It is that time of the year again when I am working on audits of U.S. companies with significant international operations, either in the form of wholly owned subsidiaries or branch offices. And my observations while performing these audits have resulted in this compilation of common errors while accounting for foreign currency, recording translation adjustments and finally the culmination into consolidated financials.
1. Lack of understanding of functional currency: Typically, it is the currency of the economic environment in which cash is generated and expended by the entity, i.e. the currency in which the majority of the subsidiary’s business activities are transacted. This can impact how changes in foreign currencies are recorded on the books – see 2. below.
2. Reclassification of all foreign currency changes as Other Comprehensive Income (OCI) rather than as a component of net income in certain cases: For instance, it is quite common for businesses to assume that accounting for a German subsidiary that:
- transacts primarily with the U.S. parent in US dollars (USD – functional currency), but
- maintains its books of accounts in Euros results in foreign currency losses or gains that need to be classified as OCI.
Another common error is that differences in translation of inter-company accounts between U.S. parent and foreign subsidiary that are maintained in different currencies are often included in OCI rather than recognizing in net income as foreign currency gains or losses.
In the first case, the conversion of the German subsidiary’s books from Euros into USD is referred to as a remeasurement which is included in net income. And in the second instance, the inter-company balance on the subsidiary’s books needs to be reconciled to the USD balance on the U.S. parent’s books through a charge to net income and then these inter-company balances need to be eliminated in consolidation.
3. Preparation of consolidated statement of cash flows from amounts reported on consolidated balance sheets: This is by far the most common error simply because the consolidated balance sheets have been prepared using exchange rates at the end of each reporting period whereas cash flows should be presented at exchange rates in effect during the year. Oftentimes, the variance between the period-end and the average exchange rates can vary significantly, which can have a material impact on the consolidated financials. The correct way to do this would be to prepare separate statements of cash flows (SCF) for the parent and each subsidiary in their respective currencies and then translate the SCF of the subsidiaries into USD using the average exchange rates and finally combine all of the SCFs, complete with any necessary eliminations to arrive at the consolidated statement of cash flows.
Hopefully, understanding these key concepts and following a well-documented foreign currency transactions policy will help mitigate these risks of misstatements of the financial statements and related disclosures. And if that doesn’t help, reach out to your trusted professional to help you navigate through these foreign currency related matters.