Financial consolidation is the process by which you collect and tally an organizations results. This is usually for a company with multiple legal entities, for external reporting. Those external reporting consumers are a variety of types of consumers usually based concerned party. They vary from governmental agencies, like the SEC, to banks, or to controlling and non-controlling owners. Financial consolidation systems allow collection, aggregation and reporting of data.
There are a variety of different challenges in financial consolidation systems that emerge when trying to account for an organization’s financial performance. It isn’t always as easy as “just adding it up”. Financial consolidations require that you choose the format you submit your external reporting in. Essentially, you must create a common reporting structure across the organizations that you will be aggregating for your total financial results. This is generally a certain level of granularity for your major external financial statements, Income Statement (Profit & Loss), Balance Sheet and Cash Flow.
There are many structured Financial Consolidation Systems available in the marketplace. But it isn’t required to have a formal financial consolidation system. However, it is important to understand the concepts so that you can minimize risk and time it takes to report externally.
Challenge 1 – Source Systems in Financial Consolidations
Operating companies can have different accounting system (or general ledgers). If the entities have different systems, you must develop a method to collect the data so that it can be aggregated and reported. This is your financial consolidation. When the owned organizations have different accounting system, there needs to be a mapping for each of the system into the common reporting structure. For example, Organization 1 has two cash accounts (1000 – Cash, 1001 – Petty Cash) and Organization 2 has two Cash accounts (10000 – Cash in Bank and 10001 – Cash in hand). When reporting externally, you may only want to report Total Cash. In this case, you would add would add all 4 accounts together to get Total Cash. This mapping can be complex or simple. Across all organizations being consolidated, definitions should stay consistent across time (month to month).
Challenge 2 – Foreign Currency in Financial Consolidations
Depending on the type of organization, it is common practice to have multiple operating currencies. This generally occurs when some component of your organization operates in a foreign country. When aggregating financial results, these currencies will need to be converted to a common reporting currency or reporting currencies. For example, assume Organization 1 is based in the US and Organization 2 is in Germany. When reporting consolidated results in the US, you will need to convert the German entity to US dollar. Or if you need to report consolidated results in Germany, US would need to convert the US entity to Euros. Depending on organization, you may have multiple required reporting currencies. However, in general, consolidated organizations convert to a single reporting currency where they do most of their external financial reporting.
Challenge 3 – Inter-company Transactions in Financial Consolidations
If an organization has multiple operating organizations, there may be transactions that occur between the organizations. An “arm’s length” transaction is defined as the buyers and sellers acting independently and in their own self–interest without any influence from any other party. Because both organizations are owned by the same parent company, this invalidates the concept of not being influenced by another party. The owners could dictate terms in related party transactions.
If this is the case, any transactions between the two organizations are considered inter-company transaction. Therefore, they would need to be eliminated at the Total Organization level. For example, consider that Organization 1 sold $1M of items to Organization 2. When reporting externally for the Total Organization, that $1M should be eliminated and not count as Sales (from Organization 1) and Cost of Sales (from Organization 2).
Solution – Financial Consolidation System
There are many Financial Consolidation solutions available. These vary from using one of your general ledgers, Excel spreadsheets to structured Financial Consolidation software. Based on complexity of your consolidation, your acceptable risk profile and reporting time requirements on any of these solutions may make sense. As the number of related parties grow and the complexity grows, the risk profile increases. Many organizations find that a structured Financial Consolidation software solution makes sense. The solution’s ability to minimize risk, provide audit trails and minimize reporting time cycles creates the needed reason to implement a structured software solution. Organizations also find it invaluable to have a powerful transformation (mapping) tool in place. This allows for these new GL systems to onboard quickly and accurately.
Do these challenges sound familiar in your consolidation process? Please reach out to eCapital Advisors’ consolidation practice team to discuss your situation and solutions to solve your Financial Consolidation business challenges.
