When establishing a new international subsidiary in an Enterprise Resource Planning (ERP) system, selection of currency for international subsidiaries can be confusing as ERP systems don’t typically use the term, “functional currency.” Typically, these systems use words like, “base currency,” or, “transactional currency.”
Why is it important to understand your functional currency?
Functional currency will drive the type of accounting required to handle your foreign currency gains and losses. Aligning your functional currency correctly with your ERP system will ensure that you are leveraging the power of your accounting system to drive the proper accounting and financial consolidations. By setting up the currency incorrectly you will ensure endless complex reconciliations in the future. This is often a foundational decision in the setup of a subsidiary ledger in ERP systems and not able to be changed. To change the base currency for a subsidiary often requires setting up a new subsidiary with the proper currency.
How do I determine my functional currency?
Accounting standards detail the requirements for determining functional currency which is based on a number of economic indicators and an evaluation of the subsidiary’s dependence on the parent organization. These indicators include:
- Cash flow
- Sales market & pricing
- Financing sources
- Inter-company activityNow that I know my functional currency – what are the implications?
- There are 2 methods of accounting for foreign currency:
- To generalize, if a subsidiary is dependent in a number of these indicators, then the functional currency is likely the parent company currency. Those international sales offices that drive sales back to the parent company are a prime example. If the subsidiary is a fully functional operation that has its own sales and expenses then the local currency is likely the functional currency. My colleagues in the assurance practice assist clients with the evaluation and determination of proper functional currency.
- Translation – Used when the subsidiary’s functional currency is different from the parent functional currency. Under translation, foreign exchange gains and losses are not posted to the P&L; but instead appear in the equity section of the balance sheet as a Cumulative Translation Adjustment.
- Re-Measurement – Used when the subsidiary’s functional currency is deemed to be that of the parent entity and gains and losses are posted to the P&L.
Proper Setup in ERP
In order to leverage the capabilities of the ERP, the base currency for the subsidiary should be set to functional currency. This ensures that your base accounting is done in the proper functional currency and can feed directly into your consolidations.
Functional currency equals local currency of subsidiary
The bookkeeping is done in local currency. During consolidation, a rate table is used to define average, spot and historical rates for that period. In the chart of accounts setup, each account will specify the rate that account should use for consolidation. The resulting Cumulative Translation Adjustment is applied to the equity section of the consolidated balance sheet to account for the differences that arise from translating a balanced trial balance in local currency with the varying rates.
Functional currency does not equal local currency
When the functional currency is deemed to be the parent currency the setup and the bookkeeping becomes a bit more complex, but we can leverage the power of the ERP system to re-measure transaction as we go. In this case, we set the base currency to the functional currency then we effectively treat every local currency transaction as a foreign currency transaction (as re-measurement is the accounting required for foreign currency transactions). Realized gains and losses will be calculated as we transact and unrealized gains and losses are calculated as a step in the monthly closing process. Now we can consolidate the local books to parent with no extra steps for currency, as our ledger is already in sync with the parent entity.
What about my local statutory reporting – I need a local currency ledger.
One of the challenges with setting the base currency to be functional currency, is that local jurisdictions also have reporting requirements independent of our consolidated requirements, and that report is often required in the local currency. Many systems, such as NetSuite, have introduced, “multi-book” accounting. What multi-book enables you to do is create a second complete ledger that helps clients meet the needs of multiple reporting requirements. These include accounting in alternate currencies, or differences in accounting treatment of things like revenue recognition, depreciation and amortization.