Gains and losses on those foreign currency transactions are generally included in determining net income for the period in which exchange rates change unless the transaction hedges a foreign currency commitment or a net investment in a foreign entity.
Intercompany transactions of a long-term investment nature are considered part of a parent's net investment and hence do not give rise to gains or losses.
This issue really isn’t new, because let’s face it, the underlying literature has been around longer than most of us have been in practice.
Rather, it highlights a common mistake in preparing the consolidated statement of cash flows for a company that deals with more than one functional currency.
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). 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!
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.
An entity can be any form of operation, including a subsidiary, division, branch, or joint venture.
The Statement provides guidance for this key determination in which management's judgment is essential in assessing the facts.
This is the common mistake that many financial statement preparers make. There are probably many reasons, not the least of which is that it is just 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.
However, we have recently had several of our audit-firm clients ask us to include this issue in trainings on both foreign currency issues and cash flow statement preparation. 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.