Can you provide a general overview of "local" vs. "functional currency", and the impact on hedging and intercompany transactions? (Webinar Attendee Question)

Many companies are seduced into electing local currency for the functional currency of a foreign subsidiary, not because it is a truly independent operating entity, but because the accounting looks good in the first few years. It looks good because the changes in value of the assets and liabilities of the subsidiary are revalued in OCI—where no one is looking. The intercompany balance on the other hand creates gains and losses in earnings—where everyone is looking (unless they have be designated long-term of an investment nature). This has a tendency to take management’s eyes “off the currency ball”: the true economic risk to the company is the USD value of the foreign currency receivables & payables, not the intercompany. Historically, in the widget sale world, the parent would send a widget to a subsidiary, the subsidiary would sell it to a 3rd party in local currency. When the sub received payment they would pay the parent, so the intercompany served as a proxy for the 3rd party exposure. These days the popular “cost-plus” tax strategy frequently results in intercompany balances that are the reverse of the economic exposure of the company (intercompany payable/short position from cost plus when the subsidiaries 3rd party assets generally exceed their 3rd party liabilities). This results in companies placing hedges that exacerbate rather than mitigate economic exposures.

Additional differences between a local currency functional and USD functional subsidiary is how “non-monetary” accounts impact consolidation. If you are a software company with deferred revenue held in a foreign functional subsidiary, you must wait each month to learn what rate that fixed amount of foreign deferred revenue will equal in USD. If that same deferred revenue were held in a USD functional entity you could accurately predict to the penny the USD value that would appear in consolidation when it is reclassified to revenue. Same with heavy capital outlays: a foreign functional entity’s depreciation will be translated to USD at whatever the rate is when consolidated, whereas a USD functional entity will report those same depreciation costs at a fixed USD value every period throughout its useful life. Very useful planning tool, don’t you think?

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