12.4 Consolidation and currency translation
Even though MNEs receive reports from their subsidiaries in a variety of different currencies, they must eventually produce one set of financial statements in the home currency so that both management and investors can have an aggregate view of the MNE's activities in a common currency. The process of converting foreign subsidiary financial statements into the home currency is known as translation. The combination of these translated financial statements into one is known as consolidation. We will deal first with consolidation.
Consolidation is an accounting process in which the financial statements of a parent company and its subsidiaries are added together to yield a unified set of financial statements. The underlying theme is that, although subsidiaries are usually separate legal entities, they are not separate economic entities. The consolidated financial statements acknowledge the economic interdependence of the parent and its subsidiaries.
The consolidated financial statements include only:
- assets
- liabilities
- revenues
- expenses with external third parties.
Consolidated financial statements do not include transactions between units of the MNE. The reason for this is shown in the example on pages 644-645 of your text. The reason may become more obvious when we examine transfer payments in Part B of this chapter, but let's see if you have grasped the point already.
Activity 12.2
In two sentences, describe why transactions between the legal entities of an MNE are not included in the consolidated financial statements.
Foreign financial statement translation is a two-step process. First, the accounts must be made consistent by being restated according to the same (for example, Australian or American) accounting principles, such as those relating to the valuing of inventories and assets, and determining depreciation. After the basis of the accounts has been adjusted for consistency, the foreign currency amounts in the results are converted into the reporting or home currency.
Translation must not be confused with conversion which was discussed in Chapter 6. Translating is merely the restating of currencies, while conversion refers to the actual physical trade or exchange of units of one currency for another.
There are four methods of translating statements to the reporting or home currency:
- the current rate method
- the temporal method
- the monetary-non-monetary method
- the current-non-current method.
We are concerned only with the first two because the others are not used in Australia .
The current rate method
Under the current rate method the exchange rate used is that which is 'current' at the date of the balance sheet. For Australian MNEs this would be the exchange rate in effect on 30 June; for most American MNEs it would be 31 December because they tend to use the calendar year. It need not concern us here, but the income statement in both countries uses the average exchange rate for the year.
The main problem with the current rate method is that it is inconsistent with the historic cost principle. For example, if an Australian MNE invests $100 000 in a Thai subsidiary when the exchange rate is 20 baht to the dollar, the subsidiary has two million baht to spend. If the subsidiary spends the money to buy land the baht subsequently depreciates against the Australian dollar by, say 5%, the land is then worth only 1.9 million baht and the MNE would appear to have lost $5000, although in reality the 'loss' is simply a function of the change in the exchange rate. The value of the land in Thailand has not changed, but the consolidated accounts of the MNE would present a misleading picture of that real value.
The temporal method
The temporal method translates the accounts of a foreign operation whereby:
- non-monetary assets are translated at the exchange rates current at the date of acquisition (hence 'temporal' meaning 'time')
- capital / equity acquisitions and revenue and expense items are translated at the date of the transaction
- dividends, paid or proposed, are translated at the date they were proposed; and
- monetary items are translated at the exchange rate current at balance date.
The temporal method ensures that the value of assets does not fluctuate because of changes in the exchange rate, but it may lead to a situation where the MNEs balance sheet does not balance.
Activity 12.3
Write a brief description (not more than 50 words) as to why the MNEs balance sheet may not balance using the temporal method.
In your text
Hill 2005, Chapter 19, pp. 654-658.
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