If your company has a foreign subsidiary or affiliate, at some point you will be faced with foreign currency transaction and translation adjustments. Do you know what each one represents and which financial statement(s) they impact? Do you understand how foreign currency adjustments should be reported on the cash flow statement?
Foreign currency transaction and translation adjustments can be confusing. Ensuring you have them properly reported on your consolidated financial statements is an important step — which means understanding what each represents, how each is calculated and which statement each impacts. We will take you through an example below.
What is a Foreign Currency Translation Adjustment?
Let’s assume your company has a Canadian subsidiary and reports its financial results to the parent in the CAN dollar. The parent company also sells product directly to European countries, and those transactions are settled in Euros. At the end of each reporting period it is your job to consolidate the company’s financial data. Since the parent company is in the US, the parent’s functional currency, the main currency in which an entity conducts its business, is the US dollar. In addition, you have also determined that the reporting currency, the currency the consolidated financial statements will be reported in, is the US dollar.
The Canadian subsidiary’s functional currency is the CAN dollar, but since the reporting currency is the US dollar, you will need to convert the Canadian financial statements into the US dollar as of the end of the reporting period. This is referred to as the translation adjustment and is reported in the statement of other comprehensive income with the cumulative effect reported in equity, as other comprehensive income. The translation adjustment does not have any impact on net income.
What is a Foreign Currency Transaction Adjustment?
You also need to consider any transactions you currently have recorded on the balance sheet in US dollars as of the end of the reporting period that will be settled in a foreign currency.
In our example above, we have accounts receivable as of the end of the reporting period that will be settled in Euros. Therefore, you will need to do two things:
- Identify the current accounts receivable that will be settled in Euros, and
- Determine what the settlement amount is in Euros and remeasure that amount, as of the balance sheet date exchange rate, into U.S. dollars.
Once you have determined the year-end remeasured amount, you will need to adjust the accounts receivable ledger to that amount with any difference flowing through the income statement, typically accounted for in other income/(loss). This is referred to as the transaction adjustment. As you remeasure each transaction, the difference, gain or loss, flows through the income statement as a foreign currency transaction adjustment. Net income is impacted as a result of the remeasurement as it will impact the future cash flows of the company.
How Do the Foreign Currency Transaction and Translation Adjustments Impact the Cash Flow Statement?
So far in our scenario, the balance sheet and the income statement have been adjusted for any remeasurement of transactions to be settled in a currency other than the functional currency as of year-end. The equity and the statement of other comprehensive income have been impacted as a result of the conversion of the statements from CAN dollar to US dollar. Therefore, the last statement we need to consider is the cash flow statement.
To prepare the cash flow statement properly, you will need to prepare individual cash flow statements for each entity in their functional currency, convert them to the reporting currency (using the appropriate exchange rates) and consolidate them. In our example, the parent company’s cash flow statement is in US dollars and the Canadian subsidiary’s cash flow statement is in CAN dollars. Once the Canadian subsidiary’s cash flow statement is prepared in CAN dollars, you will need to convert it to US dollars, the reporting currency. Once the statement has been converted, the differences between the exchange rates used for conversion and at the period end on the cash provided/(used in) will be the amount needed to get the statement to balance. That amount will be presented on the consolidated cash flow statement as “effect of exchange rates on cash and cash equivalents.” There is a tendency to have this amount equal the current year translation amount presented in accumulated comprehensive income — but this would be incorrect! If these two amounts agree, the cash flow statement is not right. Although it takes additional time to prepare the cash flow statement properly, this statement is often used by others to gauge the consolidated company’s cash position. Therefore, it’s important to ensure the statement reflects the proper amounts.
This example should help you understand how each of the individual entity’s financial statements, using different functional currencies, impacts the consolidated company’s financial statements. It is important to understand how the remeasurements and conversions impact the consolidated financial statements to help ensure your reporting is correct.
Contact Beth Reho at email@example.com or a member of your service team to discuss this topic further.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.