Plug the flow? No, this blog post isn’t about a plumbing issue. Rather, it highlights a common mistake in preparing the consolidated statement of cash flows for a company performing foreign currency translation when it has more than one functional currency. This issue really isn’t new, because let’s face it, the underlying literature (ASC 830) has been around longer than most of us have been in practice. However, we have recently had several of our audit-firm clients ask us to include this issue in training on both foreign currency issues and cash flow statement preparation. The reason? Not only have foreign currency issues and cash flow statement issues been prevalent in recent years, they have been seeing this specific issue at many of their clients. Even the Journal of Accountancy has recognized currency translation in the consolidated cash flow statement as one of three common foreign currency adjustment mistakes in their article, Three Common Currency-Adjustment Pitfalls.
Let’s first start with the basics. ASC Topic 830, Foreign Currency Matters (ASC 830), prescribes the accounting for foreign currency within the statement of cash flows. When a company has foreign operations, the foreign currency cash flows must be translated into the reporting currency using the exchange rates in effect at the time of the cash flows. An appropriately weighted average exchange rate for the period may also be used if it provides a substantially similar result. The statement of cash flows must then report the effect of exchange rate changes on cash as a separate part of the reconciliation of the change in cash during the period. Translation? (Pun intended!) When consolidated financial statements are prepared for a company that has foreign subsidiaries, the statement of cash flows must be translated to the reporting currency and the effect of the foreign exchange rates shown. Okay great, but how?
The Wrong Way
Let’s look at the wrong way to do things. When preparing the consolidated cash flow statement using the indirect method for a company with multiple functional currencies, many financial statement preparers base it on the consolidated balance sheets for the current and prior periods. The problem with this approach is that the consolidated balance sheets contain foreign currency balances translated using the period end rate, as required by the accounting guidance (summarized in this post). However, ASC Topic 830 also requires the foreign currency cash flows to be translated using the exchange rates in effect at the time of the cash flows, and the difference in those rates can be material.
This means that the “effect of exchange rates on cash” presented by companies, as required by the guidance, corresponds to the currency translation adjustment within other comprehensive income and is essentially a “plug.” Sometimes this amount is omitted all together and is buried in operating cash flows. This is the common mistake that many financial statement preparers make. Why? There are probably many reasons, not the least of which is that it is just easier. Wrong, but easier. Also, many times a cash flow statement is only prepared at the consolidated level, therefore it is prepared by those that are working on the consolidated financial statements. So, for them, it makes sense to start with the consolidated balance sheets.
The Right Way
So, what is the right way to prepare the consolidated statement of cash flows? First, cash flow statements should be prepared for all subsidiaries, including foreign subsidiaries. Prepare the cash flow statements for foreign subsidiaries in their functional currencies. Next, translate the foreign subsidiary cash flow statements using the appropriate rate(s) as required by ASC Topic 830. Finally, combine the individual cash flow statements, and with elimination entries, this creates the consolidated statement of cash flows. Overall, this approach takes more effort; however, it is required.
Remember, you can’t plug the flow! The “effect of exchange rates on cash” actually means something, and yes, is provable. In basic terms, the “effect of exchange rates on cash” starts with the effect of the change in exchange rates from the beginning of the period to the end of the period on the beginning cash balance. To that, you add the effect of the change in exchange rates from the beginning of the period to the end of the period on all cash flows (operating, investing and financing). This is essentially how you can prove the number.
If you ever see that the “effect of exchange rates on cash” equals the currency translation adjustment in other comprehensive income, or that you can’t prove “effect of exchange rates on cash” as illustrated above, the consolidated cash flow statement was probably prepared incorrectly!
We hope this post has helped you understand this fairly common, yet complex, issue!