Financial Consolidation Introduction
One of the main functionalities and appeal of SAP BPC 10.0 is the capability to perform legal financial consolidations. Let us get a good understand of exactly what this means and why we need consolidated financial results.
One of the reasons why we need consolidated financial results is to track how a company is performing and provide that information to people. Whether that is to provide a consolidated report to external regulators (10K and 10Q for US regulators), internal management teams, or even other groups within the accounting department (i.e.tax team to calculate tax reserves), financial consolidation is a complex set of rules set forth in accounting standards by regulators and internal accounting standards by regulators and internal accounting groups of any given company. When we look at financial consolidations we need to look at a few different areas:
Entity Trial Balance:
The most basic information needed for legal consolidation is each entity’s trail balance. A trial balance holds all of the detailed information recorded on the entities’ book and records and is the ingredients needed to perform consolidations.
Trail balance of each entity normally comes from the general ledger system. The general ledger system would then normally go through a data warehouse(in SAP’s world that would that would be BW) and feed into the BPC system all relevant information needed that every single bit of information is needed for consolidations. The general ledger may have detailed information such as what bank account number is associated with a cash balance, but this information is not necessary for consolidation. Normally information is aggregated up to the level that is needed for consolidations in the business warehouse and transferred over to BPC all of the more detailed information is left out of the dataset.
However, not all entities that exist may be set up in a general ledger system. But that’s okay, a trail balance is just financial information can be directly input into the BPC system. As long as all of the necessary information is captured, it does not matter where the trail balance comes from. Just remember the trail balance is the base level information that is needed to the consolidation process.
So now that we have the entire source data, isn’t that enough? Well, another step that needs to be taken into consideration is currency translation. Currency translation is the process of standardizing all of the data from each individual trial balance that maybe in all different currencies into 1 common reporting currency.
In any given business, there could be multiple subsidiaries that operate in all different areas of the world. Those subsidiaries trial balance are most likely in different currencies. In order to have consolidated results we must first standardize all of these different trial balances into 1 currency. This way when all of the balances are combined it is not really adding apples and oranges together. The reporting currency can be any currency but it should reflect which currency is needed for reporting. Also it is important to note that the exchange rates used should reflect the local currency used in an entity to the reporting currency.
The currency translation process will translate each individual trial balance into the reporting currency. However, there are very specific rules to follow in currency translation. Regulatory bodies around the world may require different ways for translating different types of balances.
It is normal for Profit or Loss accounts(income, Expense) must use the average rates of a given period during currency translation. However, an Asset account must use the ending spot rate of that period.
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So now we have all of our trial balance in 1 reporting currency, we can just add it all up and we are done right? Well not so fast, we need to look at intercompany transactions. Intercompany transactions are transactions that happen between entities that belong to the same overall company. These transactions can be between 2 subsidiaries of a parent company or between a subsidiary and its parent company and vice versa. The point is, these transactions should be taken out in the consolidation process because as a whole, the company did not do anything more than just move something from one place to another.
An example can be thought like this. There is a household of 3 people.
- A father
- A mother
- A son
The father owns 3 bicycles. He gives 1 bicycle to his wife and another 1 to his son. So even though while the father now only owns 1 single bicycle the house hold still has 3 bicycles. So we have to discount the fact that the father gave 2 of his bicycles to other family members.
This is the same as intercompany transactions. Even though each company is booking the transactions, if it is doing business with one of its own subsidiaries, if it is doing business with one of its own subsidiaries, that transaction needs to be discounted and eliminated from the consolidated financial results. Usually these transactions are transferring of goods or services between 2 subsidiary companies.
Elimination of Investments:
Another more specific type of intercompany transaction has to do with recording of a transaction when a parent company invests in a subsidiary. Even though a product between an entity with another entity, these types of transactions need to be taken out because it is still doing business within yourself.
Let’s go back to the example of the 3 family household.
Now let’s say that the father has a total of $1000 dollars. He gives his son $500 and says you go and take this $500 dollars and start a lemonade stand.
- The son takes the $500 and makes a profit from his lemonade stand of $100.
As s household we do not really care about the exchanging of money between the father and the son of $500, all we would care about is that there is a $100 profit. This is why the transfer of money between the father and son should not be considered. Hence this is why the transfer of money between the father and son should not be considered. Hence this is the why investments for parent companies in subsidiaries need to be eliminated in the consolidation process. This process seems easy enough but it is very complex when there are multiple investors and multiple subsidiaries. Imagine how someone would account for the above scenario if the son also received a $500 investment from his uncle who is not a part of the household.
Equity Income Calculation:
So we have standardized all trial balances and eliminated all of the intercompany transactions, what else is there? There are a lot of complex rules on how to account for subsidiaries especially when you have a joint venture or just do not own 100% of the subsidiary. Equity income is income generated from a subsidiary that you do not wholly own but have a major stake in but do not control it<=50%, someone else does.
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Non-Controlling Interest Calculation:
Similarly to Equity Income, Non-Controlling Interest also needs to be considered when performing consolidations. Non-Controlling Interest needs to be considered when a company own a subsidiary and control it but do not own it 100% someone else owns a piece of the subsidiary.
Balance Carry Forward:
One final consideration for year-end consolidation system processing is around balance carry forward. Balance Carry Forward is done on a yearly basis at the end of the year to close out the previous year’s books and records while establishing the opening balances in the new year. There are multiple aspects of balance carry forward to consider.