A brief primer on currency issues and consolidated cash flow statements
Why is it so difficult to prepare consolidated cash flow statements without variances when all the statements prepared at the entity level are correct?
And why does the process take so much time?
These are questions that often arise during the period when financial statements are being prepared. In this article, we’ll try to make sense of them, and more.
Let’s look at the challenges that can occur when preparing a consolidated cash flow statement and which do not appear in the individual statements prepared for each company in the group, and some of the difficulties involved in moving from an individual cash flow statement to a consolidated statement.
But first, a refresher on theory
The purpose of the cash flow statement is to explain the changes in cash between two accounting years.
Typically, these changes fall into three categories:
- Cash flows from operating activities
- Cash flows from investing activities
- Cash flows from financing activities
The cash flow statement is prepared based on the movements of the year in the balance sheet accounts and the information contained in the income statement.
To translate these movements, consolidation managers use the concept of “flow” to identify the changes in each balance sheet item with an impact on cash (cash movements) and those with no impact, such as currency fluctuations and inflows and outflows from the scope (non-cash movements).
At this point, we can already spot a major difference between the individual cash flow statement and the consolidated cash flow statement.
The individual statement is created in local currency, whereas the consolidated statement is prepared in the group currency.
As they show variations between two financial periods, the default exchange rate used to convert the flows is the average rate for the period.
This means that the change in cash is converted at the average rate as are the cash movements included in the consolidated cash flow statement.
Now, here’s the part where things get a little more complicated, because the average rate is not used for certain transactions.
We’ll look at different examples showing how cash conversions at a different rate than the average rate can create problems for the preparation of the consolidated cash flow statement.
Dividends paid to minority shareholders in a foreign currency
Given that the dividends distributed within the group are eliminated on consolidation, only dividends paid to third parties will appear in the consolidated cash flow statement.
Because this is a distribution of income from the previous year, the rate used to convert the dividend in a foreign currency into the group’s currency will normally be the average rate of the preceding financial year.
On the other hand, the change in cash associated with the dividend payment will be converted at the average rate for the current financial year.
Here’s an example of how this affects the consolidated cash flow statement
Let’s say Company M in € holds 80% of an American subsidiary.
During financial year N, F distributes $100 in dividends for the income of financial year N-1. The average exchange rate for the current financial year is 0.7, and is 0.9 for N-1.
Here’s what that looks like:
Capital increases in a foreign currency subscribed by third parties
Let’s take another look at our example in which M owns 80% of American subsidiary F.
Let’s assume that F carries out a capital increase of $100,000 to which M subscribes in the amount of its percentage.
The consolidated cash flow statement will only indicate the share of the third parties in the capital increase, i.e., an external cash contribution of $20,000.
If the change in F’s shareholders’ equity is converted at the average rate, there won’t be a cash flow problem. However, a transaction rate (also called a historical rate) is often used to convert the capital increase into the group currency.
In our example, we’ll use 0.75 as the rate of the day for the transaction and 0.8 as the average rate for the year. The latter rate will be used for the conversion of the change in cash. This would look as follows:
Intercompany transactions in different currencies
Let’s assume that company M makes a €10,000 loan to American subsidiary F during the year. F receives the loan and records it in its accounts in $US.
For this purpose, the company then converts the €10,000 at the rate of the day on which the loan was received, i.e., 1.2 in our example. The €10,000 loan is worth $12,000 in F’s accounts.
Clearly, if we only look at the individual cash flow statements of M and F, there is no problem.
There is a cash outflow of €10,000 on one hand, and an inflow of $12,000 on the other.
The consolidated cash flow statement
Let’s take a closer look at the consolidated cash flow statement.
All intercompany transactions are reconciled, then eliminated during the consolidation process.
As balance sheet accounts are converted at the closing rate, transactions between companies such as loans and receivables are reconciled at that rate.
On the other hand, the movements for the year will be converted at the average rate. This is the conversion that may be flagged for the cash flow statement.
For our example, let’s assume an average €/$ exchange rate of 1.25 and, to simplify, keep the closing rate of 1.2.
The first table demonstrates the change in the debt item at F, first in $ then converted into € before the transaction is eliminated during consolidation, then after the transaction is eliminated.
It quickly becomes apparent that no information about changes in the debt item at F is available in the consolidated statements.
This will create a problem when preparing the consolidated cash flow statement because we are no longer able to differentiate between the real cash movement, i.e., €9,600, and the currency difference of €400 which is non-cash by nature and, as a result, cannot appear in the consolidated cash flow statement.
The second table shows the impact of this intercompany transaction on the consolidated cash flow statement.
After the elimination of the intercompany transaction which, it should be noted, is reconciled because the $12,000 converted at the closing rate does give us €10,000, we no longer have any information on the flows.
In fact, there was no loan at the beginning of the period and the transaction is eliminated at the close.
The change in cash provides us with a cash outflow (the loan by M) of €10,000 and a cash inflow of €9,600, i.e. the $12,000 loan received by F and converted at the average exchange rate of the financial period.
The change in cash of €400 at the group level is due to the change in currency and should be explained as such. However, we can’t do this because there isn’t any information about the loan and borrowing account flows (see the first table in this section).
Having presented the main currency exchange problems, we should also look at consolidation adjustments.
There’s a lot of ground to cover, so to keep things brief, we’ll illustrate the subject using two examples.
Acquisition/disposal of consolidated holdings
The fact that consolidated equity investments are eliminated during the consolidation process can result in problems when preparing the consolidated cash flow statement.
How can we find the cash amount of the purchase or disposal of securities when there is nothing at the consolidated level in the balance sheet account, at opening or at close?
Here’s another example:
Company M in € acquires 100% of subsidiary F in € for €500,000.
Here’s what this means in the statutory cash flow statement and in the consolidated cash flow statement in the table below.
Adjustment posting for a currency difference on intercompany transactions
M has revenue of €100 vis-à-vis F, a fully consolidated subsidiary in USD.
F records a corresponding charge compared with M in the amount of $120, i.e. €110 when converted at the average rate.
The difference of €10 is a currency exchange difference which has to be adjusted in the consolidation via the following entry:
IC charge 10 => cash movement
Unrealized translation adjustment 10 => non-cash movement
Let’s look at the result in the statutory and consolidated cash flow statements.
We’ll only consider the indirect method for creating the cash flow statement, so we’ll be excluding the direct method—not used very much in practice—although it is recommended by international rules.
The fact that, in the consolidation entry, the charge is intercompany, and the translation adjustment isn’t, creates a difference in the cash flow because the charge is eliminated by the consolidation process and the translation adjustment remains.
This results in an imbalance in the consolidated cash flow statement, as seen in the table above.
The few examples presented in this article show how difficult it is to create a consolidated cash flow statement, whereas it’s relatively easy to produce a statutory cash flow statement.
We sometimes forget that it shouldn’t juggle with the concepts of currency translation, intercompany transactions, securities and stockholders’ equity elimination entries, account consolidation methods ourselves. That’s where a consolidation application comes in, which can enable a fairly automatic configuration of the consolidated cash flow statement.
