6. Most expenses incurred and paid in U.S. dollars
7. Accounting records kept in U.S. dollars
8. Subject to U.S. tax, SEC, and 1940 Exchange Act regulations

Since the fund was set up to invest in Spain, it is assumed that U.S. shareholders are interested in the impact of an exchange rate change on the fund’s cash flows and equity; that is, the shareholders do not invest in Spanish securities only because of attractive yields, but also are making a currency play that directly affects the measurement of cash flow and equity.

Management’s Viewpoint

Management disagreed with the auditors. Following is its rebuttal:

1. Incorporation in the United States with U.S. shareholders. FAS 52 clearly states that the functional currency should be determined by “the primary economic environment in which that entity operates rather than by the technical detail of incorporation.” Similarly, nowhere does FAS 52 state that the facts that the company has U.S. shareholders and pays dividends in U.S. dollars are relevant. In fact, FAS 52 concerns itself throughout with the firm and its management rather than its shareholders.
2. Financial reporting in U.S. dollars under U.S. GAAP. The auditors fail to differentiate between reporting currency and functional currency. It is clear that the U.S. dollar should be the reporting currency, but that alone does not mean that the U.S. dollar is the functional currency.

3. Payment of certain expenses in dollars. The payment of expenses in U.S. dollars is no reason to make the dollar the functional currency. While expenses of some $8 million for calendar year 2010 were incurred in U.S. dollars, income of over $100 million was earned in euros.
4. U.S. tax and SEC regulations. These considerations are relevant for the reporting currency, not the functional currency.

The decisive argument against identifying the dollar as the functional currency is that doing so does not provide information that is, in the words of FAS 52, “generally compatible with the expected economic effect of a rate change on an enterprise’s cash flow and equity.” Specifically, the operating cash flow of the Fund is located entirely in Spain once the initial transfer of funds raised by the issue of capital is made. The Fund buys and sells investments in Spain, and receives all its income from Spain. If the functional currency is euros, then realized currency fluctuations are recognized only when money is repatriated to the United States. The present practice of “realizing” an exchange profit or loss when, for example, cash in Spain is exchanged for an investment purchased in Spain is wrong and misleading.

Consider an example. Suppose that the fund deposits EUR100,000,000 in a Spanish bank when the exchange rate is EUR1 = $1.4090. One month later, when the exchange rate is EUR1 = $1.3988, the fund purchases and pays for an investment of EUR100,000,000, which it sells for cash on the same day, having decided the investment was unwise. Ignoring transaction costs, the fund has EUR100,000,000 in cash in Madrid at both the beginning and the end of the week. If the functional

currency is euros, there is no realized gain or loss. However, translation to dollars generates an unrealized currency loss of $1,020,000 , which would be realized only when the amount in question is repatriated to the United States. This is analogous to the purchase of a stock whose price later falls. If the U.S. dollar is the functional currency, the transaction in question would result in a realized loss on exchange of $1,020,000. This result is absurd in terms of any commonsense view of cash flow; indeed, it highlights that, given the fund’s purpose, the effect on the reporting of income of adopting the U.S. dollar as the functional currency is equally absurd.

The net asset value of the fund is determined each week in U.S. dollars, and reported to stockholders in U.S. dollars. This is entirely consistent with having the U.S. dollar as the appropriate reporting currency. Using the dollar as the functional currency implies that there is a realistic and practical option on each transaction of moving between the dollar and the euro. This assumption is patently wrong; the fund will only repatriate its base capital under two circumstances: (1) liquidation or (2) as a temporary expedient if Spanish yields fall below U.S. yields.

General Thrust of FAS 52

The language of FAS 52 indicates that its authors did not write it with direct reference to a situation such as that of the Offshore Investment Fund, that is, a company that raises money for the single purpose of investing it in a foreign country. FAS 52 seems rather to be written from the viewpoint of an operating holding company owning a separate, distinct foreign operating subsidiary.

FAS 52 defines the functional currency of an entity as the currency of the primary economic environment in which that entity operates. Had the fund been incorporated in Malta and, as a separate entity, borrowed the funds from its U.S. parent, use of the local currency would have been automatic. If substance is to prevail over form, one must conclude that the euro should still be used.

Paragraph 6 of FAS 52 states, “for an entity with operations that are relatively self-contained and integrated within a particular country, the functional currency generally would be the currency of that country.” This statement reinforces the operational aspect that governs the choice of the functional currency; it is surely wrong to argue that the operations of the fund are conducted anywhere but in Spain.

Paragraph 8 reinforces the contention that “management’s judgment will be required to determine the functional currency in which financial results and relationships are measured with the greatest degree of relevance and reliability.”

Finally, paragraphs 80 and 81 draw a very clear distinction that reinforces our ( management’s) contention. Paragraph 80  reads :

In the first class are foreign operations that are relatively self-contained and integrated within a particular country or economic environment. The day-to-day operations are not dependent upon the economic environment of the parent’s functional currency; the foreign operation primarily generates and expends foreign currency. The foreign currency net cash flows that it generates may be reinvested and converted and distributed to the parent. For this class, the foreign currency is the functional currency.

This definition should be contrasted with paragraph 81, which states:

In the second class . . . the day-to-day operations are dependent on the economic environment of the parent’s currency, and the changes in the foreign entity’s individual assets and liabilities impact directly on the cash flows of the parent company in the parent’s currency. For this class, the U.S. dollar is the functional currency.

Since the purpose of single-country funds is to create entities of the first rather than the second class, paragraph 80  precisely describes the operations of the Overseas Investment Fund.

Required

1. Based on the arguments presented, what do you think should be the functional currency in this case?