Sigma Conso: Currency issues and consolidated cash flow statement
Sigma Conso Advisory provides you with advanced expertise in consolidation, on demand.
By Jean-Luc Squifflet, Senior Consultant, Sigma Conso
Why is it so difficult to prepare consolidated cash flow statements without variances when all of the statements prepared at the entity level are correct?
And, why does it take so much time?
These questions arise periodically at the time annual financial statements are prepared. We’ll try to answer them in this article.
To do so, we’ll present a series of problems which arise when preparing a consolidated cash flow statement and which, on the other hand, do not appear in the individual statements prepared for each company in the group.
Our goal in this article is not to provide an exhaustive description of all of the problems encountered, but simply to explain to readers the difficulties involved in moving from an individual cash flow statement to a consolidated statement.
We’ll begin with a brief theory refresher.
The purpose of the cash flow statement is to explain the changes in cash between two accounting years.
These changes are allocated to three categories: cash flows from operating activities, cash flows from investing activities and 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 identify 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.
This is where things get more complicated, because the average rate is not used for certain transactions.
We’ll look at different examples which show that 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.
As 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.
Let’s look at an example to illustrate what this does to the consolidated cash flow statement.
Company M in € holds 80% of an American subsidiary.
During financial year N, F distributes USD100 in dividends for the income of financial year N-1. The average exchange rate for the current financial year is 0.7. It is 0.9 for N-1.
|F in $||F in €||M + F in €|
|Dividend paid||-100||-90 (-100 $ * 0.9)||-18 (-90 * 20%)|
|Change in cash||-100||-70 (-100 $ * 0.7)||-14 (-70 * 20%)|
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 show 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 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.
|F in $||F in €||M + F in €|
|Capital increase||+100.000||+75.000 (100.000$ * 0.75)||15.000 (75 K€ *20%)|
|Change in cash||+100.000||+80.000 (100.000$ * 0.8)||16.000 (80K€ * 20%)|
Intercompany transactions in different currencies
Let’s assume that company M in € makes a €10,000 loan to American subsidiary F during the year. F receives the loan and records it in its accounts in $.
For this purpose, it 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 $12,000 on the other.
The consolidated Cash Flow Statement
Now, let’s take a closer look at the consolidated cash flow statement.
All intercompany transactions are reconciled then eliminated during the consolidation process.
As balance sheet accounts are converted at the closing rate, transactions between companies such as loans and receivables are reconciled at that rate.
On the other hand, the movements for the year will be converted at the average rate. This is the conversion that will cause trouble in the cash flow statement.
For our example, let’s assume an average €/$ exchange rate of 1.25 and, to simplify, keep the closing rate of 1.2.
The first table shows 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.
|F in $||F in € before IC elim.||F in € after IC elim.|
|Change in cash||12.000||9.600 (12.000$ / 1.25)||0|
|Closing N||12.000||10.000 (12.000$ / 1.2)||0|
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.
|F in € before IC elim.||M in €||M + F in € after IC elim.|
|Mvt on the loan/debt||9.600||-10.000||0|
|Change in cash||9.600||-10.000||-400|
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.
On the other hand, 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 chapter).
Having presented the main currency exchange problems, we should also take a look at consolidation adjustments.
This article is too short to go into great detail on the topic. We’ll illustrate the subject with 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?
Let’s take a look at another example.
Company M in € acquires 100% of subsidiary F in € for €500,000.
Let’s compare what this means in the statutory cash flow statement and in the consolidated cash flow statement in the table below.
|M statutory accounts||M consolidated accounts|
|Acquisition of LT invest.||-500.000||0|
|Change in cash||-500.000||-500.000|
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 vis-à-vis 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|
|Unrealised translation adjustment||10||=> non-cash movement|
Let’s look at the result in the statutory and consolidated cash flow statements.
Note that we’ll only consider the indirect method for creating the cash flow statement. We will, therefore, exclude the direct method, which is not used very much in practice, although it is recommended by international rules.
|F in €||M in €||Consolidation entry||M + F|
|Result||-110||100||+10 IC charge – 10 EC||-10|
|Non-cash mvt adjustment||0||0||10||10|
|Change in cash||-110||100||0||-10|
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 shown in the table above.
In conclusion, 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, etc.
Fortunately, current consolidation software enables fairly automatic configuration of the consolidated cash flow statement. However, given the complexity of the task, manual intervention by the consolidation manager is often still required to prepare this statement.