entity’s business changes to dealing less in EUR and become a GBP-centric business, this could signal that a change in functional currency is appropriate. The same could be true for a European based company that currently does most of its business in the UK and may have had GBP set as its functional currency.
While changing functional currency may at first appear to only be a reporting issue, companies should be mindful of how different currencies interact with these entities. If UK based entities that have the EUR as a functional currency currently also have significant payable / receivable balances in EUR, a change in functional currency could trigger FX remeasured noise in earnings. Capital finance decisions may also be impacted as companies may want to reconsider in which currencies they fund UK and European businesses if business practice and therefore functional currency were to change.
Additionally, hedging of foreign exchange rates is based on functional currency (accounting-wise you can only hedge currencies other than your functional currency). Companies may find that existing hedge accounting relationships may no longer be valid if functional currency were to change. There are also accounting rules that require FX hedges to be executed out of specific entities. Companies should evaluate where hedges are booked and evaluate if a change in functional currency will require updates to policy and/or a change to existing trades.
In conclusion, functional currency may be simply viewed as an accounting convention, selecting a functional currency and a subsequent change to it can have a number of significant consequences. Companies should consider the guidance on functional currency and carefully evaluate how Brexit could change the judgments made when initially setting functional currency for entities doing business across the UK and EU.
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