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RECONCILING FINANCIAL STATEMENTS

Some Complexities

 

As users of financial statements, you will frequently encounter situations in which changes in balance sheet accounts are NOT equal to the corresponding change in the statement of cash flows.  Is there something wrong with these financial statements?

 

 

RECONCILING FINANCIAL STATEMENTS

Some Complexities

 

Discrepancies arise for at least 3 reasons:

  • Assets write-offs due to impairment, corporate restructuring, or retirement;
  • Translation adjustments on assets held by foreign subsidiaries;
  • Acquisitions and divestitures of other companies;

 

These discrepancies will be illustrated in the context of inventory changes;

 

 

RECONCILING FINANCIAL STATEMENTS

Some Complexities

Write-Offs

 

  • On the statement of cash flow, inventory change is computed by comparing purchases with COGS:
  • When purchases exceed COGS, an inventory increase is recorded as a decrease on the cash flow statement to convert accrual earnings to cash from operations;
  • When purchases are lower than COGS, an inventory decrease is recorded as an increase on the cash flow statement to convert accrual earnings to cash from operations;
  • Write-Offs of inventory, which result to a decrease in the ending balance sheet inventory, do not affect inventory change on the statement of cash flows;

 

 

RECONCILING FINANCIAL STATEMENTS

Some Complexities

Translation Adjustments Using The Current Rate Approach (1)

 

  • To determine the direction of inventory change for foreign subsidiaries on the statement of cash flows, translated purchases and COGS are compared;
  • Inventory purchases and COGS are translated into $s using the exchange rate in effect at the time of the transaction;

 


 

RECONCILING FINANCIAL STATEMENTS

Some Complexities

Translation Adjustments Using The Current Rate Approach (2)

 

  • By contrast, the inventory change on the balance sheet is computed differently:
  • Foreign subsidiaries’ beginning inventories are translated at the beginning rate of exchange;
  • Foreign subsidiaries’ ending inventories are translated at the ending rate of exchange;
  • It should not be surprising therefore that the measures of inventory change on the two statements will differ;

 

 

RECONCILING FINANCIAL STATEMENTS

Some Complexities

Acquisitions and Divestitures (1)

 

  • Companies bought and sold almost invariably possess inventory;
  • The ending inventory reported on the consolidated balance sheet includes the inventory of subsidiary companies purchased and excludes the inventories of subsidiaries that were sold during the year;

 

 

RECONCILING FINANCIAL STATEMENTS

Some Complexities

Acquisitions and Divestitures (2)

 

  • But, on the statement of cash flows:
  • The inventory of acquired companies is reported as a component of “Acquisitions”;
  • The inventory of companies sold is part of ”Proceeds from Divestitures”;
  • Therefore, the inventory change figure on the cash flow statement is limited to changes for those segments of the firm that were owned at both the start and end of the reporting period;

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