Introduction
The consolidation of foreign
subsidiaries includes the preparation and presentation of consolidated
financial statements for a group of entities under the control of a foreign parent
company. The parent has the obligations to prepare a consolidated financial statement, which is the financial
statement of a group presented as those of a single economic entity. Control by the parent is the power to
govern the financial and operating policies of the subsidiary entities so as to
obtain benefits from their activities (Holt, P. E.; 2004).
Generally accepted accounting principles (GAAP) in the United
States (US) usually require that companies which own more than 50 percent of
the voting stock of foreign corporations prepare consolidated financial
statements. The foreign financial statements must be recast into US GAAP and
the foreign currency financial statements must be translated into US dollars.
Alternative methods of translating foreign currency have major impacts on
consolidated financial statements and on the behavior of management. The
interests of financial statement users are better served by alternative
presentations of foreign currency denominated accounts rather than by
consolidation (Sinn, H. W.; 1990)
This
paper provides a comprehensive review of the primary requirements and
application of International Financial Reporting Standards (IFRS), which are
relevant to the consolidation of foreign subsidiaries. We shall be
discussing the various types of business consolidation, the concept of a
consolidated financial statement, including the rights, powers and operational
duties of a consolidated
company. In addition to this, we shall also discuss the effects of changes in
foreign exchange rates, strategies used by foreign parent companies in
reporting foreign currency transactions in the functional currency and the
translation of a foreign operation.
Finally, this paper will discuss the issue of parent-subsidiary
relationship emanating from stock acquisition where the parent is the acquiring
company and the subsidiary is the acquired company. In addition to this, we
shall discuss the concept of controlling interest where the parent company owns
a majority of the common stock; and non-controlling interest or minority
interest which covers the rest of the common stock that the other shareholders
own.
Types of Business Consolidations
In essence, there are four forms of business combinations
and consolidations. To start with, we have the concept of statutory merger, where a business combination results
in the liquidation of the acquired company’s assets and the survival of the
purchasing company. In other words, it is the legal combination of two or more corporations in which only
one survives as a legal entity. In addition to this, we have the statutory consolidation,
a process through which a business combination creates a new company in which
none of the previous companies survive. It is a situation where all the companies in a combination
cease to exist as legal entities and a new corporate entity is created.
Furthermore, there
is what we refer to as stock acquisition, a business combination in which the
purchasing company acquires the majority, more than 50%, of the common stock of
the acquired company and both companies survive; and finally, the concept of
amalgamation, which covers an existing company taken over by another existing company (Marcos, M.; Whalley, J.; Robert, M. 2006). In such
course of amalgamation, the consideration may be paid in cash or in Kind, and
the purchasing company services in this process.
Consolidation Procedures
Consolidated financial statements shall be
prepared using uniform accounting policies for like transactions and other
events in similar circumstances within the consolidation. In preparing
consolidated financial statements, an entity combines the financial statements
of the parent and its subsidiaries line by line by adding together like items
of assets, liabilities, equity, income and expenses. In order that the
consolidated financial statements present financial information about the group
as that of a single economic entity, the following steps are then taken:
(a) The carrying amount of the
parent’s investment in each subsidiary and the parent’s portion of equity of
each subsidiary are eliminated.
(b) Minority interests in the
profit or loss of consolidated subsidiaries for the reporting period are
identified; and
(c) Minority interests in the net
assets of consolidated subsidiaries are identified separately from the parent
shareholders’ equity in them.
Intragroup
balances, transactions, income and expenses shall be eliminated in full
Minority interests shall be presented in the consolidated balance
sheet within equity, separately from the parent shareholders’ equity. Minority
interests in the profit or loss of the group shall also be separately disclosed
(Holt, P. E. 2004). Minority interest
is that portion of the profit or loss and net assets of a subsidiary
attributable to equity interests that are not owned, directly or indirectly
through subsidiaries, by the parent.
Non-controlling Interests of Foreign
Subsidiaries
A noncontrolling
interest, sometimes called minority interest, is the portion of equity in a
subsidiary not attributable, directly or indirectly, to a parent. The objective
of this is to improve the relevance, comparability, and transparency of the
financial information that a reporting entity provides in its consolidated
financial statements by establishing accounting and reporting standards that
requires the ownership interests in subsidiaries held by parties other than the
parent be clearly identified, labeled, and presented in the consolidated
statement of financial position within equity, but separate from the parent’s equity
(Shao, L. P.; 2004).
The amount of
consolidated net income attributable to the parent and to the noncontrolling
interest should be clearly identified and presented on the face of the
consolidated statement of income. Changes in a parent’s ownership interest
while the parent retains its controlling financial interest in its subsidiary
should be accounted for consistently. A parent’s ownership interest in a
subsidiary changes if the parent purchases additional ownership interests in
its subsidiary or if the parent sells some of its ownership interests in its
subsidiary. It also changes if the subsidiary reacquires some of its ownership
interests or the subsidiary issues additional ownership interests. When a
subsidiary is deconsolidated, any retained noncontrolling equity investment in
the former subsidiary should be initially measured at fair value. The gain or
loss on the deconsolidation of the subsidiary is measured using the fair value
of any noncontrolling equity investment rather than the carrying amount of that
retained investment. Entities provide sufficient disclosures that clearly
identify and distinguish between the interests of the parent and the interests
of the noncontrolling owners (Marcos, M.; Whalley, J.;
Robert, M.; 2006).
Financial Accounting Standards (FAS 52) established the
rules governing the consolidation of foreign subsidiaries, which form the
corner stone of foreign subsidiary consolidation. It begins with the determination
of the functional currency. Basically, the functional currency is the currency
in which the bulk of the business activities of the entity are carried out. Intuitively,
the functional currency
is the currency of the primary economic environment
in which the entity operates. The primary economic environment in which an
entity operates is normally the one in which it primarily generates and expends
cash (Shao, L. P.; 2004).
An entity considers the following factors in
determining its functional currency:
(a) The currency that mainly
influences sales prices for goods and services (this will often be the currency
in which sales prices for its goods and services are denominated and settled);
and secondly, the currency of the country whose competitive forces and
regulations mainly determine the sales prices of its goods and services.
(b) the currency that mainly
influences labor, material and other costs of providing goods or services (this
will often be the currency in which such costs are denominated and settled).
In this case, let’s assume we are faced with a set up in
which an Indian subsidiary of a US company has a home currency (Rupees) that
differs from its functional currency (Dollars) and also carries out some debt
service transactions in British Pounds. In addition to this, we determine
whether the functional currency is also the home currency; stating that, if the
functional currency is the
home currency of the subsidiary, one uses the current method to find the correct multipliers. On the
other hand, if the functional currency is not the home currency of the subsidiary, one uses the temporal or historical method to find the correct multipliers (Kaminarides, J. S.; 1981).
The Financial Accounting Standards (FAS 52) also stated
that if the current method applies, all assets and liabilities use current
(spot) rate on the closing date. Equity items other than retained earnings use
the spot rates on transaction dates, i.e. specific identification; and with
retained earnings, shares of pre-control retained earnings use specific
identification, i.e., the spot rate on the date of purchase or consolidation.
Furthermore, retained earnings components identifiable with specific dates
(including dividends) are recorded with income statement items. Under the current
method, all assets and liabilities are translated at the same rate with all
income statement items translated at the same rate except for some identifiable
exceptions. Under the temporal method however, assets and liabilities are translated
at different rates depending on whether they are monetary or non-monetary and
the income statement items are translated using a number of different dates.
Reporting Foreign Currency Transactions in the Functional Currency
Statement of Financial Accounting Standards (SFAS 52) is
the primary source of the Generally Accepted Accounting Principles (GAAP) for
translation of foreign currency financial statements. SFAS 52 introduced the
concept of functional currency,
defined as “the currency of the primary
economic environment in which the entity operates; normally, that is, the
currency of the environment in which an entity primarily generates and expends
cash.” Foreign currency
is a currency other than the functional currency of an entity. Exchange difference is the
difference resulting from translating a given number of units of one currency
into another currency at different exchange rates.
A foreign currency transaction shall be recorded on
initial recognition in the functional currency by applying to the foreign
currency amount, the spot exchange rate between the functional currency and the
foreign currency at the date of the transaction. At each balance sheet dates,
all foreign currency monetary items shall be translated using the closing rate.
In addition to this, non-monetary items that are measured in terms of
historical cost in a foreign currency shall be translated using the exchange
rate at the date of the transaction, and non-monetary items measured at fair
value in a foreign currency shall be translated using the exchange rates at the
date when the fair value was determined (Kaminarides, J. S.; 1981).
Exchange differences arising from the
settlement of monetary items or from translating monetary items at rates
different from those at which they were translated on initial recognition
during the period, or in previous financial statements, shall be recognized in
profit or loss in the period in which they arise. However, exchange differences
arising from a monetary item that forms part of a reporting entity’s net
investment in a foreign operation shall be recognized in profit or loss in a
separate financial statements of the reporting entity or the individual
financial statements of the foreign operation, as appropriate.
An entity is required to translate its
results and financial position from its functional currency into a presentation
currency using the method required for translating a foreign operation for
inclusion in the reporting entity’s financial statements. The results and
financial position of an entity whose functional currency is not the currency
of a hyperinflationary economy shall be translated into a different
presentation currency using the following procedures:
(a) Assets and
liabilities for each balance sheet presented shall be translated at the closing
rate at the date of that balance sheet.
(b) Income and
expenses for each income statement shall be translated at exchange rates at the
dates of the transactions.
(c) All
resulting exchange differences shall be recognized as a separate component of
equity.
It is important to note that any goodwill
arising on the acquisition of a foreign operation and any fair value
adjustments to the carrying amounts of assets and liabilities arising on the
acquisition of that foreign operation shall be treated as assets and
liabilities of the foreign operation.
Conclusively, foreign
operation is an entity that is a
subsidiary, associate, joint venture or branch of a reporting entity, the
activities of which are based or conducted in a country or currency other than
those of the reporting entity. According
to the International Accounting Standards (IAS 21), an entity may carry on foreign activities in two ways. It may have
transactions in foreign currencies or it may have foreign operations. An entity
may present its financial statements in a foreign currency. The objective of
this is to prescribe how to include foreign currency transactions and foreign
operations in the financial statements of an entity and how to translate
financial statements into a presentation currency. The issue here is which
exchange rate(s) to use and how to report the effects of changes in exchange
rates in the financial statements, but if the presentation currency differs
from the entity's functional currency; it translates its results and financial
position into the presentation currency (Johnson, R. A. et al. 1967).
It is good to note that consolidated financial statements shall
include all subsidiaries of the parent company.
According to
the International Accounting Standards (IAS 27), a parent company shall present consolidated financial statements in
which it consolidates its investments in subsidiaries in accordance with this
Standard. A parent need not present consolidated financial statements if the
parent is itself a wholly-owned subsidiary, or is a partially-owned subsidiary
of another entity and its other owners. In addition to this, if the parent’s
debt or equity instruments are not traded in a public market, or the parent did
not file, nor is it in the process of filing its financial statements with a
securities commission, it could be prevented from presenting a consolidated
financial statement.
It is also important to note that a business combination may
involve more than one exchange transaction, for example when it occurs in
stages by successive share purchases.
The
International Financial Reporting Standard (IFRS) requires all business
combinations within its scope to be accounted for by applying the purchase
method. It also requires an acquirer, the combining entity that obtains control
of the other combining entities or businesses, to be identified for every
business combination and the preparation of its financial statement.
References
Holt, P.
E.; (2004). Consolidation of Foreign Subsidiaries and a United States Parent’s
Financial Statement. (Vol. 28; pp 159-165). Accounting Forum, 2004.
Marcos, M.; Whalley, J.; Robert, M.; (2006). Foreign Investment
and Consolidation.
Published by Emerald Group Publishing
Limited. (Vol. 8, pp 60-77).
Sinn, H. W.; (1990). Taxation and Birth of Foreign Subsidiaries (2nd
Edition, pp 245
-247).
Shao, L. P.; (2004). Capital Structure Norms among Foreign
Subsidiaries of United
States Multi-National Enterprise.
Kaminarides, J. S.; (1981). Methods for Translating Financial
Statements of Foreign
Subsidiaries into the Currency of the Parent
Company. (pp 25-29).
Johnson, R. A. et
al; (1967). The Theory and
Management of Business Decisions.
New
York: McGraw-Hill.
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