RSMUS.comWhen establishing a new international subsidiary in a NetSuite, selection of currency can be confusing, as NetSuite does not use the term “Functional Currency”. These systems use words like “Base Currency” or “Transactional Currency”.
Why is it important to know 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 inside NetSuite will ensure that you are leveraging the power of your system to drive the proper accounting. Setup the currency incorrectly – and you ensure yourself of endless complex reconciliations. Selecting a currency is a foundational decision in the setup of a subsidiary in NetSuite cannot to be changed. To change the base currency for a subsidiary requires setting up a replacement subsidiary with the proper currency and inactivating the original.
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
- Expenses
- Financing Sources
- Intercompany Activity
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 RSM’s Technical Accounting Consulting (TAC) practice assist clients with the evaluation and determination of proper functional currency.
Now that I know my Functional Currency – what are the implications?
There are 2 methods of accounting for foreign currency. Translation and Re-measurement.
Translation is used when the subsidiary’s functional currency is different from the parent functional currency. For example; if we have a US parent with a USD functional currency and a UK subsidiary with a GBP functional currency. The UK books would be kept in GBP and translated to USD as part of the consolidation process. Generally, Revenue and Expenses are translated at average rates, assets and liabilities at the reporting date spot rate and equity is carried at historical rate at the time of the investment. 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 is used when the subsidiary’s functional currency is deemed to be that of the parent entity. For example; if we have a US parent with a USD functional currency and a UK subsidiary with a USD functional currency, but transacts business in GBP. Because we need to keep the books in USD, we need to re-measure all of our transactions in GBP to USD and book the resulting gains and losses in the P&L. Under re-measurement we will have both Realized gains and losses and Unrealized gains and losses.
Realized gains and losses happen when we close out a transaction. For example, when we vouch an invoice the expense in GBP will be translated to USD at the spot rate of the expense date. When we subsequently pay that invoice, the payment will be translated to USD at the spot rate of the payment date. A realized gain or loss will be posted based on the change in the rate from the time of vouching to the time of payment.
Unrealized gains and losses are assessed on open transactions (open AR and AP balances) and also on assets held in currency other than the functional currency, such as bank accounts held in the local currency. These are measured against the period end spot rate to book the unrealized gain or loss.
Proper Setup in NetSuite
The base currency for each 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
When the local currency is the functional the ERP setup is fairly straightforward. The accounting is done in local currency which matches the transactional currency. No need to worry about gains & losses while bookkeeping for the local entity. As part of the month end close you will define for each period the 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. Generally, Revenue and Expenses are translated at average rates, assets and liabilities at the reporting date spot rate and equity is carried at historical rate at the time of the investment. 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 NetSuite to re-measure transaction as we go. In this case, we set the base currency to be that of the parent entity. Then we effectively treat every local currency transaction as a foreign currency transaction (as re-measurement is also the accounting required for foreign currency transactions). To facilitate this, in the customer and vendor setup processes, we need to set a transaction default currency for our interactions with those vendors and customers. In addition, our local bank account will need to be setup as denominated in local currency. Now 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 may also have reporting requirements independent of our consolidated requirements, and that report is often required in the local currency. NetSuite uses “Multi-Book” accounting to be able to fulfill this need. What multi-book enables is the creation a second complete ledger that enables clients to meet the multiple reporting requirements. This include accounting in alternate currencies, or differences in accounting treatment of things like revenue recognition, depreciation and amortization.
Graydon Smith
Graydon Smith is a Principal in RSM's Management Consulting Practice