Foreign exchange transactions - and related realised or unrealised gains - require specific adjustments in the cash flow statement to accurately reflect cash flows at the exchange rates applicable on the dates transactions occurred.
The cash flow statement must reconcile cash and cash equivalents from the beginning to the end of the reporting period, and foreign exchange movements affect this reconciliation in two distinct ways:
- through foreign exchange components embedded in profit or loss, and
- through the direct effect of exchange rate changes on foreign currency cash balances.
Understanding how to adjust for foreign exchange differences is essential for preparers using either the indirect or direct method, as both methods require elimination of foreign exchange effects that distort the presentation of actual cash flows.
Profit Adjustments for Foreign Exchange
Under the indirect method, foreign exchange gains and losses included in profit or loss must be adjusted for as non-cash items. The indirect method starts with profit and eliminates non-cash items to arrive at operating cash flows, and unrealised foreign exchange differences represent one category of such non-cash movements.
Under the direct method, similar adjustments are typically necessary to derive the actual cash paid to suppliers and received from customers. The direct method requires showing major classes of gross cash receipts and payments, which means the amounts must reflect cash transferred at the spot rates on the dates of transfer.
In practice, most entities using the indirect method will include a line item such as "Foreign exchange gains and losses" or "Unrealised foreign exchange movements" in the reconciliation from profit to operating cash flows.
Adjustment Categories
Foreign exchange adjustments fall into two categories:
- adjustments to eliminate unrealised gains/losses from profit (non-cash items), and
- adjustments to reclassify realised gains/losses to match the classification of the underlying cash flow (operating, investing, or financing).
Realised vs Unrealised Foreign Exchange Differences
Unrealised foreign exchange gains and losses arise when foreign currency monetary assets or liabilities are revalued at the reporting date exchange rate, without any actual settlement or cash movement occurring. For example, if an entity has a USD payable of $100,000 at year-end, it must revalue this payable at the year-end spot rate. If the exchange rate has moved from £0.75 per dollar to £0.78 per dollar, the entity recognises an unrealised foreign exchange loss of £3,000 ([£78,000 - £75,000]). No cash has changed hands—this is purely an accounting adjustment.
Realised foreign exchange gains and losses occur when a foreign currency transaction is actually settled. Using the same example, when the entity eventually pays the $100,000 liability and the spot rate at settlement is £0.80 per dollar, a further realised loss of £2,000 arises ([£80,000 - £78,000]). This time, the entity actually pays £80,000 in cash to settle a liability originally recorded at £75,000, representing a real cash impact of the foreign exchange movement.
The distinction matters because unrealised movements have not resulted in cash flows, whilst realised movements have—but both require adjustment in the cash flow statement for different reasons.
Why Both Types Must Be Adjusted
In practice, both unrealised and realised foreign exchange gains or losses are adjusted for, each for distinct reasons:
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Unrealised gains and losses are adjusted because they are not cash flows. They represent accounting revaluations at reporting date exchange rates and have no impact on cash movement during the period. Leaving them in the cash flow statement would misrepresent the amount of cash generated from operations.
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Realised gains and losses are adjusted because they need to follow the same classification as the underlying payment or receipt. If left unadjusted, these gains or losses will always be included under operating cash flows (as they flow through profit or loss). However, the substance of the transaction may require classification as an investing or financing cash flow.
For example, if an entity purchases equipment for €500,000 when the spot rate is £0.85 per euro (£425,000), but pays for it three months later when the rate is £0.88 per euro (£440,000), the entity has experienced a realised foreign exchange loss of £15,000.
This loss appears in profit or loss, but it should not be classified as an operating cash flow. Instead, it should be included with the equipment purchase as part of investing activities, showing total cash outflow of £440,000 for the purchase of property, plant and equipment.
Without adjusting for the realised loss in the reconciliation from profit to operating cash flows, the cash flow statement would incorrectly show the equipment purchase at £425,000 (the original transaction rate) and leave the £15,000 loss in operating activities.
Classification Principle
The realised foreign exchange component must travel with its underlying cash flow. Equipment purchase foreign exchange losses belong in investing activities, loan settlement foreign exchange gains belong in financing activities. This ensures each activity classification shows the total cash impact of that transaction.
Recording Cash Flows in Foreign Currency
Both IAS 7 and ASC 230 provide consistent guidance on recording foreign currency cash flows.
IAS 7 states:
Cash flows arising from transactions in a foreign currency shall be recorded in an entity's functional currency by applying to the foreign currency amount the exchange rate between the functional currency and the foreign currency at the date of the cash flow.
ASC 230-830-45-1 states:
A statement of cash flows of an entity with foreign currency transactions or foreign operations shall report the reporting currency equivalent of foreign currency cash flows using the exchange rates in effect at the time of the cash flows.
This means each cash flow is recorded at the spot rate on the date the cash was transferred. This is fundamentally important: the cash flow statement must reflect the actual amount of functional currency that was paid or received, not the amount at which the original transaction was initially recognised.
Since the initial transaction (for example, Dr Property, Plant and Equipment, Cr Trade Payables) was recognised at the spot rate on the transaction date, we need to include the realised gain or loss with that amount to reflect the actual cash amount at the rate prevailing when cash was transferred.
If we don't adjust for realised gains or losses, we will incorrectly show the cash flow at the rate of the initial transaction date, rather than at the rate of the cash flow date. This would misstate the actual cash impact and prevent proper reconciliation of the cash balance.
Both standards permit the use of an appropriately weighted average exchange rate for the period if the result is substantially the same as if the rates at the dates of the cash flows were used. This practical expedient is particularly useful when an entity has numerous foreign currency transactions throughout a period.
Translating Foreign Subsidiary Cash Flows
For consolidated cash flow statements that include foreign subsidiaries, both IAS 7 and ASC 230 require translation at the exchange rates on the dates of cash flows.
IAS 7 states:
The cash flows of a foreign subsidiary shall be translated at the exchange rates between the functional currency and the foreign currency at the dates of the cash flows.
ASC 830-230-45-1 provides equivalent guidance under US GAAP, requiring entities to report foreign currency cash flows using the exchange rates in effect at the time of the cash flows.
As with individual foreign currency transactions, the principle is that cash flows should be translated at the rates prevailing when the actual cash movements occurred. Both standards permit the use of an exchange rate that approximates the actual rate, allowing practical expedients:
Weighted average exchange rates for a period may be used for recording foreign currency transactions or translating the cash flows of a foreign subsidiary. This is particularly useful when a subsidiary has numerous cash flows throughout the period, as translating each individual cash flow at its specific date would be impractical. ASC 230-830-45-1 permits an "appropriately weighted average exchange rate" if the result is substantially the same as using actual rates.
Year-end exchange rates cannot be used for translating foreign subsidiary cash flows. IAS 21 The Effects of Changes in Foreign Exchange Rates explicitly prohibits using the reporting date exchange rate for cash flow translation, as this would not reflect the rates at the dates the cash flows actually occurred. This prohibition is consistent under US GAAP.
The difference between translating cash flows at actual rates (or weighted averages) versus the year-end rate creates exchange differences that must be presented separately in the cash flow statement to achieve reconciliation of opening and closing cash balances.
How to Account For Forex on Cash Balances
Effect of Exchange Rate Changes on Cash Balances
Both IAS 7 and ASC 230 require separate presentation of the effect of exchange rate changes on cash balances, though the scope differs slightly between the standards.
IAS 7 states:
Unrealised gains and losses arising from changes in foreign currency exchange rates are not cash flows. However, the effect of exchange rate changes on cash and cash equivalents held or due in a foreign currency is reported in the statement of cash flows in order to reconcile cash and cash equivalents at the beginning and the end of the period.
ASC 230-830-45-1 provides similar guidance:
The statement of cash flows shall report the effect of exchange rate changes on cash, cash equivalents, and amounts generally described as restricted cash or restricted cash equivalents held in foreign currencies as a separate part of the reconciliation of the change in the total of cash, cash equivalents, and amounts generally described as restricted cash or restricted cash equivalents during the period.
The key difference is that US GAAP includes restricted cash and restricted cash equivalents in the scope of the cash flow statement, whereas under IFRS, restricted cash is typically disclosed separately and not included in cash and cash equivalents.
This amount is presented separately from cash flows from operating, investing and financing activities. It represents the exchange differences that would arise if those cash flows had been reported at end-of-period exchange rates, compared to the rates at which they were actually recorded.
For example, if an entity holds €100,000 in a bank account throughout the year, and the exchange rate moves from £0.85 to £0.88, the entity's cash balance in functional currency terms has increased by £3,000 purely due to exchange rate movements. This £3,000 is not a cash flow—no cash has been received or paid—but it must be shown in the cash flow statement to reconcile the opening balance (£85,000) to the closing balance (£88,000).
The presentation typically appears as:
| Line Item | £'000 |
|---|---|
| Net increase in cash and cash equivalents | 125 |
| Effect of exchange rate changes on cash and cash equivalents | 3 |
| Cash and cash equivalents at beginning of period | 85 |
| Cash and cash equivalents at end of period | 213 |
Under US GAAP, the caption would reference "cash, cash equivalents, and restricted cash" if restricted cash is present.
Conclusion
Foreign exchange transactions in the cash flow statement require careful treatment to ensure cash flows are presented at the exchange rates prevailing on the dates of the cash movements. Both unrealised and realised foreign exchange gains and losses must be adjusted for—unrealised amounts because they are not cash flows, and realised amounts because they must be classified with their underlying transactions rather than defaulting to operating activities.
The separate presentation of exchange rate effects on cash balances completes the reconciliation between opening and closing cash positions, providing users with a clear picture of how foreign exchange movements have impacted the entity's cash position during the period.
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