Consolidation of Foreign Subsidiaries and Exchange Differences

CONSOLIDATION OF FOREIGN SUBSIDIARY

Subsidiary with significant autonomy

Every entity should have its functional or home currency – ie, the currency of the economic environment in which it mainly generates and expends cash.  In order to determine the functional currency, you first need to consider the following set of primary factors:

1. The currency in which the entity’s goods are priced or the sales revenues are collected.
2. The currency of the country whose competitive forces and regulations most influence the price of the goods.
3. The currency in which costs such as labour and materials are denominated and settled, or the currency that influences such costs.

If you can’t make a definitive conclusion based on these, you’ll need to consider the following secondary factors:

1. The currency in which funds from financing activities (debt and equity) are generated

1. The currency in which receipts from operating activities are retained – ie, the currency in which the entity maintains its excess working capital balances.

These factors will normally need to be considered when the primary factors don’t point to a single currency – eg when the “sales” factor shows euros to be the functional currency while the “cost” factor indicates dollars.

FOREIGN CURRENCY TRANSACTIONS IN A SINGLE ENTITY

In essence, there are two steps to dealing with a foreign currency transaction:

1. Initial recognition and
2. Subsequent measurement.

On the initial recognition, the amount of foreign currency involved has to be converted to the entity’s functional currency by applying the spot exchange rate between the currencies at the transaction date.

The subsequent measurement step is more complicated because monetary items and non-monetary items require different accounting treatments.

Monetary items are defined by IAS21 as “money held, and assets and liabilities to be received or paid, in a fixed or determinable number of units of currency”. Examples include cash, accounts receivable, and accounts payable.

Non-monetary items are characterized by the “absence of the right to receive, or obligation to deliver, a fixed or determinable number of units of currency”. Examples include inventories, plant and equipment, and investments in equity instruments.

THE CONSOLIDATION OF FOREIGN SUBSIDIARIES

Foreign subsidiaries can be classified into two groups.  First, those which are dependent on parents and in fact act as an extension of parent current operations.  The second category is where the foreign subsidiary is independent in its operations and acts with autonomy.  

In the first category which is a dependent subsidiary the consolidation process is rather straightforward.  In the second category, that is, an autonomous subsidiary the consolidation rules relating the foreign exchange are significantly different.

This blog covers the topic of accounting treatment when consolidating a foreign subsidiary that is autonomous in its activities

In a group context, when an entity determines the functional currency of a foreign operation – eg, an overseas subsidiary – the relationship between the two organizations needs to be considered.  There are two possible scenarios.

One is that the overseas operation has a significant degree of autonomy – eg, inter-company transactions are infrequent. In this case, the functional currency of the foreign subsidiary is that entity’s local currency.

The other scenario is that the foreign operation is an extension of the parent – eg, inter-company transactions are frequent – and it depends on the parent company for financing. In this case, the subsidiary takes the parent’s functional currency.

The essence of consolidating foreign subsidiaries is that their financial statements are presented in a different currency from that of their parent’s presentation currency. An important first step in the consolidation process is to translate the statements of the foreign operation into the parent’s presentation currency.

The method to use is determined as shown in the diagrams below.

Here, we shall focus on illustrating the rules for translation using the “closing rate method” in the first scenario – ie, that of a subsidiary with significant autonomy. These are as follows:

1. Items on the statement of profit or loss and other comprehensive income are translated using the rate on the transaction date, although average rates are acceptable.
2. Assets and liabilities are translated using the closing rate.
3. Dividends paid during the year are translated using the rate on the date of payment.
4. Share capital and pre-acquisition reserves are translated using the rate on the date of acquisition.
5. The remaining balance in equity is the “plug-in” figure for post-acquisition reserves.
6. Exchange differences on intra-group items are recognized in profit or loss unless they are a result of the retranslation of an entity’s net investment in a foreign operation when it is classified as equity.
   
7. When a subsidiary is disposed of, all the accumulated exchange losses and gains which were part of equity are transferred to the profit and loss.

You should learn and remember the basic consolidation techniques such as goodwill calculations under IFRS 3 (revised) and the implication behind non-controlling interests (NCI), together with how the NCI figures should be determined.

On top of these methods, there are two key “top-ups” for the consolidation of foreign subsidiaries:

1. Goodwill and fair-value adjustments to the carrying amounts of net assets are treated as net assets of foreign operations, so they will be translated in the same way as any other net assets of the acquired subsidiary. If the closing rate method is applied, goodwill and fair-value adjustments have to be retranslated every year-end at the closing rate, giving rise to a translation gain or loss.
2. If the closing rate method is applied, the translation gain or loss is reported in the other comprehensive income (OCI) section of the consolidated financial statements.