Process consolidating foreign currency subsidiaries
If hedging is deemed desirable, the objective should be to operate only on these excesses.
Fortunately, for enterprises that operate in this space – particularly for those that transact with counterparties having major currencies as their functional currency – there are a variety of derivative instruments that can be used in connection with these risks, including forward contracts, futures contracts, options, and cross currency interest rate swaps.While this area can be fraught with idiosyncratic variances, in the typical case when a parent company establishes or acquires a foreign subsidiary, that subsidiary will declare its home currency to be its functional currency and it will keep its books and records in that same currency.The consolidated entity’s balance sheet would include the assets and liabilities of the parent and all subsidiaries.Income statement line items, however, are translated using the average exchange rate that prevailed during the accounting period. Net Investments in Foreign Operations Net investments are carried on the books of the parent company as a result of establishing or purchasing foreign subsidiaries.The net investment line item, however, is eliminated in consolidated statements.To the extent that any subsidiary’s assets were greater than its liabilities, a strengthening of the subsidiarysidiary’s’s functional currency (relative to the parent’s) would benefit the consolidated entity, and vice versa.
This benefit (or detriment) relating to nonmonetary balance sheet items, however, isn’t recorded in earnings.
In other words, the economic exposure would be excess sales or excess purchases, whichever prevails.
Similarly, when payables and receivables of a common denomination are on the balance sheet, risk derives only from the larger of the two to the extent of the excess.
Otherwise, the risk mitigating efforts by a subsidiary or related party may end up exacerbating the exposure of the consolidated entity.
This article highlights these concerns and provides a framework for developing an enterprise-wide process for managing these exposures.
Where discretion is required, however, it should be understood that the decision should be thought of as being virtually permanent.