Chapter 19 Outline

Multinational Consolidation and Currency Translation

A consolidated financial statement combines the separate financial statements of two or more companies to yield a single set of financial statements as if the individual companies were really one. Most multinational firms are composed of a parent company and a number of subsidiary companies located in various other countries. Such firms typically issue consolidated financial statements, which merge the accounts of all the companies, rather than issuing individual financial statements for the parent company and each subsidiary. In this section we examine the consolidated financial statements and then look at the related issue of foreign currency translation.

Consolidated Financial Statements

Many firms find it advantageous to organize as a set of separate legal entities (companies). For example, a firm may separately incorporate the various components of its business to limit its total legal liability or to take advantage of corporate tax regulations. Multinationals are often required by the countries in which they do business to set up a separate company. Thus, the typical multinational comprises a parent company and a number of subsidiary companies located in different countries, most of which are wholly owned by the parent. However, although the subsidiaries may be separate legal entities, they are not separate economic entities. Economically, all the companies in a corporate group are interdependent. For example, if the Brazilian subsidiary of a US parent company experiences substantial financial losses that suck up corporate funds, the cash available for investment in that subsidiary, the US parent company, and other subsidiary companies will be limited. Thus, the purpose of consolidated financial statements is to provide accounting information about a group of companies that recognize their economic interdependence.

Transactions among the members of a corporate family are not included in consolidated financial statements; only assets, liabilities, revenues, and expenses with external third parties are shown. By law, however, separate legal entities are required to keep their own accounting records and to prepare their own financial statements. Thus, transactions with other members of a corporate group must be identified in the separate statements so they can be excluded when the consolidated statements are prepared. The process involves adding up the individual assets, liabilities, revenues, and expenses reported on the separate financial statements and then eliminating the intragroup ones. For example, consider these items selected from the individual financial statements of a parent company and one of its foreign subsidiaries:

^*Subsidiary owes parent $300.
^**Subsidiary pays parent $1,000 in royalties for products licensed from parent.


The $300 receivable that the parent includes on its financial statements and the $300 payable that the subsidiary includes on its statements represent an intragroup item. These items cancel each other out and thus are not included in consolidated financial statements. Similarly, the $1,000 the subsidiary owes the parent in royalty payments is an intragroup item that will not appear in the consolidated accounts. The adjustments are as follows:

^*Subsidiary owes parent $300.
^**Subsidiary pays parent $1,000 in royalties for products licensed from parent.


Thus, while simply adding the two sets of accounts would suggest that the group of companies has revenues of $12,000 and receivables of $3,900, once intragroup transactions are removed from the picture, these figures drop to $11,000 and $3,600, respectively.

Preparing consolidated financial statements is becoming the norm for multinational firms. Investors realize that without consolidated financial statements, a multinational firm could conceal losses in an unconsolidated subsidiary, thereby hiding the economic status of the entire group. For example, the parent company in our illustration could increase its profit merely by charging the subsidiary company higher royalty fees. Since this has no effect on the group's overall profits, it amounts to little more than window dressing, making the parent company look good. If the parent does not issue a consolidated financial statement, however, the true economic status of the group is obscured by such a practice. With this in mind, the IASC has issued two standards requiring firms to prepare consolidated financial statements, and in most industrialized countries this is now required.

Currency Translation

Foreign subsidiaries of multinational firms normally keep their accounting records and prepare their financial statements in the currency of the country in which they are located. Thus, the Japanese subsidiary of a US firm will prepare its accounts in yen, a Brazilian subsidiary in real, a Korean subsidiary in won, and so on. When a multinational prepares consolidated accounts, it must convert all these financial statements into the currency of its home country. As we saw in Chapter 9, however, exchange rates vary in response to changes in economic circumstances. Companies can use two main methods to determine what exchange rate should be used when translating financial statement currencies--the current rate method and the temporal method.

The Current Rate Method

Under the current rate method, the exchange rate at the balance sheet date is used to translate the financial statements of a foreign subsidiary into the home currency of the multinational firm. Although this may seem logical, it is incompatible with the historic cost principle, which, as we saw earlier, is a generally accepted accounting principle in many countries, including the United States. Consider the case of a US firm that invests $100,000 in a Malaysian subsidiary. Assume the exchange rate at the time is $1 = 5 Malaysian ringgit. The subsidiary converts the $100,000 into ringgit, which gives it 500,000 ringgit. It then purchases land with this money. Subsequently, the dollar depreciates against the ringgit, so that by year-end, $1 = 4 ringgit. If this exchange rate is used to convert the value of the land back into US dollars for preparing consolidated accounts, the land will be valued at $125,000. The piece of land would appear to have increased in value by $25,000, although in reality the increase would be simply a function of an exchange rate change. Thus, the consolidated accounts would present a somewhat misleading picture.

The Temporal Method

One way to avoid this problem is to use the temporal method to translate the accounts of a foreign subsidiary. The temporal method translates assets valued in a foreign currency into the home-country currency using the exchange rate that exists when the assets are purchased. Referring to our example, the exchange rate of $1 = 5 ringgit, the rate on the day the Malaysian subsidiary purchased the land, would be used to convert the value of the land back into US dollars at year-end. However, although the temporal method will ensure the dollar value of the land does not fluctuate due to exchange rate changes, it has its own serious problem. Because the various assets of a foreign subsidiary will in all probability be acquired at different times and because exchange rates seldom remain stable for long, different exchange rates will probably have to be used to translate those foreign assets into the multinational's home currency. Consequently, the multinational's balance sheet may not balance!

Consider the case of a US firm that on January 1, 1999, invests $100,000 in a new Japanese subsidiary. The exchange rate at that time is $1 = ¥100. The initial investment is therefore ¥10 million, and the Japanese subsidiary's balance sheet looks like this on January 1, 1999:

Assume that on January 31, when the exchange rate is $1 = ¥95, the Japanese subsidiary invests ¥5 million in a factory (i.e., fixed assets). Then on February 15, when the exchange rate is $1 = ¥90, the subsidiary purchases ¥5 million of inventory. The balance sheet of the subsidiary will look like this on March 1, 1999: