business Foreign Subsidiaries: Accounting Basics 101 July 25, 2022 Does your U.S. company have a branch or subsidiary abroad? Do you maintain records in U.S. dollars? Make note of some important accounting rules. *Editor's Note: This blog has been updated as of July 25, 2022 for accuracy and comprehensiveness. If your company reports on a US GAAP basis and has control over a foreign subsidiary, the foreign subsidiary must be consolidated into the U.S. parent for financial reporting purposes. If the foreign subsidiary doesn’t maintain its records in U.S. dollars, the financial statements must be converted into U.S. dollars. There are two different ways to account for the translation into U.S. dollars: Translation gain or loss is included in net income, or as a Component of Other Comprehensive Investment (OCI) Which approach should be used? It depends on the circumstances: Cash flow – Are the cash flows of the foreign subsidiary primarily in the foreign currency and not directly affecting the parent’s cash flow?Sales price – Are sales prices for the foreign subsidiary determined more by local competition or local government regulation, rather than by the parent in U.S. dollars?Sales market – Is there an active local sales market for the foreign subsidiary’s products, even if there are also sales to other countries?Expenses – Are labor, materials, and other costs for the foreign subsidiary’s products or services primarily local costs, even though there may also be imports from other countries?Financing – Are loans or leases of the foreign subsidiary denominated in the local foreign currency, and are funds generated by the foreign subsidiary’s operations sufficient to pay the financing obligations?Intra-entity transactions – Is there a low volume of intra-entity transactions between the subsidiary and parent companies? If you answered “yes” to most or all of the questions above, your foreign subsidiary likely has a foreign functional currency and the translation gain or loss would be included in OCI. OCI is shown on the Income Statement after net income, and the cumulative gain or loss is shown as a separate line in the Equity section of the balance sheet. OCI may alternatively be shown on a separate Statement of Comprehensive Income if not shown on the Income Statement. If your response was generally “no” to the questions above, the functional currency is likely that of the U.S. parent or another foreign subsidiary, necessitating the “remeasurement” of the amounts into the functional currency with the remeasurement gain/loss included in net income. If the functional currency differs from the U.S. reporting parent, the accounts must then be translated into U.S. dollars, generating OCI as discussed above. Intercompany transactions Transactions (for example, loans and related interest income and expense, sales, purchases and the related accounts receivable or payable) between subsidiaries and/or the U.S. parent company must be eliminated. Translation rates Asset and liability accounts are typically translated at the translation rate at the end of the year and equity accounts are translated at historical rates. When remeasurement is required, nonmonetary accounts like inventory, fixed assets and retained earnings are remeasured using the historical translation rate when the original transaction occurred (for example, the date equipment was purchased). The income statement is translated using the average translation rate for the period (e.g., monthly or average rate for January 1 – March 31 for first quarter financial statements). There are several sources for historical interest rates, including Oanda.com. Tax issues A primary issue for taxes, both in the foreign country and the U.S. relates to “transfer pricing,” which is the price charged to sell goods between entities that are under common control. Often a sales price will be used between entities, which can reduce taxable income for the foreign or U.S. entity, thereby reducing foreign or U.S. taxes. Taxing authorities, both abroad and in the U.S., look closely at transfer pricing. It is also important to note that a foreign branch is taxed differently than a foreign subsidiary. Reporting under IFRS There are significant differences between International Financial Reporting Standards (IFRS) and US GAAP when it comes to consolidations and foreign currency translations. International Accounting Standards (IAS), particularly IAS 21 and IAS 29, present indicators for the determination of functional currency and prescribe reporting in hyperinflationary economies somewhat differently than under US GAAP. Sounds complicated? Accounting for foreign subsidiaries can be challenging. If you have tax or accounting questions regarding a foreign subsidiary contact us.