Question

Translation of financial statements and consolidation of a foreign subsidiary (no amortization of AAP) Assume that your company owns a subsidiary operating in Great Britain. The subsidiary maintains its books in British Pounds (£) as its functional currency. Your parent company prepares its consolidated financial statements in U.S. Dollars (USD).

a) Explain the concept of 'functional currency' and why it's important in translating the subsidiary's financial statements.
b) Describe the general translation process your company would follow to include the subsidiary's financial data in the consolidated financial statements.
c) Discuss the potential impact of exchange rate fluctuations between the GBP and USD on the parent company's financial statements and earnings.
d) Are there any regulatory or accounting standards (e.g., IFRS, GAAP) that your company must adhere to when dealing with foreign subsidiaries? Explain their relevance.

Answer 1

Understanding the functional currency is vital in translating financial statements. The general translation process involves converting the subsidiary's accounts using appropriate exchange rates, and exchange rate fluctuations can significantly impact financial statements. Companies must adhere to IFRS or GAAP standards in these processes.

Step-by-step explanation:

When dealing with a foreign subsidiary, such as a British-based company owned by a U.S. parent company, understanding the concept of functional currency is crucial. The functional currency is the currency of the primary economic environment in which the subsidiary operates.

It is critical for translating the subsidiary's financial statements because it reflects the economic activities and transactions conducted. Thus, it contributes to the accuracy and relevance of the company's reported financial performance and position.

The general translation process for including the subsidiary's financial data in consolidated financial statements involves converting the subsidiary's accounts from British Pounds (GBP) to U.S. Dollars (USD). This process requires using an appropriate exchange rate, generally the rate at the balance sheet date for assets and liabilities, and a weighted average rate for revenues and expenses.

Exchange rate fluctuations between the GBP and USD can significantly impact the parent company's consolidated financial statements and earnings. If the USD strengthens, the conversion results in fewer USD, potentially leading to lower reported profits. Conversely, a weaker USD can result in higher reported earnings.

Regarding regulatory and accounting standards, companies must adhere to International Financial Reporting Standards (IFRS) or Generally Accepted Accounting Principles (GAAP) when translating and consolidating foreign subsidiaries. These standards specify the methods and procedures for translation, ensuring comparability and consistency in financial reporting.