Understanding the Choice and Consequences of a Subsidiary's Functional CurrencyWhen U.S. multinationals establish new overseas subsidiaries, management is required todetermine whether the functional currency for each overseas subsidiary should be the local currencyor the U.S. dollar. Under SFAS 52, the functional currency should be the primary operating currencyof that subsidiary. (There is one exception: parent companies are required to use their own reportingcurrency in highly inflationary economies.) A self-contained unit with substantial local currencyreceipts and expenses should select the local currency as its functional currency. However, asubsidiary that purchases much of its raw inputs from a U.S. parent or sells a substantial part of itsproduction to its U.S. parent each year—in short, operations that are essentially an extension of theparent company’s business—should select the U.S. dollar as its functional currency. While theselection of a subsidiary’s functional currency does not change the economic realities of the businessor its operations, it does change how a company reports the changes in value resulting fromfluctuating exchange rates.The following simple example illustrates the consequences when a subsidiary’s functionalcurrency is the USD and when a subsidiary’s functional currency is its local currency (see Exhibit 8 for an illustration of these issues). The example assumes the following: •

GM-Strasbourg (GMS) is a foreign subsidiary of GM, financed entirely by equity •

GMS has assets of € 50 cash •

The euro depreciates 10% against the dollar, moving from € 1.00=$1.00 to € 1.10=$1.00 Functional currency is USD If GMS is very tightly integrated into its parents operations thenits functional currency should be the same as its parent’s reporting currency (U.S. dollars). GMS’scash holding of 50 euros is therefore considered a foreign currency exposure. A depreciation of theeuro against the U.S. dollar reduces the value of GMS’s euro holdings: the € 50 that used to be worth$50 are now only worth $45. GM, as a consolidated entity, reports this on its income statement as a$5 foreign exchange loss. This reduction in net income flows through to the balance sheet reducingshareholder’s equity (retained earnings) by $5. Functional currency is the local currency If GMS is less tightly integrated into its