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What are the pitfalls of fee adjustments?

Hiding foreign-currency gains and losses in other comprehensive income (OCI) instead of recognizing them in net income. The first common mistake is difficult to detect without knowing how the accounting system consolidates subsidiaries. This mistake occurs when a company misclassifies a foreign-currency gain or loss in OCI instead of net income. Such a misclassification sounds benign, but it misstates net income and hides the gain or loss in an account that is normally presented as part of the statement of changes in equity.

This mistake can arise when a company has an intercompany account (for example, a parent’s intercompany receivable from a subsidiary) recorded on the books of companies with different functional currencies. The issue boils down to how to account for an intercompany balance when each of the parties has the balance recorded in different currencies (for example, the parent company records the balance in U.S. dollars, while the subsidiary records the balance in euros).

Preparing the consolidated statement of cash flows based on amounts reported in the consolidated balance sheets. The second common mistake is misstating the statement of cash flows by allocating changes in cash flows from the effects of foreign-currency rates among individual cash flow line items. U.S. GAAP requires that the statement of cash flows present changes in cash flows at the rate in effect on the date the cash flows took place, although the rules permit use of the average rate in effect during the period if it reasonably approximates the timing of cash flows.

The issue is that many preparers present the statement of cash flows under the indirect method. When preparing the statement of cash flows for a consolidated company that deals in more than one functional currency, it is simple to prepare a statement of cash flows based on the consolidated balance sheets of the current and prior periods—simple, but not correct. The consolidated balance sheets have been prepared using the exchange rates in effect on each balance sheet date; cash flows, however, should be translated into the reporting currency using the average exchange rate in effect during the period. The differences between those rates can be significant.

Even if the difference between exchange rates is relatively small, the error is often obvious on the face of a company’s financial statements because either the statement of cash flows will omit the line item used to account for the effects of foreign currencies on cash flows or changes in cash flows will, on their face, correspond to changes in amounts reported on the consolidated balance sheets.

Failing to recognize the need to modify accounting for foreign-currency translations in highly inflationary environments. Companies may fail to recognize that they are operating in an economy that has become highly inflationary, and hence do not appropriately modify their accounting for foreign-currency translations. Essentially, they continue to recognize currency translation adjustments in OCI and continue to translate all assets and liabilities at current translation rates.

However, under U.S. GAAP, the financial statements of the foreign entity operating in a highly inflationary environment are required to be remeasured as if the functional currency were the reporting currency, which generally results in translation adjustments’ being reported in earnings currently and requires that different procedures be used to translate nonmonetary assets and liabilities.

An example of this is Venezuela, which reached highly inflationary status for U.S. GAAP purposes effective Nov. 30, 2009. On that date, a U.S. company with a Venezuelan subsidiary would cease using bolivars as the functional currency of the Venezuelan subsidiary. The subsidiary would remeasure assets and liabilities into U.S. dollars as of Nov. 30, 2009, and those amounts would become the accounting basis of assets and liabilities for the Venezuelan subsidiary. Going forward, the subsidiary should measure monetary assets and liabilities at current (that is, balance sheet) exchange rates and recognize a gain or loss on that translation in net income. This diverges significantly from the rules prior to the application of highly inflationary accounting where such gains and losses would be recognized only in OCI.