Overview of the Accounting treatment of Consolidation under US GAAP
With accelerated globalization as evidenced in recent history, as well as, the number of multinationals and conglomerates on the rise, accurate means of financial reporting for business combinations is direly needed. Subsidiaries operating in foreign countries face entirely different market risks than what their parent companies witness in their respective business environment. The uncertainty attached to the global economy, and resulting currency rate movements lead to amplified translation risks. While, currency can be methodically converted, resulting in loss of informational credibility that has rendered currency translation unreliable.
Additionally, the global convergence towards IFRS has opened up several new arenas for accountants; while, previously used global reporting standards are now being questioned for effectiveness, enterprises prepare themselves for the shift to IFRS.
As we are already aware Consolidation or ‘Business Combinations’ of more than one enterprise results in the formulation of combined financial statements, and companies are to be presented as a ‘group’ or a single economic entity (FASB, 2010). This takes place when the acquirer entity owns the acquiree entity by a minimum of 50% voting stock. A set of combined line items (like items added) of Financial Statements of both entities are presented along with the minority interest (non-controlling interest) whose share is computed based on the subsidiary company’s carrying values of assets and liabilities. The proportioned profit and loss and changes in equity are based on the relevant controlling percentage in the subsidiary of both the parent and minority interest; whereas, intra-group current account balances, sale, and purchase transactions, and resulting profits are fully eliminated as the two companies are perceived as a single economic entity.
Accounting Treatment of Consolidation Involving Foreign Subsidiary
Complications may arise when the subsidiary transacts in a foreign currency. The foreign accounts have to be reported as per the US GAAP. Also, a devised set of procedures is to be followed to tackle the issues for specific line items with varying transaction dates (if any), and the correct exchange rate for conversion purposes is normally established.
Financial Accounting Standard (FAS) 52 requires that a functional currency be determined. Either the ‘current’ or ‘temporal’ method is used to compute appropriate multipliers. Where specific transaction dates cannot be identified the spot rate for the closing date is used for individual line items (except for retained earnings) (FASB, 1981). Once a translated version of the foreign subsidiary’s financial statements is formulated the parent company can proceed with the conventional consolidation procedures. The cumulative impact resulting from exchange rate differences is adjusted or reclassified in the profit and loss statement on the disposal of the subsidiary.
Opinion on the Author’s conclusion
Holt (2004) is inclined towards approaching alternative means of representing group financial statements about foreign subsidiaries. He has emphasized that translation risk associated with exchange rates is significant and translated financial statements do not provide an accurate portrayal of the economic environment specific to the foreign market. I would agree with the author in this regard as currency fluctuations tend to be high in case of unstable economic and financial conditions prevailing in the parent’s or subsidiary’s country.
As domestic subsidiaries are consolidated with the parent company, the same economic conditions would be influencing both entities. Both companies would not only face a similar set of systematic risks, but also the same inflationary and interest rates movements; translation risk would not be applicable altogether. Consolidating such entities can provide an accurate view of the group’s financials. However, if two different economies are in the picture then it can be safely assumed that the risk appetite, as well as, the risk exposure of the two can differ greatly (while one is ‘risk averse’ and stable the other can be significantly volatile). Like the author has mentioned, the benchmark toward a gearing ratio, perceived as ‘non-risky’, can vary in two different markets that are not only unrelated but face entirely different risks.
Author’s concerns and Convergence to IFRS
Addressing the Control-Based approach as presented by IAS 27 and assessing the research put forward by Hsu, Duh, & Cheng (2012), it would be appropriate to say that simpler organizational structures may successfully reflect financial information accurately using this approach. As per this analysis, the global convergence to IFRS can be anticipated to greatly assist with consolidation-related issues of simpler structures. While the Ownership based approach, as presented by the U.S. Accounting Research Bulletin No. 51, is better suited for complex organization structures, the research presented above concludes that greater overall value relevance of financial information is generated via the Control-based approach (Hsu, Duh, & Cheng, 2012).
While the shift from GAAP to IFRS is expected to bring about an amicable transformation in the global accountancy; in some respects, the treatment of foreign subsidiary business combinations as per IFRS is as analogous to that of US GAAP (Deloitte Touche Tohmatsu Limited, 2011). The IFRS directs entities to use the closing spot rate or identifiable individual transaction spot rates (where available) like the US GAAP does; however, it is noteworthy that it also incorporates the adjustment for current purchasing power in a subsidiary operating in a hyperinflationary economy before currency translation. This can be expected to severely reduce the differences arising due to varying inflation and the resulting difference in purchasing power in the two countries (KPMG, 2012). This, in my opinion, can help with some of the concerns put forward by the author.
Value Relevance of Consolidated Statements & the US GAAP
As per the IFRS guidelines, entities are directed to perform consolidation-related computations using the parent’s controlling percentage as a preference to its holding percentage in the subsidiary. In the study presented by Duh & Hsu (2012), it can be seen that in a market with an incomplete flow of information, a control-based approach appears to provide better value relevance of the company than the ownership-based approach. Relating to this study, Radhakrishnan (2012) believes that even in those markets which have readily available information, the market value of equity does not necessarily incorporate all information. Therefore, we can safely conclude that “consolidated statements under more stringent control criteria can be more informative than otherwise” (Duh & Hsu, 2012).
While US GAAP defines control in terms of ownership of the parent in the subsidiary, effective control involves other domains such as the parent’s involvement in decision making via placing the desired person in the subsidiary’s management board. From this, it can be conferred that sufficient control may not be a guaranteed consequence to the ownership or limited ownership as a reason for limited control. Therefore, a control-based approach to consolidation appears to be the better option.
I would draw a plausible conclusion from this analysis regarding the reporting techniques of the US and other International establishments operating under the GAAP. The discussed inefficiency with foreign currency translation, as well as, the ownership-based approach towards business combinations may lead us to believe that the transfer to IFRS is more likely to assist with consolidated reporting in years to follow. While there isn’t any single idealistic solution to the deficiencies of consolidation accounting, IFRS incorporates a more realistic means of not only measuring translated foreign currency but also combining subsidiary accounts according to the level of effective control practiced by the parent. I believe that companies under the US GAAP should reconsider their reporting methodologies as following IFRS is more likely to retain valuable information credibility than otherwise.
Alternative means to Consolidated Statements
Alternative means to consolidation when concerned with foreign subsidiaries can also be considered. Even when inflationary effects of unstable economies are adjusted in currency translation, some level of financial value is still sacrificed (Müller, 2011).
Financial ratios serve as an integral method of assessing financial performance and as the currency is translated the credibility of the financial ratios is lost. Mapping of every individual financial ratio may not at all be a practically feasible option, especially when more than one subsidiary’s currency is involved (Holt, 2004). So, as no universal methodology can be introduced to serve the purpose of financial statements of foreign subsidiaries should be better presented as stand-alone within the annual reports of parents. The foreign market risks and norms can be explained as notes to accounts as a separate exhibit. This will not only eliminate the need and cost of derivative accounting but also save the company from the significant administrative burden of currency translation.
Deloitte Touche Tohmatsu Limited. (2011). Beyond the Standards. iGAAP Newsletter, pp. 4-5.
Duh, R. R., & Hsu, A. W. (2012). Response to Discussant “Does the Control-Based Approach to Consolidated Statements Better Reflect Market Value than the Ownership-Based Approach? The International Journal of Accounting, 47(2), 232-234.
FASB. (2010). Consolidation Topic 810. Web.
FinancialAccountingStandardsBoard. (1981). Financial Accounting Standards No.52. Web.
Holt, P. E. (2004). A case against the consolidation of foreign Subsidiaries’ and a United States parent financial statements. Accounting Forum, 28(2), 159-165.
Hsu, A. W.-h., Duh, R.-R., & Cheng, K. (2012). Does the Control-based Approach to Consolidated Statements Reflect Better Market Value than the Ownership-based Approach? The International Journal of Accounting, 47(2), 198-225.
KPMG. (2012). IFRS compared to US GAAP: An overview. Delaware: KPMG LLP.