Consolidation of foreign subsidiaries

It is common for entities to be engaged in foreign currency activities. In addition to simply entering directly into transactions denominated in foreign currencies, entities also conduct foreign operations via a foreign subsidiary, whose functional currency could be different from that of the presentation currency of the group’s financial statements. In such case, in order to prepare consolidated financial statements, it is necessary to translate the financials of a subsidiary into the presentation currency of the group.

General guidance

To translate the results of foreign subsidiaries, rules of IAS 21 The Effects of Changes in Foreign Exchange Rates under IFRS or ASC 830 Foreign Currency Matters shall be followed. Both standards reach to conclusion that an entity’s functional currency is the currency of the primary economic environment in which the entity operates, whereas the presentation/reporting currency of financial statements could be any currency or currencies.

However, there is no such concept as group’s functional currency. Each individual entity in the group has its own functional currency, and the financial position and results of each subsidiary will need to be translated into the presentation currency that is used for the consolidated financial statements.

The same rules should also be applied when incorporating the results of associates and joint arrangements (e.g. applying the equity method), as well as the results of a foreign branch into the financial statements of an individual entity.

How to translate foreign subsidiaries

On the assumption that functional and presentation currencies are not those of a hyperinflationary economy, the summary of guidance provided in IAS 21 and ASC 830 is such:

Actual rate is the exchange rate at the date of the transaction and shall be used for translating income and expense items of both current and comparative period. For practical reasons, it is allowed to use the average rate for the period instead, only if the exchange rates do not fluctuate significantly.

Translating equity items

There are no specific rules in IAS 21 for the translation of equity items. Depending on components of equity, historical, closing and actual translation rates could be applied. Thus, each component should be evaluated separately.

Share capital

When a subsidiary is presenting its financial statements in the currency of its parent, it seems more appropriate to apply the historical rate in issue at the date of acquisition, rather than at the initial historical date when these shares were issued by the subsidiary.

If the company elects to retranslate share capital at closing rate, then exchange differences arising shall be taken either to retained earnings or recognised in some other reserve within equity. Consequently, selection between the historical rate and the closing rate, does not have any implication on the overall equity.

Other equity balances

When the other equity balances arise from transactions with equity holders (e.g. share premium arising from shares issue), then such balances are translated using the same rate as applied to share capital.

If however such balances result from income and expenses recognised in other comprehensive income (e.g. revaluation results, debts measured at FV through OCI), and as income and expenses shall be translated using the actual transaction date rate, this would suggest that the same rate is also applied for related equity balances. However, applying closing rate would also be acceptable, as in either case, when reclassifying these items to profit or loss, this would be done in the amount of the balance as at the date when reclassification takes place.

Translating intragroup balances and transactions

Assets and liabilities

Intragroup monetary assets and liabilities (e.g. trade receivables/payables) expose the company to a foreign currency fluctuation risk and therefore exchange differences arising from such balances are required to be included in the consolidated financial statements, even though the balances are eliminated upon consolidation.

As an exception to the above, if the monetary intragroup balance is considered as part of the net investment in a foreign operation (e.g. a loan which settlement is neither planned nor likely to occur in the foreseeable future), then exchange differences arising would not be recognised in profit or loss in the consolidated financial statements. Upon consolidation, such exchange differences would need to be reclassified into other comprehensive income and accumulated in a separate component of equity.

Unrealised profits on intragroup transactions

These are also not ruled by IAS 21, however using the actual transaction date rate could be appropriate. This is also in line with US GAAP rules.

Dividends

If the subsidiary distributes profits, then parent records for these dividends using the exchange rate applicable on the date dividends were declared. Exchange difference thus arises in the parent’s financial statements due to exchange rate fluctuations between declaration date and the actual payment date. This exchange difference is recognised in profit or loss and is included in the consolidated financial statements.

Translating financial statements of foreign subsidiary

Illustrative example – Translation of financial statements of foreign operation

Disposal of foreign subsidiaries

When a parent disposes of a foreign subsidiary (loss of control), the exchange differences relating to that subsidiary which have been recognised in other comprehensive income and accumulated in the separate component of equity (including exchange differences arising on intragroup balances that, in substance, form part of the entity’s net investment in such foreign subsidiary) should be recognised in profit or loss when the gain or loss on disposal is recognised.

However, in case of partial disposal of a proportionate interest in a subsidiary (without loss of control), only the proportionate share of the cumulative amount of exchange differences recognised in other comprehensive income is reattributed to the non–controlling interests (NCI) in that foreign subsidiary, meaning that such exchange differences are not reclassified to profit or loss. Consequently, once the parent disposes of the remainder of its interest in such subsidiary, the exchange differences attributed to NCI are derecognised and included in the calculation of gain or loss on disposal but not reclassified to profit or loss.

IFRS vs US GAAP

Similarities

IAS 21 and ASC 830 are similar in their approach to foreign currency translation. Note that the criteria to determine an entity’s functional currency differ under IFRS and US GAAP, however both standards mostly result in the same end result (i.e., the currency of the entity’s primary economic environment).

Both standards rule that foreign currency transactions shall be remeasured into the entity’s functional currency and exchange differences arising recognised in profit or loss. Similarly, both standards allow financial statements to be presented in a currency other than the entity’s functional currency, i.e., the presentation currency (IFRS) or reporting currency (US GAAP).

In non-hyperinflationary economies, both US GAAP and IFRS use generally similar methods to translate financial statements from the functional currency to the reporting currency and both require remeasurement into the functional currency before translation into the reporting currency.

Main differences

Consolidation rules of foreign subsidiaries somewhat differ between the two standards. Under US GAAP a “bottom-up” approach shall be applied, meaning that a subsidiary should be consolidated by the entity that directly controls it. Thus, the “step-by-step” method of consolidation is used – i.e. each entity is consolidated into its immediate parent until the ultimate parent has consolidated the financial statements of all the entities below it.

Under IFRS the method of consolidation is not specified and, thus, either the “direct” or the “step-by-step” method of consolidation can be applied. Under the “direct” method, each entity within the consolidated group is directly translated into the functional currency of the ultimate parent and then consolidated into the ultimate parent (i.e., the reporting entity). No translation to intermediate parent functional currency takes place. Based on the choice of consolidation method used, the exchange differences deferred within equity at intermediate levels could differ, and therefore the recycling of such exchange differences upon disposal of an intermediate foreign subsidiary also differ.

Significant differences also exist in accounting for foreign currency translation in hyperinflationary economies under ASC 830 and IAS 29 Financial Reporting in Hyperinflationary Economies, but both are ignored for the purpose of this article.