Consolidated Financial Reporting Limitations

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Table of Contents

Abstract
Introduction
Limitations of Recasting Financial Statements
Aggregated Information
Limitations of Translation
Conclusion
References

Abstract

Companies use financial statements to portray their true financial positions. Managers use financial statements in planning and forecasting. In addition, financial statements show the long-term stability of the company. Companies should be able to interpret information in financial statements. Various factors determine the interpretation of information in financial statements. Companies in various regions have different acceptable values of information in the financial statements.

Debt-to-equity ratio is one of the major information that determines the financial performance of an organization. However, the acceptable value of the debt-to-equity ratio differs from one business environment to another. This may pose several problems to multinational corporations (MNC), which have subsidiaries in various business environments. In addition, subsidiaries of MNCs operate using different currencies.

Introduction

The United States’ Generally Acceptable Accounting Principles (GAAP) requires multinational corporations that have 50% of voting rights in foreign companies to have consolidated financial statements. Some companies may reduce their ownership to less than 50% to eliminate the need to consolidate equity investments. To tackle this problem, the Financial Accounting Standards Board (FASB) expanded consolidation to beyond ‘legal’ control (Radhakrishnan, 2012). MNCs should recast the financial statements of the foreign GAAP to US GAAP. In addition, multinational corporations should translate foreign currency into US dollars.

Finally, multinational corporations should combine the financial statements of the foreign companies with the financial statements of the parent company (Holt, 2004). One of the major advantages of consolidating financial statements is that it enables a company to access more credit. However, foreign currency translations and consolidation pose several problems to an organization. Therefore, an organization should look for alternative methods of presenting the financial statements of foreign companies. Therefore, a company needs to consider the benefits and limitations of consolidation before deciding whether to consolidate the financial reports. Consolidation is usually beneficial to companies that have interdependent operations (Muller, 2012).

Limitations of Recasting Financial Statements

Companies may face several problems due to foreign currency translation of financial statements of foreign subsidiaries from the foreign GAAP to US GAAP. A company cannot consolidate its financial statements unless it translates the foreign currency. However, these financial statements are not as effective as the original statements. An organization can’t have a good analysis of the financial statements without referring to the business environment of the foreign subsidiary. Referring to the business environment of the foreign subsidiary provides insights that are unavailable in the translated financial statements. This limits the effectiveness of recasting financial statements.

The debt-to-equity ratio is one of the major pieces of information that one can decipher from financial statements. An increase in the debt-to-equity ratio increases the risks that a company faces. Therefore, companies strive to keep the debt-to-equity ratio at an acceptable value. This value usually differs from one business environment to another. Therefore, an individual needs to consider the business environment while analyzing the debt-to-equity ratio.

The acceptable debt-to-equity ratio in Japan and Korea is usually high in comparison to the acceptable value in the United States. If a foreign subsidiary has a high value of debt-to-equity ratio according to the United States standards, it does not imply that the subsidiary is a speculative investment. It may imply that the subsidiary is very stable. In addition, it may indicate the creditworthiness of the subsidiary. However, if an American company has similar values of debt-to-equity ratio it may be a speculative investment. It may show that the company has a very high risk of collapsing (Holt, 2004). However, the translated financial statements do not show this information. This limits the effectiveness of the translated financial statements.

Financial statements show earnings per share. Earnings per share determine the viability of investing in a certain company. Investors may desist from investing in companies that have low earnings per share (Hsu, Duh & Cheng, 2012). Japanese companies usually lower earnings per share than American companies. Therefore, a Japanese subsidiary may have lower earnings per share than an American company, yet the value may be higher than the Japanese average. However, translated financial statements may not show the performance of the subsidiary in comparison to other Japanese companies (Holt, 2004). Therefore, it is vital to consider the business environment before making any conclusive reports.

Aggregated Information

Consolidated financial statements strive to fulfill the information needs of equity shareholders of the company. They are not important to other stakeholders of the company. These include creditors, tax authorities and employees. This is because consolidated financial statements provide information in aggregate form. They do not provide a detailed analysis of the information. This necessitates the stakeholders of an organization to use other financial information to analyze the financial performance of the company (Duh & Hsu, 2012).

Consolidated financial accounts show the average performance of a company. Consolidated financial reports do not provide a distinction between the loss-making and profitable subsidiaries of the company. The profit of certain subsidiaries may offset the losses of other subsidiaries. Therefore, the consolidated financial accounts may hide the financial difficulties of various subsidiaries. In some instances, the assets of the parent company may not be able to offset the liabilities of the subsidiary. A subsidiary may only use its assets to offset its liabilities. Therefore, the consolidated financial statements do not show the real financial position of the company.

Consolidation is usually vital for companies that have interdependent operations. The parent company may be highly dependent on the operations of the subsidiary. In addition, consolidated financial accounts are vital for companies where the cost of separate disclosure is higher than consolidated disclosure. In these firms, the group financial report may be vital for monitoring the debt agreements (Muller, 2012).

Limitations of Translation

Translating financial reports damages the content of the reports. Regardless of the method that a company uses to translate information, the translated currency can never be equivalent to the dollar measures. Exchange rates may distort the cash account during translation and consolidation. The exchange rates do not guarantee that an individual can purchase the same basket of goods and services at prices indicated by the exchange rates. In fact, no exchange rate portrays the real value that one may use to purchase a certain basket of goods and services. This limits the effectiveness of the translated and consolidated financial reports (Holt, 2004).

Consolidation may force data in the financial statements to form meaningful relationships. The meaning of the data may differ in various business environments. The debt-to-equity ratio is one of the data that may have different interpretations. Debt-to-equity ratio of five is favorable for a Japanese subsidiary. This value may be comparable to a debt-to-equity ratio of 1.25 in the United States. Consolidating the debt-to-equity ratio of an American company with its Japanese subsidiary would yield a value that is unacceptable according to American standards. On the other hand, the number may be very low according to Japanese standards.

This may mislead an individual who tries to interpret the financial report. De-consolidation is the only method that would help in a proper interpretation of the financial information. De-consolidation would help an individual to interpret the financial data separately (Holt, 2004).

Translating financial data maps helps in mapping a problem from a certain statistical distribution to another statistical distribution. A company needs to translate the financial accounts in a method that ensures that the accounts would maintain their significance after translation. The translation of the debt-to-equity ratio of a Japanese subsidiary to an American environment should yield a lower value.

This value should portray the ability of the Japanese subsidiary to meet its short-term liabilities as they become marginal. The relationship of a Japanese subsidiary with the Keiretsu bank enables it to have various benefits, which are non-existent in other locations. Keiretsu enables a subsidiary to roll over a sizeable percentage of its current liabilities (Holt, 2004). This enables a Japanese subsidiary to have a high debt-to-equity ratio.

An effective translation method should help in mapping the relationship of various financial ratios. In addition, the translation method should be effective for various foreign currencies. The translation method should translate the Japanese financial information in yen to US dollar. The translation method should also translate the British financial information in British pounds to US dollars. However, it is impossible to devise such a translation method. In addition, even if such a translation method existed, it would be ineffective for different accounting periods (Holt, 2004). This is due to the changing significance of the relationships between various accounting entries in various business environments.

Even though it is possible to convert one currency to another, a translation method that maintains the information content is non-existent. For a translation method to be effective, it should translate the factors that affect the foreign environment into the US environment effectively. In addition, it should ensure that it achieves this using currency measures. This is practically impossible. The inefficiencies of translation necessitate companies that have foreign subsidiaries to present the foreign financial information as they appear in the foreign subsidiaries (Duh & Hsu, 2012). However, the inefficiencies of translation methods do not warrant a company to desist from including the financial information of foreign subsidiaries.

A company should at least provide a list of all subsidiaries in its annual financial reports. In addition, a company should indicate the percentage ownership in each foreign subsidiary. The company should hold majority ownership in the foreign subsidiaries that are included in the annual financial reports (Holt, 2004).

Conclusion

Financial reports show the financial position of a company. The debt-to-equity ratio is one of the major entries of financial reports. However, the acceptable value of the debt-to-equity ratio may be different for different business environments. This may limit the effectiveness of consolidated financial reports. No translation method may enable a company to overcome these limitations.

References

Duh, R. & Hsu, A.W. (2012). Response to discussant of “does the control based approach to consolidated statements better reflect market value than the ownership-based approach.” The international Journal of Accounting, 47(2), 232-234.

Holt, P.E. (2004). A case against the consolidation of foreign subsidiaries’ and a United States parent’s financial statements. Accounting Forum, 28(2), 159-165.

Hsu, A.W., Duh, R. & Cheng, K. (2012). Does the control-based approach to consolidated statements better reflect market value than the ownership-based approach. The International Journal of Accounting, 47(2), 198-225.

Muller, V. (2012). Value relevance of consolidated versus parent company financial statements: Evidence from the largest three European capital markets. Accounting and Management Information Systems, 10(3), 326-350.

Radhakrishnan, S. (2012). Discussion of “does the control based approach to consolidated statements better reflect market value than the ownership-based approach.” The International Journal of Accounting, 47(2), 226-231.

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