U.S. businesses (large and small organizations) continue to expand operations into overseas markets via the creation of subsidiaries and joint ventures agreements. These companies choose to invest in foreign markets for different reasons:
- Businesses go overseas to find new customers or maintain relationships with existing customers.
- A company may find better or less-expensive resources overseas to produce its product which could include labor, capital, natural resources or logistics/distribution channels, etc.
There are many challenges that impact multinational companies. The focus of this article is to highlight the most common financial reporting difficulties or mistakes that U.S. parent companies make when reporting foreign related results and transactions.
Determination of Functional Currency for Reporting
As stated in ASC 830, an entity’s functional currency is the currency of the primary economic environment in which the entity operates. In simple terms, it is the currency in which the entity generates (sales transactions) and expends (expense transactions) cash. Many organizations assume that the functional currency is always the local currency of the country in which the foreign entity resides, but that is not necessarily the case. As defined in ASC 830, there are two broad classes of foreign operations that need to be identified in order to determine the functional currency.
- Foreign entities that are self-contained (who rely very little on their parent) with their own customers, suppliers and manufacturing operations typically use a functional currency that mirrors the local currency.
- Foreign entities which are a direct extension or component of the parent company’s operations, typically use a functional currency that mirrors their parent because the foreign operation’s cash flows are directly linked to the parent company’s currency. An example of this type of entity is a sales office who solely distributes product that is manufactured by the parent or a manufacturing plant that supplies 100% of its product to the parent company
Intercompany Transactions – Identification and Matching
Within most multinational organizations, the subsidiaries contract a significant amount of work with the parent and each other. The process of identifying intercompany sales, expenses, accounts receivable and accounts payable can be a time consuming but critical routine in consolidating the financial results. The matter can be made more difficult due to the fact that each entity’s revenue recognition policy may vary throughout the year until it is adjusted. For example, the selling entity may recognize the sale when the item ships while the purchasing entity will not recognize the inventory until it is received. Organizations need to be careful to make sure that intercompany revenue and expenses are properly recorded (matched) in the same period so they can be identified and eliminated.
Intercompany Transactions – Proper Valuation
Organizations may confuse foreign currency translation adjustments with foreign currency transaction adjustments.
- When the subsidiary’s financial statements are translated from their functional currency to the reporting currency of its parent, the resulting translation adjustment is recorded in “Other Comprehensive Income” (OCI) which is a component of stockholder’s equity.
- While foreign currency transaction gains and losses (adjustments) are a result of the effect of exchange rate changes on transactions denominated in currencies other than the functional currency of the entity. Gains and losses on foreign currency transactions are generally included in income statement.
Many organizations will incorrectly record foreign currency transaction gains and losses (adjustments) in OCI in the equity section of the balance sheet instead of recognizing them in net income. A common example of when this can occur is when the parent may record an intercompany trade receivable due from a European subsidiary in U.S. dollars while the European subsidiary records the trade payable balance in a different functional currency (e.g. euros). At the end of a reporting period, the receivable and payable may not equal due to differences in the FX rate that is used. The organization will incorrectly record the foreign currency transaction adjustment to balance the receivable and payable in OCI. The entity that bears the foreign currency risk should adjust the payable balance to the proper balance and record the adjustment in their income statement.
Please note that there is one exception. Foreign currency gains and losses on intercompany accounts that are essentially permanent in nature are recorded in OCI. The intercompany account is essentially a permanent investment in the subsidiary and therefore the gain or loss on that account is excluded from net income. Unless the intercompany account meets this narrow exception, foreign currency gains and losses on intercompany accounts should be included in the determination of net income.
Elimination of Intercompany Profit
The elimination of intercompany profits (ASC 830-30-45-10) that are attributable to the sale of inventory or other assets between entities that are consolidated in the reporting entity’s financial statements is based on the exchange rates as of the dates of the sales (reasonable approximations of exchange rates are permitted). This elimination needs to be recorded until the asset is subsequently sold by the consolidated group.
The logic behind this elimination entry is simple: you cannot make a consolidated profit by selling product to yourself. Yet many organizations either lack the resources to identify all intercompany transactions or simply overlook or underestimate the impact of these transactions during their financial reporting process.
Although we cannot anticipate all of the potential errors that are involved in the consolidation of foreign results, we hope you find these examples interesting and informative.