A. If labor, materials and other costs are primarily local costs, that means the foreign entity is expending cash in its local currency. That is an indication that the foreign entity's local currency should be designated as its functional currency.
B. If financing is obtained from local foreign sources and from its own operations, then the foreign entity is dealing in its own currency for its financing needs. Financing is considered to be an activity that both generates and expends cash, because the company borrows money and then repays it with interest. So that is an indication that the foreign entity's local currency should be designated to be its functional currency.
C. If the cash flows of the subsidiary are in the foreign currency, that means it is generating and expending cash in its local currency. That is an indication that the foreign entity's local currency should be designated as its functional currency.
D. The definition of a foreign entity's functional currency is that it is normally the currency in which the entity generates and expends cash. If a company generates and expends cash in one currency only, then its purchases and its sales will not be subject to exchange rate risk. Furthermore, a company that operates only in the currency of its own economy will find that its selling prices are determined by its local market or its local government's regulations. In this case, the entity's functional currency should be the currency it buys and sells in, and that will be its local currency. On the other hand, if the entity's sales prices are determined more by worldwide competition or by international prices, that is an indication that it may be buying and selling goods in currencies other than its own currency. And when the foreign entity is buying and selling goods in currencies other than its own currency, then the FASB Accounting Standards Codification recommends that its functional currency be designated as the U.S. parent's currency and not the foreign entity's local currency.
The reason for this is that the foreign entity is not operating in its local currency only. It is operating in multiple currencies. Therefore, since it is necessary to choose one currency to be the functional currency, it is better to just make the functional currency the U.S. dollar. That limits the number of currency conversions that are necessary to convert the entity's financial statements into the parent's currency, which is assumed to be the U.S. dollar.
Therefore, when sales prices are influenced by changes in the exchange rate between the dollar and the foreign currency, this is an indication that the foreign entity is operating in multiple currencies, and thus the dollar is the functional currency. Note that this is an indication and this is not the strongest indication that could exist, but it is the best of the choices provided. This question is easier to answer if you use the process of elimination. All of the other answer choices point to designating the foreign entity's local currency to be its functional currency rather than the U.S. dollar.
