[SOLVED] The Offshore Investment Fund (OIF) was incorporated

The Offshore Investment Fund (OIF) was incorporated in Fairfield, Connecticut, for the sole purpose of allowing U.S. shareholders to invest in Spanish securities. The fund is listed on the New York Stock Exchange. The fund custodian is the Shady Rest Bank and Trust Company of Connecticut (“Shady Rest”), which keeps the fund’s accounts. The question of which currency to use in keeping the fund’s books arose at once. Shady Rest prepared the fund’s books in euros,
since the fund was a country fund that invested solely in securities listed on the Madrid Stock Exchange. Subsequently, the fund’s auditors stated that, in their opinion, the functional currency should be the U.S. dollar. This case is based on an actual occurrence. Names and country of origin have been changed to ensure anonymity.

Effects of the Decision
The decision to possibly adopt the U.S. dollar as the functional currency for the fund created considerable managerial headaches. For one thing, the work of rewriting and reworking the accounting transactions was a monumental task that delayed the publication of the annual accounts. The concept of the functional currency was a foreign concept in Spain, and the effects of the functional currency choice were not made clear to the managers. Consequently, they continued to manage the fund until late in November without appreciating the impact the currency choice had on the fund’s results.

Additional difficulties caused by the functional currency choice were:
a. Shady Rest, with some $300 billion in various funds under management, still had not developed an adequate multicurrency accounting system. Whereas accounting for a security acquisition would normally be recorded in a simple bookkeeping entry, three entries were now required. In addition, payment for the purchase itself could impact the income statement in the current period.
b. More serious problems related to day-to-day operations. When a transaction was initiated, the fund manager had no idea of its ultimate financial effect. As an example, during the first year of operations, the Fund manager was certain that his portfolio sales had generated a profit of more than $1 million.

When the sales finally showed up in the accounts, the transaction gain was offset by currency losses of some $7 million!

Reasons Given for Choosing the Dollar as Functional
The auditors gave the following reasons for choosing the dollar as the fund’s functional currency:
a. Incorporation in the United States
b. Funded with U.S. shareholder capital
c. Dividends determined and paid in U.S. dollars
d. Financial reporting under U.S. GAAP and in U.S. dollars
e. Administration and advisory fees calculated on U.S. net assets and paid in U.S. dollars f. Most expenses incurred and paid in U.S. dollars
g. Accounting records kept in U.S. dollars
h. 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:
a. 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.

b. 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.

c. 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.

d. 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?

Question: The Offshore Investment Fund (OIF) was incorporated