Appendix 16B. Evaluating the Validity of the Functional Currency Concept

Transcription

1 Appendix 16B Evaluating the Validity of the Functional Currency Concept 1

2 2 APPENDIX 16B EVALUATING THE VALIDITY OF THE FUNCTIONAL CURRENCY CONCEPT In this appendix, we show the third possible approach to translating foreign currency financial statements that was mentioned in Chapter 15: the current-value approach using purchasing power parity theory (hereafter the PPP current-value approach). We then use this approach to reveal the characteristics (strengths and weaknesses) of the current rate and temporal methods of translation. Next, we address the environment and thinking that gave rise to the functional currency concept and whether it is a valid concept. Last, we discuss how to evaluate and manage foreign operations when the reporting results of FAS 52 are so unrealistic that the translated statements cannot be relied upon. I. THE CURRENT-VALUE APPROACH USING PURCHASING POWER PARITY THEORY In Chapter 13, we discussed that long-term exchange rate changes are best explained by purchasing power parity theory, which states the following: The differential rate of inflation between two countries can be expected to result over the long term in an equal but opposite change in the exchange rate between the two currencies. Recall further that foreign inflation drives the direct exchange rate down and that domestic inflation has the opposite result. The Rationale The premise of the PPP current-value approach is that it makes little sense to apply an exchange rate that has been impacted downward for foreign inflation to amounts that likewise have not been adjusted upward for the same inflation. To do so is to deal with only half of accounting for the exchange rate change problem. Accordingly, under this approach, nonmonetary assets that have increased in value because of foreign inflation are adjusted for the foreign inflation and then translated at the current rate. This approach largely achieves current-value accounting. 1 All remaining assets and liabilities are also translated at the current rate. All income statement accounts are translated using exchange rates in effect when the items were recognized in earnings (the current rate). Managerially, a foreign currency unit of measure is achieved only if local management internally uses the inflation-adjusted foreign currency statements to manage the subsidiary. The Focus: The Net Asset Position This approach assumes that all of the foreign unit s assets and liabilities are exposed to the risk of exchange rate changes. Thus the exposure pertains to the net asset position (which equals the parent s net investment) the same focus used for the foreign currency unit of measure approach discussed in Chapter 15. Because a single exchange rate is used in translating all assets and liabilities, 1 The modifier largely is used because no general price-level index can exactly achieve current values on a company-by-company basis. Also, the base to which the general price index is applied could be unreliable inasmuch as the depreciable life used and/or the depreciation method used could be inappropriate.

3 APPENDIX 16B EVALUATING THE VALIDITY OF THE FUNCTIONAL CURRENCY CONCEPT 3 the relationships that exist in the inflation-adjusted foreign balance sheet are maintained in translation (as under the foreign currency unit of measure approach shown in Chapter 15). Key Observations Regarding the PPP Current-Value Approach This approach eliminates the disappearing plant problem that can occur in the foreign currency unit of measure approach (current rate method). To fully understand the reporting results of the PPP current-value approach, it is necessary to analyze the exchange rate change for the period using PPP. We will do this shortly. To illustrate translation under this approach, we will use the same set of assumptions used in illustrating the other two approaches in Chapters 15 and 16. For convenience, we list those assumptions again here. Assumed Factual Data for Illustrations of the Three Possible Translation Approaches Assume that in late 2004, a U.S. company created a 100%-owned subsidiary in Mexico when the direct exchange rate was $.50, making a $1,000,000 cash equity investment at that time. For simplicity, assume that this direct exchange rate did not fluctuate through December 31, The subsidiary s first sales were on January 1, The subsidiary s balance sheets at the end of 2004 and 2005 and the subsidiary s 2005 income statement are shown in Illustration 16B-1. Additional assumptions are that (1) no dividends were declared or paid in 2005; (2) fixed asset additions of Mex$ 200,000 (equal to 2005 depreciation expense) occurred on January 3, 2005, when the exchange rate was $.50; (3) Mexico had 25% inflation for 2005; (4) the United States had 10% inflation for 2005; and (5) the direct exchange rates were $.50 at December 31, 2004, $.44 at December 31, 2005, and $.47 for 2005 as an average. ILLUSTRATION 16B-1 FOREIGN CURRENCY FINANCIAL STATEMENTS Pesos 12/31/04 12/31/05 Balance Sheets Monetary assets ,200,000 2,500,000 Inventory ,000,000 1,250,000 Fixed assets, net ,800,000 4,800,000 a Total Assets ,000,000 8,550,000 Liabilities ,000,000 6,250,000 Common stock ,000,000 b 2,000,000 Retained earnings ,000 Total Liabilities and Equity ,000,000 8,550,000 Income Statements (2005) Revenues ,300,000 Cost of sales (4,300,000) Depreciation (200,000) Expenses (500,000) Net Income ,000 a Because of the 25% inflation in Mexico during 2005, these assets are undervalued 25%. b This amount is the peso equivalent of the $1,000,000 cash investment made by the parent when it formed the subsidiary in late 2004 ($1,000,000/$.50 = Mex$ 2,000,000).

4 4 APPENDIX 16B EVALUATING THE VALIDITY OF THE FUNCTIONAL CURRENCY CONCEPT Because Mexico had 25% inflation in 2005, the 2005 inflation adjustment on the fixed assets is Mex$ 1,200,000 (historical cost of Mex$ 4,800,000 25%). The translation worksheet using the inflation-adjusted values and the current exchange rate is shown in Illustration 16B-2. To explain the $399,000 economic gain reported under the PPP current-value approach as shown in Illustration 16B-2, it is necessary to analyze the change in the exchange rate using PPP. This analysis is shown in Illustration 16B-3. The inflation effects shown in Illustration 16B-3 are used in Illustration 16B-4 to explain the $399,000 economic gain reported in Illustration 16B-2. ILLUSTRATION 16B-2 THE CURRENT-VALUE APPROACH USING PPP Inflation Exchange Adjusted U.S. (Pesos) Code Rate Dollars Income Statement (2005) Revenues ,300,000 A $.47 $ 2,491,000 Cost of sales (4,300,000) A $.47 (2,021,000) Depreciation (200,000) A $.47 (94,000) Expenses (500,000) A $.47 (235,000) Net Income ,000 $ 141,000 Balance Sheet (as of 12/31/05) Monetary assets ,500,000 C $.44 $ 1,100,000 Inventory ,250,000 C $ ,000 Fixed assets, net ,000,000(1) C $.44 2,640,000 Total Assets ,750,000 $ 4,290,000 Liabilities ,250,000 C $.44 $ 2,750,000 Common stock ,000,000 H $.50 $ 1,000,000 Retained earnings ,000 (Per above) 141,000 Revaluation capital ,200,000 n/a Economic gain from exchange rate change (forced) 399,000(2) Total Equity ,500,000 $ 1,540,000 Total Liabilities and Equity ,750,000 $ 4,290,000 (1) Includes a Mex$ 1,200,000 inflation adjustment (the historical cost at 1/1/05 of Mex$ 4,800,000 x 25%). (2) This amount can be forced out or calculated. The calculation is shown later in Illustration 16B-5. Key Review Points: 1. Note how ratios and relationships are maintained after translation: Pesos U.S. Dollars Debt-to-equity ratio :1 1.78:1 Gross profit margin ratio % 19% Net income to sales ratio % 6% Fixed assets to total assets ratio % 62% Undervaluation of fixed assets % 0% 2. Note the increase in the stockholders equity (which we later compare to the change under the other two approaches): Ending stockholders equity (per above) $1,540,000 Less Beginning stockholders equity (parent s initial capital investment per Illustration 16B-1) ,000,000 Increase in stockholders equity $ 540,000 Code: A = Average rate; C = Current rate; H = Historical rate.

5 APPENDIX 16B EVALUATING THE VALIDITY OF THE FUNCTIONAL CURRENCY CONCEPT 5 ILLUSTRATION 16B-3 ANALYZING THE CHANGE IN THE EXCHANGE RATE Direct Exchange Rate Actual rate, 1/1/ $.50 Plus: Increase expected because of U.S. 10% inflation ($.50 10%) Subtotal $.55 Less: Decrease expected because of 25% Mexican inflation ($.55/125% = $.44; $.55 $.44 = $.11) (.11) Expected end-of-year rate under PPP $.44 Plus or minus: Noninflationary factors a Actual rate, 12/31/ $.44 a For simplicity, it is assumed that there are no noninflationary factors. Later, noninflationary factors are addressed. ILLUSTRATION 16B-4 USING THE EXCHANGE RATE ANALYSIS IN ILLUSTRATION 16B-3 TO EXPLAIN THE INCREASE IN THE SUBSIDIARY S EQUITY IN ILLUSTRATION 16B-2 (1) Unrealized Nominal a Inflationary Holding Gain Resulting from U.S. Inflation (calculated on parent s beginning net investment position): Pesos Dollars Subsidiary s equity at 1/1/05 (per Illustration 16B-1) ,000,000 Effect of domestic inflation on the exchange rate ($.55 $.50) $.05 $ 100,000 (2) Unrealized Inflationary Holding Gain Resulting from Mexico s Inflation (calculated on nonindexed local (foreign) debt financing of fixed assets): b Fixed assets at 1/1/05 (per Illustration 16B-1) ,800,000 Less Equity financing at 1/1/ (2,000,000) Net Debt Financing ,800,000 Effect of Mexico s inflation on the exchange rate ($.55 $.44) $.11 $ 308,000 (3) Exchange Rate Change Effect on 2005 Earnings: Reported earnings (per Illustration 16B-2) ,000 Difference between the average rate and the year-end rate ($.47 $.44) $.03 $ (9,000) Total Effect of Exchange Rate Changes (a net gain) $ 399,000 (4) Subsidiary s net income (per Illustration 16B-2) ,000 Reported Number of U.S. Dollars the Parent Is Ahead $ 540,000 Calculation of Parent s Increase in Purchasing Power Reported (nominal) number of U.S. dollars ahead $ 540,000 Less Loss of purchasing power on beginning investment ($1,000,000 10%) (100,000) Real Increase in Purchasing Power $ 440,000 a A nominal gain in the parlance of economics means a gain in name only as contrasted to a real gain. In this case, the $100,000 unrealized gain does not result in any increased purchasing power to the parent. In a real gain, the parent would have increased purchasing power. In this chapter, a gain is assumed to be a real gain unless it is labeled a nominal gain. b Nonindexed means that the debt principal is not adjusted upward for any inflation in the foreign country.

6 6 APPENDIX 16B EVALUATING THE VALIDITY OF THE FUNCTIONAL CURRENCY CONCEPT II. WHICH OF THE THREE TRANSLATION APPROACHES REFLECTS ECONOMIC REALITY? One of the objectives in foreign currency translation is to properly reflect the economic impact of exchange rate changes. Each of the three approaches shown produces significantly different results, as summarized: Economic Gain or (Loss) from Exchange Rate Change Increase in Subsidiary s Equity 1. Current rate method, per Illustration 15-5 (page 510) $(129,000) $ 12, Temporal method, per Illustration 16-3 (page 545) , , PPP current-value approach, per Illustration 16B-2 (page 4) , ,000 They all cannot reflect economic reality because there can be only one economic reality. Only the PPP current-value approach reflects the economic effect of the exchange rate change. The only sensible way to manage the foreign subsidiary and evaluate its results both at the local level and the parent level is to use the inflation-adjusted financial statements shown under the PPP currentvalue approach. Because both the current rate method and the temporal method are permitted by FAS 52 (specific conditions determining when to use one or the other), it is necessary to fully understand them. We now compare the current rate method and the temporal method to the PPP current-value approach to isolate the reasons that the reporting differences occur and thus gain insight into the strengths and weaknesses of each method. Interwoven in this analysis is the issue of adjusting for inflation foreign fixed assets but not domestic fixed assets. III. THE CHARACTERISTICS OF THE CURRENT RATE METHOD A comparison of the reporting results of the current rate method and the PPP current-value approach is shown in Illustration 16B-5. The Current Rate Method Properly Reports the Economic Effect of Domestic Inflation Illustration 16B-5 shows that the current rate method properly reports the $100,000 economic effect of the upward inflationary effect of $.05 caused by the 10% U.S. inflation an unrealized nominal inflationary holding gain. If noninflationary factors were present, their economic effect would also be properly reported because they are dealt with as is the U.S. inflation effect. The Current Rate Method Does Not Properly Report the Economic Effect of Foreign Inflation Illustration 16B-5 also shows that the current rate method does not properly report the $308,000 economic effect of Mexico s 25% inflation an unrealized inflationary holding gain. Under the current rate method, translating the fixed assets at the $.44 current rate means that both the upward inflationary effect of $.05 (Illustration 16B-3) and the downward inflationary effect of $.11 (Illustration 16B-3) were considered in the translation process. This approach s shortcoming in relation to the PPP current-value approach is that the downward inflationary effect of $.11 (for Mexico s 25% inflation) should not have been considered in the translation of the fixed assets. The result is $528,000 of suppressed valuation of fixed assets (Mex$ 4,800,000 $.11).

7 APPENDIX 16B EVALUATING THE VALIDITY OF THE FUNCTIONAL CURRENCY CONCEPT 7 ILLUSTRATION 16B-5 COMPARISON OF THE CURRENT RATE METHOD TO THE CURRENT-VALUE APPROACH USING PPP CURRENT RATE CURRENT-VALUE METHOD APPROACH REPORTING (PER ILLUSTRATION 15-5) (PER ILLUSTRATION 16B-2) DIFFERENCE Earnings (excluding effects of exchange rate changes) $ 141,000 $141,000 $ 0 Economic gain (loss) from exchange rate changes (129,000) 399, ,000 Parent s Reported Economic Gain $ 12,000 $540,000 $528,000 Comparison of Reported Effects of Exchange Rate Changes CURRENT-VALUE CURRENT RATE APPROACH REPORTING METHOD (PER ILLUSTRATION 16B-4) DIFFERENCE Effect of U.S. inflation Beginning investment of 2,000,000 Mex$ $.05 upward inflationary effect $ 100,000 $100,000 $ 0 Effect of Mexican Inflation Beginning investment of 2,000,000 Mex$ $.11 downward inflationary effect (220,000) 220,000 Debt financing of fixed assets of Mex$ 2,800,000 $.11 downward inflationary effect , ,000 Effect of exchange rate change on net income..... (9,000) (9,000) 0 Total Effect of Exchange Rate Change $(129,000) $399,000 $528,000 Explanation of $528,000 Reporting Difference Suppressed Valuation of Fixed Assets (Mex$ 4,800,000 $.11) $528,000 Applying an exchange rate that has decreased because of Mexico s inflation to historical cost amounts in pesos that have not likewise been adjusted upward for the same inflation is illogical from an economic perspective and produces an amount that is difficult to interpret. The resulting dollar amount of $2,112,000 (Illustration 15-5, page 510) is not the $2,400,000 U.S. dollar equivalent needed to acquire the fixed assets when they were acquired (4,800,000 pesos at 1/1/05 as shown in Illustration 16B-1 the $.50 exchange rate existing when the assets were acquired in late 2004). Nor is this the current value of the fixed assets that amount being $2,640,000 (Illustration 16B-2). The amount can be described only as historical cost that has been adjusted for the exchange rate change. This difficult-to-interpret problem is not unique to fixed assets. The translated amount for a note receivable or payable having a fixed interest rate different from the current market rate is also neither the initial dollar equivalent nor a current value amount. Applying current exchange rates to historical costs does result in fixed assets being maintained at the same percentage of total assets that existed in the foreign currency statements (the preservation of the functional currency relationship). Accordingly, the dollar amounts are no less meaningful or unclear than the foreign currency amounts from which they were derived. Stated differently, if the foreign fixed assets are undervalued by 25% because of inflation, both sets of financial statements reflect this undervaluation. FAS 52 acknowledges the inability of the current rate method to deal properly with the effects of foreign inflation in dealing with highly inflationary economies. The FASB s solution to this problem was to have companies (1) disregard all of the so-called economic factors that are prescribed (in FAS 52) to determine the functional currency and (2) instead always use the U.S. dollar as the functional currency. This by itself should raise serious questions as to the validity and conceptual merits of the functional currency concept. The foreign inflation problem exists for all economies, however, not just highly inflationary ones. For instance, Great Britain had approximately 5.7% annual inflation for the 15 years ended 1995, a cumulative change of 128% for 15 years. Under PPP, the exchange rate would decrease 56% for this period. U.S. inflation during this period averaged 3.9%, a cumulative change of 76%.

8 8 APPENDIX 16B EVALUATING THE VALIDITY OF THE FUNCTIONAL CURRENCY CONCEPT Accordingly, the expected decrease in the exchange rate was only 23% instead of 56%. As shown in Illustration 16B-6, the suppressed valuation of British fixed assets acquired in 1981 is substantial for this relatively low inflationary economy even when one considers the countereffect of U.S. inflation during this period. Accordingly, the disappearing plant problem discussed in Chapter 15 can also occur in relatively low inflationary economies. Thus, given a choice between valuing foreign fixed assets at current values versus values based on preserving foreign currency relationships that can have the disappearing plant problem, users will likely choose current values every time. IV. THE CHARACTERISTICS OF THE TEMPORAL METHOD A comparison of the reporting results of the temporal method and the PPP current-value approach is shown in Illustration 16B-7. The Temporal Method Properly Reports the Economic Effect of Foreign Inflation Illustration 16B-7 shows that the temporal method properly reports the $308,000 economic effect of Mexico s 25% inflation an unrealized inflationary holding gain. This occurs because the same ILLUSTRATION 16B-6 THE EFFECTS OF INFLATION IN A LOW INFLATIONARY ECONOMY: GREAT BRITAIN ( ) Direct Exchange Rate Actual rate for the British Pound, 1/1/ $ 2.40 Less: Decrease expected because of 128% British cumulative inflation for ($2.40/228% = $1.05; $2.40 $1.05 = $1.35) (1.35) Subtotal $ 1.05 Plus: Increase expected because of 76% U.S. cumulative inflation for ($ % = $.80) Expected Rate at 12/31/95 under PPP $ 1.85 Less: Noninflationary factors (.31) Actual Rate for the British Pound, 12/31/ $ 1.54 Valuations at 12/31/95 for Land Costing U.S. 1,000,000 Acquired on 1/1/81 Pounds Rate Dollars Temporal method ,000,000 $2.40 = $2,400,000 Current rate method ,000,000 $1.54 = $1,540,000 a PPP current-value approach ,280,000 d $1.54 = $3,511,000 Current rate method assuming that no U.S. inflation had occurred ,000,000 $.74 b = $ 740,000 c PPP current-value approach assuming that no U.S inflation had occurred.... 2,280,000 d $1.05 = $2,394,000 2,280,000 d $ (.31) = (707,000) 2,280,000 d $.74 = $1,687,000 a The disappearing plant problem occurs here to the extent of $550,000 ( 1,000,000 the $.55 decrease ($2.40 $1.85) in the exchange rate because of higher foreign inflation than domestic inflation). b c The expected rate of $1.05 $.31 for the noninflationary factors. Note how severe the disappearing plant problem would have been had no offsetting inflation occurred in the United States. d Includes a 128% inflation adjustment of 1,280,000.

9 APPENDIX 16B EVALUATING THE VALIDITY OF THE FUNCTIONAL CURRENCY CONCEPT 9 ILLUSTRATION 16B-7 COMPARISON OF THE TEMPORAL METHOD TO THE PPP CURRENT-VALUE APPROACH TEMPORAL CURRENT-VALUE METHOD APPROACH REPORTING (PER ILLUSTRATION 16-3) (PER ILLUSTRATION 16B-2) DIFFERENCE Earnings (excluding effects of exchange rate changes) $ 77,500 $141,000 $ 63,500 Economic gain from exchange rate change , , ,500 Parent s Reported Economic Gain $310,000 $540,000 $230,000 Comparison of Reported Effects of Exchange Rate Changes CURRENT-VALUE TEMPORAL APPROACH REPORTING METHOD (PER ILLUSTRATION 16B-4) DIFFERENCE Effect of U.S. inflation Beginning investment of Mex$ 2,000,000 $.05 upward inflationary effect $100,000 $ 100,000 Debt financing of fixed assets (Mex$ 2,800,000 a $.05 upward inflationary effect) $(140,000) 140,000 $ 240,000 Debt financing of inventory of Mex $ 1,075,000 a $.05 upward inflationary effect (53,750) 53,750 Effect of Mexico s Inflation Debt financing of fixed assets of Mex$ 2,800,000 a $.11 downward inflationary effect , ,000 0 Debt financing of inventory of Mex$ 1,075,000 $.11 downward inflationary effect ,250 (118,250) Effect of exchange rate change on net income..... (9,000) (9,000) Reported effect of exchange rate change $ 232,500 $399,000 $ 166,500 Difference in reported amounts for depreciation and cost of sales (63,500) b 63,500 Corrected Reported Effect of Exchange Rate Change $ 169,000 $399,000 $ 230,000 Explanation of $230,000 Reporting Difference Suppressed valuation of fixed assets (Mex$ 4,800,000 $.05) $ 240,000 Overvaluation of inventory ($560,000 $550,000) (10,000) Net Overvaluation $ 230,000 a The average net monetary liability position for 2005 was Mex$ 3,875,000, which is separated here between fixed assets and inventory. b These additional income statement charges under the temporal method largely offset the $64,500 net inflationary holding gain reported for the debt financing of the inventory ($118,250 $53,750). Because the inventory turned over in 2005, there is no real inflationary holding gain. The inventory effectively is a monetary item. $2,400,000 fixed asset amount in U.S. dollars is obtained under the temporal method whether or not the subsidiary adjusts its fixed assets for inflation as shown: December 31, 2005 Exchange U.S. Pesos Rate Dollars Fixed assets, net (as shown in Illustration 16B-1) ,800,000 $.50 = $2,400,000 Inflation 25% ,200,000 (.10) a Fixed assets, as adjusted ,000,000 $.40 = $2,400,000 a ($.50/125% = $.40; $50 $.40 = $.10) The $.40 rate is the exchange rate that would have existed if U.S. inflation had been zero.

10 10 APPENDIX 16B EVALUATING THE VALIDITY OF THE FUNCTIONAL CURRENCY CONCEPT The Temporal Method Achieves Inflationary Accounting Reporting Results for Foreign Inflation As shown in Illustration 16B-7, the temporal method always reports inflationary holding gains when local inflation has caused the direct exchange rate to decrease. Management cannot conclude otherwise than the subsidiary had an inflationary holding gain. Thus, the temporal method achieves a form of inflationary accounting. Under FAS 52, such inflationary holding gains are reported as foreign currency transaction gains. In dealing with highly inflationary economies, the FASB stated in its basis for conclusions that the mandatory use of the U.S. dollar as the functional currency in these situations did not introduce a form of inflation accounting. 2 Quite to the contrary, inflation adjustment accounting is effectively being used in these situations because inflationary holding gains are always reported under the temporal method when local inflation has caused the direct exchange rate to decrease. Ironically, this is one aspect of FAS 52 that is sound because the reporting of inflationary holding gains reflects the underlying economics of these situations. 3 Thus, whenever foreign inflation occurs and nonindexed local debt finances fixed assets, FAS 52 is inconsistent in a major respect because (1) inflationary holding gains are reported currently in the income statement if the U.S. dollar is the functional currency and (2) inflationary holding gains are not reported currently (neither in the income statement nor as a direct adjustment to equity) if a foreign currency is the functional currency (an erroneous zero net effect is reported). The Temporal Method Does Not Properly Report the Economic Effect of Domestic Inflation Illustration 16B-7 shows that the temporal method does not properly report the $100,000 economic effect of the upward inflationary effect of $.05 caused by the 10% U.S. inflation an unrealized nominal inflationary holding gain. Clearly, the use of the $.50 historical exchange rate to translate fixed assets means that the upward factor of $.05 was not considered in determining the fixed asset amount in U.S. dollars. Consequently, $240,000 of suppressed fixed asset valuation exists Mex$ (4,800,000 $.05) in comparison to the PPP current-value approach. If noninflationary factors were present, their economic effect also would not be properly reported because they are dealt with in the same manner as the U.S. inflation effect. The inability of the temporal method to produce realistic translation results for the effects of domestic inflation on exchange rates is not addressed in FAS 52 (as was the inability of the current rate method to produce realistic translation results for highly inflationary economies). An interesting situation arises when (1) domestic inflation consistently exceeds foreign inflation and (2) the economic factors set forth in FAS 52 point to the U.S. dollar as the functional currency. In this situation, high domestic inflation causes the U.S. dollar to weaken against foreign currencies, pushes the direct exchange rate up, and results in the reporting of large exchange rate change losses under the temporal method. 4 Economically, such reported losses would be nonexistent. These unusual reporting results have not occurred under FAS 52 only because (1) the annual domestic inflation rates after 1981 (the year FAS 52 was issued) have not been high relative to the annual inflation rates of the majority of foreign countries 5 and (2) FAS 52 s requirements are such that the current rate method is used for most foreign operations. If domestic inflation were again to reach the high levels of and a fair number of companies changed their manner of doing business resulting in their having to use the temporal method instead of the current rate 2 FAS 52, paragraph If the liabilities of a foreign operation in a highly inflationary economy are indexed for inflation, the indexing adjustment results in a charge to the income statement. In U.S. dollars, the effect of that charge is to partially or fully negate the inflationary holding gain that otherwise would be reported. 4 This reporting result occurs in the typical situation in which the foreign unit has long-term debt. If fixed assets are financed solely by the parent s equity investment, it does not occur. 5 For the period , the United States did experience a much higher inflation rate than many foreign countries (averaging 12.5%), and the U.S. dollar weakened considerably against virtually all of these currencies during this period.

11 APPENDIX 16B EVALUATING THE VALIDITY OF THE FUNCTIONAL CURRENCY CONCEPT 11 method, however, FAS 52 would produce the same misleading results as the severely criticized FAS 8, and the business community again would be clamoring, and justifiably so, for a reexamination of the foreign currency rules, as it did with FAS 8. To be consistent with its approach in dealing with a high foreign inflation problem, the FASB s likely solution to high domestic inflation would be to amend FAS 52 so that companies operating overseas in low-inflationary economies (relative to the United States) would be required to use the current rate method instead because this would produce more realistic reporting results. Thus the underlying rationale of the approach in FAS 52 used for determining whether to use the current rate method versus the temporal method again would have to be disregarded. Thus the temporal method is no more able to produce realistic results when high domestic inflation is the dominant exchange rate change factor than the current rate method is able to produce reliable results when high overseas inflation is the dominant exchange rate change factor. So the state of affairs is that the functional currency concept is so theoretically lacking that it must be cast aside when the reporting results do not make sense. Furthermore, the temporal method is unable to produce realistic results when the exchange rate has changed because of noninflationary factors. V. THE FUNCTIONAL CURRENCY CONCEPT: IS IT VALID? The functional currency concept must be able to withstand the test of both (1) being sound theoretically and (2) being able to produce results that reflect the economic effects of changes in exchange rates. The Theoretical Soundness Test Without question, the true economics revolve around causes of exchange rate changes. Accordingly, the development of translation methodologies based on any other economic factors must be misguided. Only one true set of economic factors can exist. Consequently, the economic factors set forth in Appendix A of FAS 52 (indicators of cash flow, sales price, sales market, expense, financing, and intercompany transactions and arrangements) must be illusory and irrelevant both individually and collectively. The Results-Produced Test Because the reporting results under both the current rate method and the temporal method can reflect the true economic effect of changes to the exchange rate only by coincidence, their reporting results must be artificial. Thus the functional currency concept cannot be valid. After all, the concept calls for the use of these translation methods. Therefore, which particular currency a foreign unit uses to conduct its day-to-day operations is irrelevant especially in a world in which currencies are readily convertible into each other. Improper Linkage Any linkage between the manner of conducting operations and methods of valuing fixed assets is tenuous at best. Nobody would suggest that the fixed assets of an autonomous subsidiary in Texas should be valued differently from the fixed assets of a nonautonomous subsidiary in New York or that the economic exposure of the two operations should be measured differently. This is what the functional currency concept requires be done, however, for autonomous versus nonautonomous foreign operations. (The true economic exposure is competition, which exists for all operations whether or not they are autonomous.) The rationale set forth for making this assumption is that the economic exposure is different for each type of operation, an assertion that was soundly rejected in FAS 8 (by a 6-to-1 vote) but

12 12 APPENDIX 16B EVALUATING THE VALIDITY OF THE FUNCTIONAL CURRENCY CONCEPT barely accepted in FAS 52 (by a 4-to-3 vote). 6 Because two FASB board members voting on FAS 8 were also board members when FAS 52 was issued, 12 different individuals served as board members and voted on the autonomous versus nonautonomous argument. Of these 12 individuals, 7 rejected the autonomous versus nonautonomous argument, 4 voted for it, and 1 person voted against it in FAS 8 but for it in FAS 52. In our opinion, the focus should be on selecting the translation method that most realistically values fixed assets not on which particular perspective (foreign currency versus U.S. dollars) should be used. Unjustifiable Reporting Results of This Improper Linkage IBM has determined that all of its foreign operations have local currencies as their functional currencies. Hewlett-Packard has determined that all of its foreign operations have the U.S. dollar as their functional currency. Both companies have extensive operations in western Europe. From a commonsense perspective, it is illogical for these competing companies to be translating their European fixed assets so differently. This problem may be largely the result of the substantial latitude managements have in deciding between the two allowable translation methods a problem in implementing the concept. Thus inconsistencies in applying this ill-conceived concept can exacerbate the inherent reporting problems resulting from the concept itself. Inability to Meaningfully Deal with the Simplest of Situations The weakness of the functional currency concept is evident in even the simplest of situations. For example, if a U.S. company purchased a parcel of land in a foreign city as a long-term investment, there would be no true functional currency because there would be no day-to-day operations. An arbitrary selection between the local currency and the U.S. dollar would have to be made. Another example would be the acquisition of land in a foreign country that has natural resources, with the extraction to take place in the future. Again, an arbitrary selection would be necessary. It should not be necessary to make a completely arbitrary decision between two alternatives that in reality are totally artificial in terms of determining the translated valuation of such assets. VI. HOW THE FUNCTIONAL CURRENCY CONCEPT CAME INTO EXISTENCE FAS 52 was issued in 1981 as a solution to the perceived deficiencies of FAS 8, Accounting for the Translation of Foreign Currency Transactions and Foreign Currency Financial Statements, which was issued in The main criticism of FAS 8 was that the reporting results did not reflect the underlying economic events. This problem was attributed to using only a single unit of measure (the U.S. dollar), which allegedly could not deal well with significantly different economic facts. (FAS 8 required the use of the temporal method to achieve a U.S. dollar unit of measure.) Specifically, the complaints focused on (1) the reporting of exchange gains or losses when the events indicated that either no economic gain or loss had occurred or vice versa and (2) the requirement to report such exchange gains or losses currently in the income statement, which greatly increased the volatility of reported earnings. Prior to FAS 8, exchange gains and losses could be deferred and then amortized to income, a practice followed by most firms. These complaints were loud and many. In a nutshell, industry was furious with the reporting results of FAS 8. In response, in 1978 the FASB formed the largest task force ever assembled to 6 In 1992, we showed our analysis of the characteristics of the current rate and temporal methods and our conclusions regarding the functional currency concept presented in this chapter to Ralph Walters, one of the four FASB members who voted in favor of FAS 52. Walters stated that at the time he was not aware of the strengths and weaknesses of these two translation methods and that he strongly doubted that the other six board members were aware either. Furthermore, Walters stated that he agreed with our conclusions that the functional currency concept was not valid, and he suggested that we send the analysis and the conclusions to the FASB for the purpose of having it possibly reexamine FAS 52.

13 APPENDIX 16B EVALUATING THE VALIDITY OF THE FUNCTIONAL CURRENCY CONCEPT 13 reexamine what had proved to be the most complex of all accounting issues. Clearly, the FASB was under enormous pressure to find a politically acceptable improvement to FAS 8. The FAS 52 Solution FAS 52 (1981) made three major changes that were intended to correct the perceived deficiencies of FAS 8. Major Change 1: Allowing Multiple Units of Measure The first major change was to allow multiple units of measure so that different economic facts would be accounted for differently. Accordingly, the foreign currency unit of measure approach was sanctioned (implemented using the current rate method). 7 The U.S. dollar unit of measure approach was retained (implemented using the temporal method). Major Change 2: Bypassing the Income Statement in Most Cases The second major change required exchange rate change effects under the current rate method to be (1) called translation adjustments 8 and (2) reported as adjustments to be made directly to stockholders equity bypassing the income statement. Largely because the current rate method has since become the most widely used translation method, 9 the earnings volatility problem that occurred under FAS 8 (as discussed in Chapter 18) has substantially declined. Thus the business community s acceptance of FAS 52 may rest largely on the reduced income volatility. Major Change 3: Adding the Functional Currency Concept The third major change created the functional currency concept to serve as a framework for determining whether the foreign currency unit of measure (current rate method) or the U.S. dollar unit of measure (temporal method) is to be used for a particular foreign operation. Linkage between the Functional Currency Concept and Using Multiple Units of Measure It is unknown whether (1) the FASB first decided to allow multiple units of measure as a solution to FAS 8 and then, as an afterthought, created the functional currency concept as a means to determine when the current rate method or the temporal method should be used for a given foreign operation or (2) the FASB first created the functional currency concept in the process of trying to identify different economic facts, which, in turn, led to the decision to use multiple units of measure. In any event, the functional currency concept is not a necessary condition to allow the use of multiple units of measure; the FASB could have implemented the use of multiple units of measure simply by allowing firms to judgmentally select either the current rate method or the temporal method. What if Judgmental Selection Had Been Allowed in Choosing between the Current Rate Method and the Temporal Method? If judgmental selection had been allowed, managements would have been free to decide between the two allowable translation methods based on any rationale they deemed appropriate, such as (1) the functional currency used in the foreign operation, (2) the assessment of the causes of exchange rate changes, (3) whether the exchange rate changes are expected to be temporary or permanent, 7 Prior to being sanctioned in FAS 52, the current rate method had never been permitted in a U.S. generally accepted accounting principle, even though it was used widely in Europe. 8 Prior to the issuance of FAS 52, exchange gains and losses was the commonly used term (in FAS 8 and elsewhere) to describe the effect of exchange rate changes. FAS 52 drops this term and uses translation adjustments (current rate method) and foreign currency transaction gain or loss from remeasurement (temporal method). 9 Thomas G. Evans and Timothy Doupnik, Determining the Functional Currency under Statement 52 (Stamford: Financial Accounting Standards Board, 1986), pp

14 14 APPENDIX 16B EVALUATING THE VALIDITY OF THE FUNCTIONAL CURRENCY CONCEPT (4) the method that avoids income statement volatility, (5) the method that most closely produces current values for nonmonetary assets, (6) whether local managers are rewarded based on foreign currency statement results or U.S. dollar results, or (7) some other rationale (sound or unsound) of which there could be many. Considering such potential latitude in choosing between the two allowable translation methods, it appears worthwhile that the FASB should prohibit judgmental selection and instead identify the relevant different economic facts so that uniformity is achieved in using one translation method or the other. The Importance of Identifying the Proper Economic Facts When two accounting alternatives are allowed, the decision to identify the economic facts for deciding between the two alternatives must be done with extreme care if it is even possible. For instance, it may be impossible to determine the economic facts that indicate when to use LIFO versus FIFO. 10 If this is possible for foreign currency exchange translation (FAS 52 presumes that it is) and the wrong economic facts are identified, the wrong alternative may be selected, producing nonmeaningful reporting results. Compounding the problem is the fact that the two allowable alternative practices must be capable of achieving the stated objective. Otherwise, any attempt to decide when to use one method or the other based on economic facts is senseless. As an analogy, assume that the objective is to value a building at its fair market value, which may be above cost. If only the straight-line depreciation method and the double declining-balance method can be used, no amount of effort in trying to determine the economic facts as to when to use one depreciation method or the other will achieve the objective (although one method will always achieve a closer result than the other). In summary, achieving meaningful translated reporting results requires both (1) proper identification of economic facts and (2) the selection of appropriate related translation methods. Unfortunately, the FASB improperly diagnosed the problem with FAS 8. The problem with FAS 8 was not that it did not account differently for different economic facts, as the four members voting in favor of FAS 52 claimed, but that it was not based on addressing the causes of exchange rate changes. FAS 52 has the same major shortcoming. VII. WHY THE PPP CURRENT-VALUE APPROACH WAS NOT CHOSEN FAS 52 does not allow the use of the PPP current-value approach (nor did FAS 8). Two possible explanations for this exist. The First Possible Explanation: Not Addressing the Proper Issue One possible explanation is that the FASB did not adequately address the most important issue in foreign currency translation: causes of exchange rate changes. There appears to be substantial support for this explanation. There is no discussion of this issue in FAS 52 or in FAS 8. In the 1974 discussion memorandum that preceded FAS 8, a single page (in Appendix C) is devoted to some of the fundamental and technical causes of exchange rate changes. However, no methodology based on causes of exchange rate changes that would fit into the relatively new (at that time) floating exchange rate system was developed In light of the IASC s 1991 proposal to eliminate LIFO, (later dropped), it would have been interesting to see what economic facts the FASB could have identified for choosing between LIFO and FIFO. 11 The fixed exchange rate system existed from 1944 to August 15, 1971, under the Bretton Woods agreement. An attempt to use a similar pegged exchange rate system began in December 1971; this pegged rate system lasted until February Thus the floating exchange rate system was in its infancy during the time leading to the issuance of FAS 8.

15 APPENDIX 16B EVALUATING THE VALIDITY OF THE FUNCTIONAL CURRENCY CONCEPT 15 No Revised Discussion Memorandum The FASB did not prepare a revised discussion memorandum preceding the issuance of FAS 52. A revised discussion memorandum might have been useful if it had explored the floating exchange rate system, which was then nearly 10 years old. Thus the process that led to FAS 52 (as with FAS 8) focused on whether to use (1) a single unit of measure (the U.S. dollar or a foreign currency) or (2) multiple units of measure. Thus this process was a virtual rounding up of the usual suspects. The First Exposure Draft The first exposure draft (1980) would have required using the current rate method almost exclusively even in highly inflationary economies. This further supports the conclusion that causes of exchange rate changes were not adequately addressed because the translated financial statements would quickly become of limited value for such operations. As shown earlier, high foreign inflation would drive down the direct exchange rate so severely that the foreign fixed assets quickly would be reduced to near zero balances in the translated balance sheets (the disappearing plant problem shown earlier). The Second Exposure Draft Many companies operating in highly inflationary economies noted this problem, and in the revised exposure draft (1981), the FASB proposed that companies in such environments adjust their fixed assets for inflation prior to translation at the current exchange rate. This proposal (later withdrawn) was a clear attempt to address the causes of exchange rate changes. Even so, the consideration was narrowly focused on highly inflationary economies. Erroneous Conclusions Regarding Constructed Exchange Rates Appendix D of the 1974 discussion memorandum contains a three-page discussion of constructed exchange rates based on PPP. 12 In the process that led to FAS 8, the use of constructed exchange rates was disregarded as a viable alternative because (1) the basic approach (incorrectly) was assumed to be a possibility only under the former fixed exchange rate system and (2) the methodology that was offered did not allow for the consideration of noninflationary causes of exchange rate changes. As shown later, however, the PPP current-value approach can be applied within the framework of the floating exchange rate system. Also, the effect of noninflationary causes of exchange rate changes can be isolated and adjusted for in the translation process. Later we show how to update fixed assets for a period of several years using the PPP current-value approach when noninflationary factors exist. The Second Possible Explanation: Trying to Stay within the Bounds of Historical Cost Regardless of its ability to reflect the economics, the primary objection to using the PPP valuation technique is the perceived inappropriateness of mixing foreign fixed assets valued at current values with domestic fixed assets valued at historical costs a departure from historical cost. Accordingly, to stay within the bounds of historical cost, the PPP current-value approach may have been dismissed out of hand. An influencing factor may have been the lack of reliable price indices for some countries that have highly inflationary economies. For these situations, however, the temporal method could have been mandated as a practical matter, with the PPP current-value approach being used for other countries. As shown earlier, however, the temporal method results achieve inflationary reporting results as foreign fixed assets had been adjusted for inflation. Accordingly, its use automatically results in 12 Dealing with disparities in price levels when translating foreign currency financial statements was recommended in NAA Research Report 36, Management Accounting Problems in Foreign Operations (New York: NAA, 1960). This report recommended the use of constructed exchange rates as an alternative to fixed exchange rates when a wide disparity in relative purchasing powers at the current exchange rate exists.