Question

What happens when a company tries to consolidate a foreign subsidiary’s financial statements into its own? What kind of rules should it follow in consolidated financial statements involving foreign subsidiary’s operations under IFRS?

Answer 1

In today’s world, most groups spread their activities abroad and logically different members of the group operate in different currencies.

Is the consolidation process of combining the financial statements of two (or more) companies different when they operate in different currencies?

Yes and no.

If you want to combine the financial statements prepared in different currencies, you will still follow the same consolidation procedures.

You still need to eliminate the share capital and pre-acquisition profits of a subsidiary with parent’s investment in a subsidiary (plus recognize any goodwill and/or non-controlling interest).

You still need to eliminate intragroup balances and transactions, including unrealized profits on intragroup sales and any dividends paid by a subsidiary to a parent.

So what’s the issue here?

You guessed it – you can’t combine apples and pears because it makes no sense.

Therefore, BEFORE you start performing the consolidation procedures, you need to translate the subsidiary’s financial statements to the parent’s presentation currency.

HOW?

General rules: translating subsidiary’s financial statements

We need to follow the rules in IAS 21 The Effects of Changes in Foreign Exchange Rates for translating the financial statements to a presentation currency.

Just a small note: please, do not mess up a functional currency with a presentation currency.

Every company has just ONE functional currency, but it can present its financial statements in MANY presentation currencies.

While the functional currency depends on the economic environment of a company and its specific operations, the presentation currency is a matter of CHOICE.

For example, take some UK company. Its functional currency is in most cases GBP (exceptions exist), but this company can decide to prepare its financial statements in EUR or USD – they will be the presentation currencies.

What rates should we use to translate the financial statements in a presentation currency?

I’ve summarized in in the following table:

What?	When?	What rate?
Assets and liabilities	Current period (20X1)	Closing rate (20X1)
Comparative period (20X0)	Closing rate (20X0)
Equity items	Current and comparative period	Not specified – see below
Income and expenses (P/L and OCI)	Current period (20X1)	Actual rates or average in 20X1
Comparative period (20X0)	Actual rates or average in 20X0
Exchange rate difference	CTD (currency translation difference) = separate component in equity

Please note that the above table applies when neither functional nor presentation currency are that of a hyperinflationary economy.

Actual rates are the rates at the date of the individual transactions, but you can use the average rate for the year if the actual rates do not differ too much.

Why is there a CTD?

If you translate the financial statements using different foreign exchange rates, then the balance sheet would not balance (i.e. assets will not equal liabilities plus equity).

Therefore, CTD, or currency translation difference arises – it’s a balancing figure and shows the difference from translating the financial statements in the presentation currency.

How to translate specific items to a presentation currency

If you translate the financial statements to a presentation currency for the purpose of consolidation, you need to be careful with certain items.

How to translate equity items?

It’s true that the standard IAS 21 is silent on this matter. No rules.

Some time ago, the exposure draft proposed to translate the equity items at the closing rate, but it was not included in the standard.

It means that in most cases, companies decide whether they apply closing rate or historical rate. However, they need to be consistent.

In my own past practice, I’ve seen both cases – closing rates and historical rates, too.

What works the best?

Let me describe what’s the most appropriate in my opinion, but please remember, that it results from the practice and common sense, not from the rules (as there are none).

Translating share capital

For the share capital, the most appropriate seems to apply the historical rate applicable at the date of acquisition of the subsidiary by the parent, rather than the historical rate applicable when the share capital was issued.

The reason is that it’s easier and logical to fix the rate at the date of the acquisition when the goodwill and/or non-controlling interest are calculated.

For example, let’s say that the German company was established on 10 September 2010 with the share capital of EUR 100 000.

Then, on 3 January 2015, the German company was acquired by the UK company.

The exchange rates were 0,8234 GBP/EUR on 10 September 2010, and 0,78 GBP/EUR on 3 January 2015.

When the UK parent translates German financial statements to GBP for the consolidation purposes, the share capital will be translated at the historical rate applicable on 3 January 2015.

Therefore, the share capital amounts to GBP 78 000, rather than GBP 82 340.

Translating other equity balances

If the equity balances result from the transactions with shareholders (for example, share premium), then it’s appropriate to apply the historical rate consistently with the rate applied for the share capital.

If the equity balances result from income and expenses presented in OCI (e.g. revaluation surplus), then it’s more appropriate to translate them at the rate at the transaction date.

How to translate intragroup balances?

Intragroup assets and liabilities

Intragroup receivables and payables are translated at the closing rate, as any other assets or liabilities.

Many people assume that exchange differences on intragroup receivables or payables should NOT affect the consolidated profit or loss.

It’s not true.

In fact, they do affect profit or loss, because the group has some foreign exchange exposure, doesn’t it?

Let me illustrate again.

UK parent sold goods to the German subsidiary for GBP 10 000 on 30 November 2016 and as of 31 December 2016, the receivable is still open.

The relevant exchange rates:

• 30 November 2016: 0,8525 GBP/EUR
• 31 December 2016: 0,8562 GBP/EUR

At the date of transaction, German subsidiary recorded the payable at EUR 11 730 (10 000/0,8525).

On 31 December 2016, German subsidiary translates this monetary payable by the closing rate in its own financial statements. Be careful – this is the translation of a foreign currency payable to a functional currency, hence nothing to do with the consolidation.

Re-translated payable amounts to EUR 11 680 (10 000/0,8562) and the German subsidiary records the foreign exchange gain of EUR 50:

• Debit Trade payables: EUR 50

• Credit P/L – Foreign exchange gain: EUR 50

When the German company translates its financial statements to a presentation currency, then the intragroup trade payable of EUR 11 680 is translated to GBP using the closing rate of 0,8562 – so, it amounts to GBP 10 000 (11 680*0,85618).

You can eliminate it with the UK parent’s receivable of GBP 10 000.

However, there will still be exchange rate gain of EUR 50 reported in the subsidiary’s profit or loss. It stays there and it will become a part of a consolidated profit or loss, because it reflects the foreign exchange exposure resulting from foreign trade.

Here, let me warn you about the exception. When monetary items are a part of the net investment in the foreign operation, then you need to present exchange rate difference in other comprehensive income and not in P/L.

Let’s illustrate again.

Imagine the same situation as above. The only difference is that there was no intragroup sale of inventories.

Instead, the UK parent provided a loan to the German subsidiary of GBP 10 000. Let’s say that the settlement of the loan is not likely to occur in the foreseeable future and therefore, the loan is a part of the net investment in a foreign operation.

On the consolidation, the exchange rate gain of EUR 50 recorded in the German financial statements in profit or loss needs to be reclassified in OCI(together with the difference that arises on translation of the EUR 50 by the average rate).

Intragroup sales and unrealized profit

With regard to profit or loss items, or intragroup sales – you should translate them at the date of a transaction if practical. If not, then apply the average rates for the period.

What about the provision for unrealized profit?

Here, IAS 21 is silent again, but in my opinion, the most appropriate seems to apply the rate ruling at the transaction date. This is consistent with the US GAAP, too.

So, let’s say the German subsidiary sold the goods to the UK parent on 30 November 2016 for EUR 5 000. They remain unsold in the UK warehouse at the year-end. The cost of goods sold for the German subsidiary was EUR 4 500.

The profit shown in German books is the unrealized profit for the group (as the goods are unsold from the group’s perspective).

It is translated at the transaction date rate, i.e. 0,8525 GBP/EUR (30 Nov 2016).

At the reporting date (31 Dec 2016), the consolidated financial statements show:

• The inventories at the historical rate (this is non-monetary asset translated to a functional currency at the historical rate): GBP 4 263 (5 000*0,8525)
• Less unrealized profit: – GBP 426 ((5 000- 4 500)*0,8525)
• Inventories at the year-end: GBP 3 837

Please note the little trick here. If the German subsidiary does NOT sell the inventories to the parent, but keeps them at its own warehouse – what would their amount for the consolidation purposes be?

You would need to translate them using the closing rate, isn’t it?

Therefore, their amount would be EUR 4 500 (German cost of sales) * 0,8562 (closing rate) = 3 853. This is different from the situation when they are in the UK’s books. Yes, that happens.

Intragroup dividends

If a subsidiary pays a dividend to its parent, then the parent records the dividend revenue at the rate applicable when the dividend was DECLARED, not paid.

The reason is that the parent needs to recognize the dividend income when the shareholders’ right to receive it was established (and that’s the declaration date, not actual payment date).

Example – translating the financial statements

The UK parent acquired a German subsidiary on 3 January 2015 when the subsidiary’s retained earnings amounted to EUR 4 000. On 30 November 2016, the UK parent purchased goods from the German subsidiary for EUR 5 000. The goods remained unsold at the year-end and the payable was unpaid.

The applicable exchange rates:

• 3 January 2015​​​​​​ .78
• 30 November 2016: 0,8525
• 31 December 2016: 0,8562
• Average in 2016: 0,8188
• Average in 2015: 0,7261

The financial statements of the German subsidiary at 31 December 2016:

Required: Translate the financial statements of the German subsidiary at 31 December 2016 in the presentation currency of GBP for the purposes of consolidation.

Solution:

Before you start working on the translation, you should present the intragroup balances separately – please see the table below.

Also, I strongly recommend analyzing the retained earnings and equity items and present them separately as appropriate.

In this example, it’s appropriate to present the retained earnings by the individual years when they were generated, because you need to apply different rates to translate them.

Here, you should apply the acquisition date rate to the translation of pre-acquisition retained earnings, then the rate applicable in 2015 for 2015 profits, etc.

Please also note, that no rate was applied for the profit 2016 presented in the statement of financial position (under equity). The reason is that you simply transfer this profit from the statement of profit or loss.

The statement of financial position translated to GBP:

EUR	Rate	GBP
Property, plant and equipment	80 000	Closing	0,8562	68 496
Inventories	23 000	Closing	0,8562	19 693
Receivables – intragroup	5 000	Closing	0,8562	4 281
Receivables – other	18 000	Closing	0,8562	15 412
Cash	20 000	Closing	0,8562	17 124
Total assets	146 000		125 006
Share capital	100 000	Acquisition date	0,78	78 000
Retained earnings – pre-acquisition	4 000	Acquisition date	0,78	3 120
Profit 2015	12 000	From 2015 statements*	0,7261	8 713
Profit 2016	15 000	From P/L statement	n/a	12 451
Currency translation difference (CTD)	n/a	Balancing figure**	n/a	9 879
Bank loan	10 000	Closing	0,8562	8 562
Trade payables	5 000	Closing	0,8562	4 281
Total equity and liabilities	146 000		125 006

 

The statement of profit or loss translated to GBP:

	EUR	Rate	GBP
Sales – other	130 000	Average 2016	0,8188	106 444
Sales – intragroup	5 000	Transaction date	0,8525	4 263
Cost of sales	-110 000	Average 2016	0,8188	-90 068
Other expenses	-7 000	Average 2016	0,8188	-5 732
Profit before tax	18 000	n/a	14 907
Income tax expense	-3 000	Average 2016	0,8188	-2 456
Net profit	15 000	n/a	12 451

 

Notes:

• *Accumulated profit 2015 comes from the previous year’s financial statements. In this case, we can apply the average rate for 2015, as we assume everything was translated by the average rate. In reality, just take the previous year’s statements.
• **CTD is calculated in the end, after everything else is done. It is the balancing figure to make assets equal liabilities+equity.

Final warning

Now, you should be able to tackle the foreign currency consolidation yourself.

Once you have translated the foreign currency balance sheet and the profit or loss statement (or OCI), you can apply the usual consolidation procedures (see the example here).

Let me just warn you about the statement of cash flows.

It’s a huge mistake to make the statement of cash flows based on the consolidated balance sheets– i.e. make differences in balances, classify them, make non-cash adjustments, etc.

Your cash flow figures would contain a lot of non-cash foreign exchange differences and that’s not right. Also, this is NOT permitted by IAS 21.

Instead, please follow these steps:

1. Make the individual statements of cash flows, separately for a parent and separately for a subsidiary.
2. Translate subsidiary’s statement of cash flows to the presentation currency. You would usually use the transaction date rates for this purpose, but you can use the average rates as an approximation (exactly as for the income and expenses).
3. Aggregate subsidiary’s and parent’s cash flows.
4. Eliminate intragroup transactions. This requires a bit more work, but well, this is the correct approach
5. Done

Thank you. Sorry for any mistakes. If you have any doubts please ask me.