Under U.S. GAAP, in preparing consolidated financial statements of a U.S. parent company with a foreign subsidiary, the foreign subsidiary's functional currency is the currency:
a. In which the subsidiary maintains its accounting records.
b. Of the country in which the parent is located.
c. Of the environment in which the subsidiary primarily generates and expends cash.
d. Of the country in which the subsidiary is located.
Choice "c" is correct. The foreign subsidiary's functional currency is the currency of the environment in which the subsidiary primarily generates and expends cash.
Rule: The functional currency of a company may be:
1.A foreign entity's local currency, which is typically the one in which the entity keeps its books;
2.The currency in which the financial statements will be presented, which is the currency of the parent company; or
3.A foreign currency other than the one in which the foreign entity maintains its books.
Rule: The functional currency of an entity generally depends upon the environment in which the entity generates and expends cash (unless there is a requirement by law to use another currency), which may be any of the above three. However, the functional currency cannot be the local currency if the foreign entity operates in a highly inflationary environment (i.e., approximately 100% over three years).
Choices "a", "d", and "b" are incorrect, any of which could be considered a functional currency, given the proper circumstances. The definition of a functional currency is given in the correct selection, "c".