Solution Manual Advanced Accounting Answer Key

Answers to Problems 1. C 2. C 3. C 4. B Because the peso is the functional currency, the financial statements must be translated using the current rate method. Therefore, answers a and d can be eliminated. Because the subsidiary has a net asset position and the peso has appreciated from $.16 to $.19, a positive translation adjustment will result. 5. A All asset accounts are translated at current rates. 6. A Because the foreign currency is the functional currency, a translation is required. All assets accounts are translated at current rates. 7. C Because the U.S. dollar is the functional currency, a remeasurement is required. All receivables are remeasured at current rates. Assets carried at historical cost, such as prepaid insurance and goodwill, are remeasured at historical rates. 8. B The foreign currency is the functional currency, so a translation is appropriate. All assets (including inventory) are translated at the current exchange rate [100,000 x $.17]. 9. C Cost of goods sold is translated at the exchange rate in effect at the date of accounting recognition, which is the date the goods were sold [100,000 x $.18]. 10. D The foreign currency is the functional currency, so a translation is appropriate. All assets are translated at the current exchange rate of $.19. 11. C The U.S. dollar is the functional currency, so a remeasurement is appropriate. Inventory (carried at cost) is remeasured at the historical exchange rate of $.16. Marketable equity securities (carried at market value) are remeasured at the current exchange rate of $.19. 12. C Beginning inventory Purchases Ending inventory Cost of goods sold FCU 200,000 x $1.00 = $ 200,000 10,300,000 x $0.80 = 8,240,000 (500,000) x $0.75 = (375,000) FCU 10,000,000 $8,065,000 13. C Beginning net assets, 1/1………….. Increase in net assets: Income ........................................ Ending net assets, 12/31 ................. Ending net assets at current exchange rate ................ Translation Adjustment (positive) . P20,000 x $.15 = $ 3,000 10,000 P30,000 x $.19 = 1,900 $ 4,900 P30,000 x $.21 = $ 6,300 $(1,400) 14. C By translating items carried at historical cost by the historical exchange rate, the temporal method maintains the underlying valuation method used by the foreign subsidiary. 15. A Beginning net monetary assets, 1/1 Increases in net monetary assets: Sale of inventory ........................ Decreases in net monetary assets: Purchase of equipment ............. Purchase of inventory ............... Transfer to parent ...................... Ending net monetary assets, 12/31 Ending net monetary assets at the current exchange rate ......... Remeasurement gain ...................... P100,000 x $.16 = $16,000 50,000 x $.20 = 10,000 (60,000) (30,000) (10,000) P 50,000 x $.16 = x $.18 = x $.21 = (9,600) (5,400) (2,100) $ 8,900 P 50,000 x $.22 = (11,000) $(2,100) 16. C Marketable equity securities are carried at market value and therefore translated at the current exchange rate under the temporal method. 17. B When the U.S. dollar is the functional currency, SFAS 52 requires remeasurement using the temporal method with remeasurement gains and losses reported in income. 18. B Wages payable is translated at the current exchange rate. 19. C Gains and losses on hedges of net investments (whether through a forward contract, borrowing, or other technique) are offset against the translation adjustment being hedged. 20. D Remeasurement gains are reported in the income statement as a part of income from continuing operations. 21. (10 minutes) (Specify appropriate rates for a translation) Rent expense—use actual (historical) rate at time of recording. Rent expense would often be recorded evenly throughout the year so that an average rate for the period is acceptable. Dividends paid—use historical rate at time of recording, the date of declaration. Equipment—as an asset, use current rate at the balance sheet date. Notes payable—as a liability, use current rate at the balance sheet date. 21. (continued) Sales—use actual (historical) rate at time of recording. Sales often occur evenly throughout the year so that an average rate is acceptable. However, if sales are more prevalent at a particular time during the year, historical rates should be used. Depreciation expense—use historic rate at time of recording. In most cases, average rate for the year is acceptable, because depreciation occurs evenly throughout the year. Depreciation is recorded at year-end only as a matter of convenience. Cash—as an asset, use the current rate at the balance sheet date. Accumulated depreciation—as a contra-asset account, use the current exchange rate at the balance sheet date. Common stock—as an equity account, use historic rate at time of recording, the date of issuance. 22. (5 minutes) (Determine translated values) As a translation, both the asset (inventory) and the liability (accounts payable) utilize the current exchange rate at the balance sheet date (December 31). Thus, the translated values are as follows: Inventory LCU120,000 x 25% left = LCU30,000 x 1/3.0 = $10,000 Accounts payable LCU120,000 x 40% unpaid = LCU48,000 x 1/3.0 = $16,000 23. (10 minutes) (Determine translation and remeasurement rates) Accounts payable Accounts receivable Accumulated depreciation Advertising expense Amortization expense Buildings Cash Common stock Depreciation expense Dividends paid (10/1) Notes payable Patents (net) Salary expense Sales Translation $.16 C $.16 C $.16 C $.19 A $.19 A $.16 C $.16 C $.28 H $.19 A $.20 H $.16 C $.16 C $.19 A $.19 A Remeasurement $.16 C $.16 C $.26 H $.19 A $.25 H $.26 H $.16 C $.28 H $.26 H $.20 H $.16 C $.25 H $.19 A $.19 A * C = current rate, H = historical rate, A = average rate 24. (20 minutes) (Calculate translation adjustment and remeasurement gain/loss and explain their economic relevance) The translation adjustment and remeasurement gain/loss can be determined as the plug figure that keeps the dollar balance sheet in balance: Translation Remeasurement CHF Rate US$ Rate US$ $.75 C 375,000 $.75 C 375,000 Cash ............................ 500,000 Inventory..................... 1,000,000 $.75 C 750,000 $.70 H 700,000 Fixed assets ............... 3,000,000 $.75 C 2,250,000 $.70 H 2,100,000 3,375,000 3,175,000 Total assets ............... 4,500,000 800,000 $.75 C 600,000 $.75 C 600,000 Notes payable ............. Owners equity ............ 3,700,000 $.70 H 2,590,000 $.70 H 2,590,000 Translation adjustment 185,000 Retained earnings (15,000) (remeasurement loss) 3,375,000 3,175,000 Total ......................... 4,500,000 Alternatively, the translation adjustment and remeasurement loss can be calculated by analyzing the subsidiary’s balance sheet exposure: Translation Beginning net assets, 12/1 Ending net assets, 12/31 at current exchange rate Translation adjustment (positive) $( 185,000) Remeasurement Beginning net monetary liability position, 12/1 Ending net monetary liability position, 12/31 at current exchange rate Remeasurement loss CHF3,700,000 x $.70 = $2,590,000 CHF3,700,000 x $.75 = (2,775,000) CHF(300,000) x $.70 = $(210,000) CHF(300,000) x $.75 = (225,000) $ 15,000 Economic Relevance of Translation Adjustment The translation adjustment increases stockholders’ equity by $185,000. The positive translation adjustment arises because the Swiss subsidiary has a net asset position of CHF3,700,000 and the Swiss franc appreciates by $.05 [CHF3,700,000 x $.05 = $185,000]. The positive translation adjustment is not realized in terms of dollar cash flow. It would be a realized gain only if Stephanie sold this operation on December 31 for exactly CHF3,700,000 and converted the sales proceeds into dollars at the current exchange rate of $.75 per Swiss franc. Economic Relevance of Remeasurement Loss The remeasurement loss arises because the Swiss subsidiary has a net monetary liability position of CHF300,000 (Cash of CHF500,000 less Notes payable of CHF800,000) and the Swiss franc has appreciated by $.05 [CHF300,000 x $.05 = $15,000]. The loss is unrealized. It would be realized only if the Swiss subsidiary converted its Swiss franc cash into dollars at December 31, thereby realizing a transaction gain of $25,000 [CHF500,000 x ($.75-$.70)], and the parent paid off the Swiss franc note payable using U.S. dollars, thereby realizing a transaction loss of $40,000 [CHF800,000 x ($.75-$.70)]. (The note could have been paid at December 18 for $560,000 [CHF800,000 x $.70]. At December 31, it takes $600,000 to pay off the note [CHF800,000 x $.75].) 25. (30 minutes) (Prepare financial statements for a foreign subsidiary and then translate them into U.S. dollars) Fenwicke Company Subsidiary Income Statement LCU U.S. Dollars Rent revenue 60,000 x $1.90 A = $114,000 Interest expense (10,000) x $1.90 A = (19,000) Depreciation expense (14,000) x $1.90 A = (26,600) Repair expense (4,000) x $1.85*H = (7,400) $ 61,000 Net income 32,000 * Repair expense is the only expense not incurred evenly throughout the year. Statement of Retained Earnings U.S. Dollars LCU -0-032,000 (above) $61,000 (5,000) x $1.80 H = (9,000) $52,000 27,000 Retained earnings, 1/1 Net income Dividends paid Retained earnings, 12/31 Balance Sheet LCU 41,000 x $1.80 C = Cash Accounts receivable 10,000 x $1.80 C = Building 140,000 x $1.80 C = Accumulated depreciation (14,000) x $1.80 C = Total assets 177,000 Interest payable 10,000 x $1.80 C = Note payable 100,000 x $1.80 C = Common stock 40,000 x $2.00 H = Retained earnings 27,000 (above) Translation adjustment (below) Total liabilities and equities 177,000 Computation of Translation Adjustment Beginning net assets -0-0Increase in net assets: Issued common stock 40,000 x $2.00 = Net income 32,000 (above) Decrease in net assets: Dividends paid (5,000) x $1.80 = Ending net assets 67,000 Ending net assets at current exchange rate 67,000 x $1.80 = Translation adjustment (negative) U.S. Dollars $ 73,800 18,000 252,000 (25,200) $318,600 $ 18,000 180,000 80,000 52,000 (11,400) $318,600 $ 80,000 61,000 (9,000) $132,000 120,600 $ 11,400 26. (30 minutes) (Prepare a statement of cash flows for a foreign subsidiary and then translate it into U.S. dollars) Fenwicke Company Subsidiary Statement of Cash Flows LCU U.S. Dollars Operating Activities: Net income 32,000 (from prob 25) $ 61,000 plus: depreciation 14,000 x $1.9 A = 26,600 less: increase in accounts receivable (10,000) x $1.9 A = (19,000) plus: increase in interest payable 10,000 x $1.9 A = 19,000 87,600 Cash flow from operations 46,000 Investing Activities: Purchase of building (140,000) x $2.0 H = (280,000) Financing Activities: Sale of common stock 40,000 x $2.0 H = 80,000 Borrowing on note 100,000 x $2.0 H = 200,000 Dividends paid (5,000) x $1.8 H = (9,000) 135,000 271,000 78,600 Increase in cash 41,000 (4,800) Effect of exchange rate change on cash -0Cash, 1/1 -0Cash, 12/31 41,000 x $1.80 C = $ 73,800 27. (25 minutes) (Compute translation adjustment and remeasurement gain or loss) a. Translation—only changes in net assets have an impact on the computation of the translation adjustment. Net asset balance 1/1 Increases in net assets (income): Sold inventory at a profit 5/1 Sold land at a gain 6/1 Decreases in net assets: Paid a dividend 12/1 Depreciation recorded Net asset balance 12/31 Net asset balance 12/31 at current exchange rate Translation adjustment—positive KM30,000 x $.32 = $ 9,600 5,000 1,000 x $.34 = x $.35 = 1,700 350 (3,000) (2,000) KM31,000 x $.41 = x $.37 = (1,230) ( 740) $ 9,680 KM31,000 x $.42 = (13,020) $(3,340) b. Remeasurement—only changes in net monetary assets and liabilities have an impact on the computation of the remeasurement gain. Beginning net monetary liability position KM (3,000) Increases in monetary assets: 15,000 Sold inventory 5/1 Sold land 6/1 5,000 Decreases in monetary assets: Bought inventory 10/1 (12,000) Bought land 11/1 (4,000) Paid a dividend 12/1 (3,000) Ending net monetary liability position KM(2,000) Ending net monetary liability position at current exchange rate KM(2,000) Remeasurement gain x $.32 = $ ( 960) x $.34 = x $.35 = 5,100 1,750 x $.39 = x $.40 = x $.41 = (4,680) (1,600) (1,230) $(1,620) x $.42 = (840) $ (780) Note: The purchase of land on account did not result in a decrease in monetary assets, rather an increase in monetary liabilities. Payment on the note payable and collection of accounts receivable do not affect the net monetary liability position. 28. (20 minutes) (Compute translation adjustment and remeasurement gain or loss) a. The translation adjustment is based on changes in the net assets of the subsidiary. Net assets, 1/1 Changes in net assets Rendered services Incurred expense Net assets, 12/31 Net assets, 12/31 at current exchange rate Translation adjustment (positive) 82,000 LCU x $.24 = $19,680 30,000 LCU x $.25 = (18,000) LCU x $.26 = 94,000 LCU 7,500 (4,680) 22,500 94,000 LCU x $.29 = 27,260 $(4,760) b. The remeasurement gain or loss is based on changes in the net monetary assets of the subsidiary. Net monetary assets, 1/1 Changes in net monetary assets Rendered services Incurred expense Net monetary assets, 12/31 Net monetary assets, 12/31 at current exchange rate Remeasurement gain c. Translated value of land Remeasured value of land 22,000 LCU x $.24 = $ 5,280 30,000 LCU x $.25 = (18,000) LCU x $.26 = 34,000 LCU 7,500 (4,680) $ 8,100 34,000 LCU x $.29 = 9,860 $(1,760) 60,000 LCU 60,000 LCU x $.29 = x $.23 = $17,400 $13,800 29. (10 minutes) (Determine the appropriate exchange rate) Account (a) Translation Sales 20 A Inventory 22 C Equipment 22 C 20 A Rent expense 21 H Dividends 22 C Notes receivable Accumulated depreciation--equipment 22 C 22 C Salary payable 20 A Depreciation expense (b) Remeasurement 20 A 19 H 13 H 20 A 21 H 22 C 13 H 22 C 13 H C = current exchange rate, A = average exchange rate, H = Historical exchange rate 30. (30 minutes) (Hedge of balance sheet exposure) a. Net assets, 1/1 (132,000 – 54,000) Change in net assets: Net income Dividends, 3/1 Dividends, 10/1 Net assets, 12/31 Net assets at current exchange rate, 12/31 Translation adjustment (negative) 78,000 kites x $0.80 = 26,000 kites x $0.77 = (5,000) kites x $0.78 = (5,000) kites x $0.76 = 94,000 kites 94,000 kites x $0.75 = $62,400 20,020 (3,900) (3,800) $74,720 70,500 $ 4,220 b. Forward contract journal entries 10/1 No entry 12/31 Forward Contract ................................. 2,000 Translation Adjustment (positive) .. 2,000 (To record the change in the value of the forward contract as an adjustment to the translation adjustment) Foreign Currency (kites) ...................... 150,000 Cash ................................................. 150,000 (To record the purchase of 200,000 kites at the spot rate of $.75) Cash .................................................... 152,000 Foreign Currency (kites) ................. 150,000 Forward Contract ............................ 2,000 (To record delivery of 200,000 kites, receipt of $152,000, and close the forward contract account.) c. The net negative translation adjustment (debit balance) to be reported in other comprehensive income at 12/31 is $2,220 ($4,220 – $2,000). 31. (45 minutes) (Translation and remeasurement of foreign subsidiary trial balance) a. Translation of Subsidiary Trial Balance Debits Credits 8,000 KQ x 1.62 $12,960 9,000 KQ x 1.62 14,580 3,000 KQ x 1.62 4,860 600 KQ x 1.62 $ 972 5,000 KQ x 1.62 8,100 4,860 3,000 KQ x 1.62 5,000 KQ x 1.62 8,100 17,100 10,000 KQ x 1.71 4,000 KQ x 1.66 6,640 41,000 25,000 KQ x 1.64 5,000 KQ x 1.64 8,200 600 KQ x 1.64 984 9,000 KQ x 1.64 14,760 $71,084 Translation Adjustment (negative) 948 $72,032 $72,032 Calculation of Translation Adjustment -0Net assets, 1/1………………………….. -0Increase in net assets: Common stock issued………………. 10,000 KQ x 1.71 $17,100 Sales……………………………………. 25,000 KQ x 1.64 41,000 Decrease in net assets: Dividends paid……………………….. ( 4,000) KQ x 1.66 (6,640) Salary expense……………………….. ( 5,000) KQ x 1.64 (8,200) ( 984) Depreciation expense………………. ( 600) KQ x 1.64 Miscellaneous expense ……………. ( 9,000) KQ x 1.64 (14,760) Cash…………………………………. Accounts Receivable…………….. Equipment………………………….. Accumulated Depreciation……… Land………………………………… Accounts Payable………………… Notes Payable…………………….. Common Stock…………………… Dividends Paid……………………. Sales………………………………… Salary Expense…………………… Depreciation Expense…………… Miscellaneous Expense…………. Net assets, 12/31………………………. Net assets, 12/31 at current exchange rate……………. Translation adjustment (negative) 16,400* KQ $27,516 16,400 KQ x 1.62 $ 26,568 948 * This amount can be verified as ending assets (24,400 KQ) minus ending liabilities (8,000 KQ) – net assets, 12/31 = 16,400 KQ. 31. (continued) b. Remeasurement of Subsidiary Trial Balance Cash Accounts Receivable Equipment Accumulated Depreciation Land Accounts Payable Notes Payable Common Stock Dividends Paid Sales Salary Expense Depreciation Expense Miscellaneous Expense 8,000 9,000 3,000 600 5,000 3,000 5,000 10,000 4,000 25,000 5,000 600 9,000 KQ x 1.62 KQ x 1.62 KQ x 1.71 KQ x 1.71 KQ x 1.59 KQ x 1.62 KQ x 1.62 KQ x 1.71 KQ x 1.66 KQ x 1.64 KQ x 1.64 KQ x 1.71 KQ x 1.64 Remeasurement loss (debit) Calculation of Remeasurement Loss Net monetary assets, 1/1 -0Increase in net monetary assets: Common stock issued 10,000 Sales 25,000 Decrease in net monetary assets: Acquired equipment (3,000) Acquired land (5,000) Dividends paid (4,000) Salary expense (5,000) Miscellaneous expense (9,000) Net monetary assets, 12/31 Net monetary assets, 12/31 at current exchange rate Remeasurement loss (debit) Debits $12,960 14,580 5,130 Credits $ 1,026 7,950 4,860 8,100 17,100 6,640 41,000 8,200 1,026 14,760 $71,246 840 $72,086 $72,086 -0KQ x 1.71 $17,100 KQ x 1.64 41,000 KQ KQ KQ KQ KQ x 1.71 x 1.59 x 1.66 x 1.64 x 1.64 9,000* KQ (5,130) (7,950) (6,640) (8,200) (14,760) $15,420 9,000 KQ x 1.62 $ 14,580 840 * This amount can be verified as ending monetary assets (Cash + Accounts receivable) minus ending monetary liabilities (Accounts payable + Notes payable): 17,000 KQ – 8,000 KQ = 9,000 KQ. 32. (30 minutes) (Translate the financial statements of a foreign subsidiary) LIVINGSTON COMPANY Income Statement For Year Ending December 31, 2009 Sales Cost of Goods Sold Gross Profit Operating Expenses Gain on Sale of Equipment Net Income Goghs 270,000 (155,000) 115,000 (54,000) 10,000 71,000 U.S. Dollars x 1/.63 = 428,571 x 1/.63 = (246,032) 182,539 x 1/.63 = (85,714) x 1/.58 = 17,241 114,066 Statement of Retained Earnings For Year Ending December 31, 2009 Retained Earnings, 1/1/09 Net Income Dividends Paid Retained Earnings, 12/31/09 Goghs U.S. Dollars 216,000 given 395,000 71,000 above 114,066 (26,000) x 1/.62 = (41,935) 467,131 261,000 Balance Sheet December 31, 2009 Cash Receivables Inventory Fixed Assets (net) Total Goghs 44,000 116,000 58,000 339,000 557,000 U.S. Dollars x 1/.65 = 67,692 x 1/.65 = 178,462 x 1/.65 = 89,231 x 1/.65 = 521,538 856,923 Liabilities Common Stock Retained Earnings Translation Adjustment Total 176,000 x 1/.65 = 270,769 120,000 x 1/.48 = 250,000 261,000 above 467,131 (130,977) 557,000 856,923 Translation Adjustment Net assets, 1/1/09 Net income, 2009 Dividends paid Net assets, 12/31/09 Net assets at current exchange rate, 12/31/09 Goghs 336,000 x 1/.60 = 71,000 above (26,000) above 381,000 U.S. Dollars 560,000 114,066 (41,935) 632,131 381,000 x 1/.65 = 586,154 Translation adjustment, 2009 (negative) Cumulative translation adjustment, 1/1/ 09 (negative) Cumulative translation adjustment, 12/31/09 (negative) 45,977 85,000 130,977 33. (35 minutes) (Compute translation adjustment and remeasurement gain or loss) a. Remeasurement Gain or Loss Net monetary assets, 1/1/09* Increases in net monetary assets: Issued Common Stock (4/1/09) Sold Building** (7/1/ 09) Sales (2009) Decreases in net monetary assets: Purchased Equipment (4/1/09) Paid Dividends (10/1/09) Rent Expense (2009) Salary Expense (2009) Utilities Expense (2009) Net monetary assets, 12/31/09 Net monetary assets, 12/31/09 at current exchange rate Remeasurement gain (credit) 2,000 KR x 2.50 = $ 5,000 10,000 22,000 80,000 KR x 2.60 = 26,000 KR x 2.80 = 61,600 KR x 2.70 = 216,000 (30,000) (32,000) (14,000) (20,000) ( 5,000) 13,000 KR x 2.60 = (78,000) KR x 2.90 = (92,800) KR x 2.70 = (37,800) KR x 2.70 = (54,000) KR x 2.70 = (13,500) KR $ 32,500 13,000 KR x 3.00 = 39,000 $ (6,500) * Net monetary assets: (Cash + Accounts Receivable) - (Account Payable + Bonds Payable) ** To determine cash proceeds from the sale of the building, changes in the Accumulated Depreciation and Buildings accounts must be analyzed along with Depreciation Expense and Gain on Sale of Building. Depreciation expense is KR 15,000; KR 5,000 is attributable to equipment (Accumulated Depreciation—Equipment increases by KR 5,000), KR 10,000 is depreciation of buildings. Accumulated Depreciation —Buildings increases by only KR 5,000 during 2009, therefore, the accumulated depreciation related to the building sold during 2009 is KR 5,000. The Buildings account is decreased by KR 21,000, thus the book value of the building sold must have been KR 16,000 (as given). The Gain on Sale of Building is KR 6,000; therefore, cash proceeds from the sale are KR 22,000. 33. (continued) b. Translation Adjustment Net assets, 1/1/09* 100,000 KR x 2.50 Increases in net assets Issued Common Stock (4/1/09) 10,000 KR x 2.60 Gain on Sale of Building** (7/1/09) 6,000 KR x 2.80 Sales (2009) 80,000 KR x 2.70 Decreases in net assets Paid Dividends (10/1/09) (32,000) KR x 2.90 Depreciation Expense (2009) (15,000) KR x 2.70 Rent Expense (2009) (14,000) KR x 2.70 Salary Expense (2009) (20,000) KR x 2.70 Utilities Expense (2009) ( 5,000) KR x 2.70 Net assets, 12/31/09 110,000 KR Net monetary assets, 12/31/09 at current exchange rate 110,000 KR x 3.00 Translation adjustment (positive) = $250,000 = = = 26,000 16,800 216,000 = = = = = (92,800) (40,500) (37,800) (54,000) (13,500) $270,200 = 330,000 $(59,800) * Net assets: Common stock + Retained earnings ** Selling a building at a gain of KR 6,000 increases net assets by that amount. Although not required by Part b, the beginning translation adjustment as of January 1, 2009 can be computed by translating the January 1 accounts and assuming that the translation adjustment is the balancing figure: Common Stock, 1/1/09 70,000 KR x 2.40 = $168,000 62,319 Retained Earnings, 1/1/09 30,000 KR given 100,000 KR $230,319 Net assets, 1/1/09 Net assets, 1/1/09 at current exchange rate 100,000 KR x 2.50 = 250,000 $ (19,681) Cumulative translation adjustment (positive), 1/1/09 (59,800) Translation adjustment (positive), 2009 $ (79,481) Cumulative translation adjustment (positive), 12/31/ 09 34. (90 minutes) (Remeasure non-functional currency accounts into foreign functional currency and then translate foreign functional currency financial statements into U.S. dollars) a. Remeasurement of Mexican Operations Accounts payable Accumulated depreciation Building and equipment Cash Depreciation expense Inventory (beginning —income statement) Inventory (ending —income statement) Inventory (ending —balance sheet) Purchases Receivables Salary expense Sales Main office Remeasurement loss Total Canadian Dollars Debit Credit 17,150 4,750 10,000 20,650 500 Pesos 49,000 19,000 40,000 59,000 2,000 x .35 C x .25 H x .25 H x .35 C x .25 H 23,000 x .30 A (’08) 6,900 28,000 x .34 A(’09) 28,000 x .34 A(’09) 9,520 68,000 x .34 A(’09) 23,120 21,000 x .35 C 7,350 9,000 x .34 A 3,060 124,000 x .34 A 30,000 given Schedule One 10 81,110 Schedule One—Remeasurement Loss Net monetary liabilities, 1/1/09* Increases in net monetary assets Sales Decreases in net monetary assets Purchases Salary Expense Net monetary assets, 12/31/09** Net monetary assets, 12/31/09 at current exchange rate Remeasurement loss 9,520 42,160 7,530 81,110 Pesos (16,000) Canadian Dollars x .32 (5,120) 124,000 x .34 (68,000) ( 9,000) 31,000 x .34 (23,120) x .34 ( 3,060) 10,860 31,000 x .35 42,160 10,850 10 * Net monetary liabilities, 1/1/09, can be determined by first determining the net monetary assets at 12/31/09 and then backing out the changes in monetary assets and liabilities during 2009—sales, purchases, and salary expense. ** Net monetary assets, 12/31/09: Cash + Receivables – Accounts Payable 34. (continued) b. The following C$ financial statements are produced by combining the figures from the main operation with the remeasured figures from the branch operation. The Branch Operation and Main Office accounts offset each other. Cost of goods sold for the Mexican branch is determined by combining beginning inventory, purchases, and ending inventory as remeasured in C$. Income Statement c. Translation into U.S. dollars— Current Rate Method For the Year Ended December 31, 2009 Sales Cost of goods sold Gross profit Depreciation expense Salary expense Utility expense Gain on sale of equipment Remeasurement loss Net income C$ 354,160 (223,500) 130,660 (8,500) (29,060) (9,000) 5,000 (10) C$ 89,090 x .67 A = x .67 A = x x x x x .67 A .67 A .67 A .68 H .67 A = = = = = $ 237,287.20 (149,745.00) 87,542.20 (5,695.00) (19,470.20) (6,030.00) 3,400.00 (6.70) $ 59,740.30 Statement of Retained Earnings For the Year Ended December 31, 2009 Retained earnings, 1/1/09 Net income (above) Dividends paid Retained earnings, 12/31/09 C$ C$ 135,530 89,090 ( 28,000) 196,620 Given Above x .69 H = $ 70,421.00 59,740.30 (19,320.00) $110,841.30 34. (continued) Balance Sheet December 31, 2009 Cash Receivables Inventory Buildings and equipment Accumulated depreciation Total C$ C$ Accounts payable C$ Notes payable Common stock Retained earnings Cumulative translation adjustment C$ Total 46,650 75,350 107,520 177,000 (31,750) 374,770 52,150 76,000 50,000 196,620 374,770 x x x x x .65 C .65 C .65 C .65 C .65 C = $ 30,322.50 = 48,977.50 = 69,888.00 = 115,050.00 = (20,637.50) $243,600.50 x .65 C = $ 33,897.50 x .65 C = 49,400.00 x .45 H = 22,500.00 Above 110,841.30 Schedule Two 26,961.70 $ 243,600.50 Schedule Two —Translation Adjustment Net assets, 1/1/09 C$ 185,530 x .70 = Changes in net assets Net income 89,090 Above (28,000) x .69 = Dividends C$ 246,620 Net assets, 12/31/09 Net assets, 12/31/09 at current exchange rate C$ 246,620 x .65 = Translation adjustment, 2009 (negative) Cumulative translation adjustment, 1/1/ 09 (positive) Cumulative translation adjustment, 12/31/09 (positive) $129,871.00 59,740.30 (19,320.00) $170,291.30 160,303.00 9,988.30 (36,950.00) $(26,961.70) $ 35. (90 minutes) (Translate foreign currency financial statements and prepare consolidation worksheet) Step One Simbel's financial statements are first translated into U.S. dollars after reclassification of the 10,000 pound expenditure for rent from rent expense to prepaid rent. Credit balances are in parentheses. Translation Worksheet Exchange Account Pounds Rate Dollars Sales (800,000) 0.274 (219,200) Cost of goods sold 420,000 0.274 115,080 Salary expense 74,000 0.274 20,276 Rent expense (adjusted) 36,000 0.274 9,864 Other expenses 59,000 0.274 16,166 Gain on sale of fixed (30,000) 0.273 (8,190) assets, 10/1/09 (66,004) Net income (241,000) R/E, 1/1/09 Net income Dividends paid R/E,12/31/09 Cash and receivables Inventory Prepaid rent (adjusted) Fixed assets Total Accounts payable Notes payable Common stock Add’l paid-in capital Retained earnings, 12/31/ 09 Subtotal Cumulative translation adjustment (negative) Total (133,000) (241,000) 50,000 (324,000) Schedule 1 (38,244) Above (66,004) 0.275 13,750 (90,498) 146,000 297,000 10,000 455,000 908,000 0.270 0.270 0.270 0.270 39,420 80,190 2,700 122,850 245,160 (54,000) (140,000) (240,000) (150,000) (324,000) 0.270 0.270 0.300 0.300 Above (14,580) (37,800) (72,000) (45,000) (90,498) (259,878) Schedule 2 14,718 (245,160) (908,000) 35. (continued) Schedule 1—Translation of 1/1/09 Retained Earnings Retained earnings, 1/1/08 Net income, 2008 Dividends, 6/1/08 Retained earnings, 1/1/09 Pounds -0(163,000) 30,000 (133,000) 0.288 0.290 Dollars -0(46,944) 8,700 (38,244) Schedule 2—Calculation of Cumulative Translation Adjustment at 12/31/09 Pounds Net assets, 1/1/08 Net income, 2008 Dividends, 6/1/08 Net assets, 12/3/08 Net assets, 12/31/08 at current exchange rate Dollars (390,000) (163,000) 30,000 (523,000) 0.300 0.288 0.290 (117,000) (46,944) 8,700 (155,244) (523,000) 0.280 (146,440) (523,000) (241,000) 50,000 (714,000) 0.280 Above 0.275 (146,440) (66,004) 13,750 (198,694) (714,000) 0.270 (192,780) Translation adjustment, 2008 (negative) Net assets, 1/1/09 Net income, 2009 Dividends, 6/1/09 Net assets, 12/31/09 Net assets, 12/31/09 at current exchange rate (8,804) Translation adjustment, 2009 (negative) Cumulative translation adjustment, 12/31/09 (negative) (5,914) (14,718) 35. (continued) Step Two Cayce and Simbel's U.S. dollar accounts are then consolidated. Necessary adjustments and eliminations are made. Consolidation Worksheet Cayce Simbel Account Dollars Dollars Sales (200,000) (219,200) Cost of goods sold 93,800 115,080 20,276 Salary expense 19,000 9,864 Rent expense 7,000 16,166 Other expenses 21,000 -0Dividend income (13,750) Gain, 10/1/09 -0(8,190) Net income (72,950) (66,004) Ret earn, 1/1/09 Net income Dividends paid Ret earn, 12/31/09 Cash and receivables Inventory Prepaid rent Investment Fixed assets Total Accounts payable Notes payable Common stock Additional PIC Ret earn, 12/31/09 Subtotal Cum trans adjust Total (318,000) (72,950) 24,000 (366,950) 110,750 98,000 30,000 126,000 398,000 762,750 (60,800) (132,000) (120,000) (83,000) (366,950) Adjustments and Consolidated Eliminations Balances Debit Credit Dollars (419,200) 208,880 39,276 16,864 37,166 (I) 13,750 -0(8,190) (125,204) (38,244) (S) 38,244 (*C) (38,244) (356,244) (125,204) (66,004) (I) (13,750) 24,000 13,750 (90,498) (457,448) 39,420 80,190 2,700 -0- (*C) 38,244 (S)(164,244) (900) 122,850 (S) 9,000 (E) 245,160 (14,580) (37,800) (72,000) (S) 72,000 (45,000) (S) 45,000 (90,498) (259,878) 14,718 (E) 900 (762,750) (245,160) 217,138 150,170 178,190 32,700 -0528,950 890,010 (75,380) (169,800) (120,000) (83,000) (457,448) (905,628) 15,618 (217,138) (890,010) 35. (continued) Explanation of Adjustment and Elimination Entries Entry *C Investment in Simbel ................................................... 38,244 Retained earnings, 1/1/09 ....................................... 38,244 To accrue the 2008 increase in subsidiary book value (see Schedule 1). Entry is needed because parent is using the cost method. Entry S Common Stock (Simbel) ............... 72,000 Add'l Paid-in-capital (Simbel) ............ 45,000 Retained earnings, 1/1/09 (Simbel) ... 38,244 Fixed assets (revaluation) ............... 9,000 164,244 Investment in Simbel ............... To eliminate subsidiary's stockholders' equity accounts and allocate the excess of fair value over book value to land (fixed assets). The excess of fair value over book value is calculated as follows: Consideration paid (equal to fair value) .......... $126,000 £E420,000 x $0.30 Book value, 1/1/08 ............................................. Common stock ................................................ (72,000) (£E240,000 x $0.30) Add’l paid-in capital ........................................ (45,000) (£E150,000 x $0.30) Excess of fair value over book value ............... $ 9,000 £E 30,000 x $0.30 The excess of fair value over book value is 30,000 pounds. The U.S. dollar equivalent at 1/1/08, the date of acquisition, is $9,000 (£E30,000 x $.30). Entry I Dividend income ............................................... 13,750 13,750 Dividends paid ............................................. To eliminate intercompany dividend payments recorded by parent as income. Entry E Cumulative translation adjustment .................. 900 900 Fixed assets (revaluation) .......................... To revalue (write-down) the excess of fair value over book value for the change in exchange rate since the date of acquisition with the counterpart recognized in the consolidated cumulative translation adjustment. The revaluation of "excess" is calculated as follows: Excess of fair value over book value £E30,000 x $.27 = $8,100 U.S. dollar equivalent at 12/31/09 £E30,000 x $.30 = 9,000 U.S. dollar equivalent at 1/1/08 Cumulative translation adjustment $( 900) related to excess, 12/31/09 (negative) 36. (90 minutes) (Translate foreign currency financial statements using U.S. GAAP and explain sign of translation adjustment [remeasurement gain/loss].) Part I (a). Czech koruna is the functional currency—current rate method KCS Sales 25,000,000 Cost of goods sold (12,000,000) (2,500,000) Depreciation expense—equipment Depreciation expense—building (1,800,000) Research and development expense (1,200,000) Other expenses (1,000,000) Net income 6,500,000 Retained earnings, 1/1/09 500,000 Dividends paid, 12/15/09 (1,500,000) Retained earnings, 12/31/09 5,500,000 Cash Accounts receivable Inventory Equipment Accum. deprec.—equipment Building Accum. deprec.—equipment Land Total assets Accounts payable Long-term debt Common stock Additional paid-in capital Retained earnings, 12/31/09 Translation adjustment Total liabilities and equities 2,000,000 3,300,000 8,500,000 25,000,000 (8,500,000) 72,000,000 (30,300,000) 6,000,000 78,000,000 2,500,000 50,000,000 5,000,000 15,000,000 5,500,000 78,000,000 Exchange Rate US$ 0.035 875,000 0.035 (420,000) 0.035 (87,500) 0.035 (63,000) 0.035 (42,000) 0.035 (35,000) 227,500 given 22,500 0.031 (46,500) 203,500 0.030 0.030 0.030 0.030 0.030 0.030 0.030 0.030 60,000 99,000 255,000 750,000 (255,000) 2,160,000 (909,000) 180,000 2,340,000 0.030 75,000 0.030 1,500,000 0.050 250,000 0.050 750,000 above 203,500 to balance (438,500) 2,340,000 36. (continued) Calculation of Translation Adjustment Cumulative translation adjustment, 12/31/09 (negative) Net assets, 1/1/09 Net income, 2009 Dividends, 12/15/09 Net assets, 12/31/09 Net assets, 12/31/09 at current exchange rate 202,500 20,500,000 6,500,000 (1,500,000) 25,500,000 0.040 0.035 0.031 820,000 227,500 (46,500) 1,001,000 25,500,000 0.030 765,000 Translation adjustment, 2009 (negative) 236,000 Cumulative translation adjustment, 12/31/09 (negative) 438,500 36. (continued) Part I (b). U.S. dollar is the functional currency—temporal method Exchange US$ 875,000 (493,500) (118,000) (85,200) (42,000) (35,000) 101,300 408,000 509,300 given 353,000 0.031 (46,500) 815,800 KCS Sales 25,000,000 (12,000,000) Cost of goods sold (2,500,000) Depreciation expense—equipment (1,800,000) Depreciation expense—building Research and development expense (1,200,000) (1,000,000) Other expenses Income before remeasurement gain 6,500,000 Remeasurement gain, 2009 6,500,000 Net income 500,000 Retained earnings, 1/1/09 (1,500,000) Dividends paid, 12/15/09 Retained earnings, 12/31/09 5,500,000 Rate 0.035 Sched.A Sched.B Sched.C 0.035 0.035 Cash Accounts receivable Inventory Equipment Accum. deprec.—equipment Building Accum. deprec.—equipment Land Total assets 0.030 60,000 0.030 99,000 0.032 272,000 Sched.B 1,180,000 Sched.B (418,000) Sched.C 3,408,000 Sched.C (1,510,200) 0.050 300,000 3,390,800 Accounts payable Long-term debt Common stock Additional paid-in capital Retained earnings, 12/31/09 Total liabilities and equities 2,000,000 3,300,000 8,500,000 25,000,000 (8,500,000) 72,000,000 (30,300,000) 6,000,000 78,000,000 2,500,000 50,000,000 5,000,000 15,000,000 5,500,000 78,000,000 0.030 0.030 0.050 0.050 above KCS 6,000,000 14,500,000 (8,500,000) 12,000,000 ER 0.043 0.035 0.032 75,000 1,500,000 250,000 750,000 815,800 3,390,800 Schedule A—Cost of goods sold Beginning inventory Purchases Ending inventory Cost of goods sold US$ 258,000 507,500 (272,000) 493,500 36. (continued) Schedule B—Equipment Old Equipment—at 1/1/09 New Equipment—acquired 1/3/09 Total KCS 20,000,000 5,000,000 25,000,000 ER 0.050 0.036 US$ 1,000,000 180,000 1,180,000 Accum. Depr.—Old Equipment Accum. Depr.—New Equipment Total Deprec expense—Old Equipment Deprec expense—New Equipment Total 8,000,000 500,000 8,500,000 2,000,000 500,000 2,500,000 0.050 0.036 400,000 18,000 418,000 100,000 18,000 118,000 Schedule C—Building Old Building —at 1/1/09 New Building—acquired 3/5/09 Total Accum. Depr.—Old Building Accum. Depr.—New Building Total Deprec. expense—Old Building Deprec. expense—New Building Total KCS 60,000,000 12,000,000 72,000,000 30,000,000 300,000 30,300,000 1,500,000 300,000 1,800,000 0.050 0.036 ER 0.050 0.034 0.050 0.034 0.050 0.034 US$ 3,000,000 408,000 3,408,000 1,500,000 10,200 1,510,200 75,000 10,200 85,200 Calculation of Remeasurement Gain Net monetary liabilities, 1/1/09 Increase in monetary assets: Sales Decrease in monetary assets: Purchase of inventory Research and development Other expenses Dividends paid, 12/15/09 Purchase of equipment, 1/3/09 Purchase of buildings, 3/5/09 Net monetary liab, 12/31/09 Net monetary liab, 12/31/09 at current exchange rate Remeasurement gain—2009 KCS (37,000,000) ER US$ 0.040 (1,480,000) 25,000,000 0.035 875,000 (14,500,000) (1,200,000) (1,000,000) (1,500,000) (5,000,000) (12,000,000) (47,200,000) 0.035 0.035 0.035 0.031 0.036 0.034 (47,200,000) 0.030 (1,416,000) (408,000) (507,500) (42,000) (35,000) (46,500) (180,000) (408,000) (1,824,000) 36. (continued) Part I (c). U.S. dollar is the functional currency—temporal method (no longterm debt) Exchange KCS Rate US$ Sales 25,000,000 0.035 875,000 (12,000,000) Sched.A (493,500) Cost of goods sold (2,500,000) Sched.B (118,000) Depreciation expense—equipment (1,800,000) Sched.C (85,200) Depreciation expense—building (1,200,000) 0.035 (42,000) Research and development expense (1,000,000) 0.035 (35,000) Other expenses 6,500,000 101,300 Income before remeasurement loss (92,000) Remeasurement loss, 2009 6,500,000 9,300 Net income 500,000 given (147,000) Retained earnings, 1/1/09 (1,500,000) 0.031 (46,500) Dividends paid, 12/15/09 5,500,000 (184,200) Retained earnings, 12/31/09 Cash Accounts receivable Inventory Equipment Accum. deprec.—equipment Building Accum. deprec.—equipment Land Total assets Accounts payable Long-term debt Common stock Additional paid in capital Retained earnings, 12/31/09 Total liabilities and equities 3,390,800 2,000,000 3,300,000 8,500,000 25,000,000 (8,500,000) 72,000,000 (30,300,000) 6,000,000 78,000,000 0.030 60,000 0.030 99,000 0.032 272,000 Sched.B 1,180,000 Sched.B (418,000) Sched.C 3,408,000 Sched.C(1,510,200) 0.050 300,000 3,390,800 2,500,000 0.030 75,000 0 0.030 0 20,000,000 0.050 1,000,000 50,000,000 0.050 2,500,000 5,500,000 above (184,200) 78,000,000 Schedule A—Cost of goods sold - same as in Part I (b) Schedule B—Equipment - same as in Part I (b) Schedule C—Building - same as in Part I (b) 36. (continued) Calculation of Remeasurement Loss Net monetary assets, 1/1/09 Increase in monetary assets: Sales Decrease in monetary assets: Purchase of inventory Research and development Other expenses Dividends paid, 12/15/09 Purchase of equipment, 1/3/09 Purchase of buildings, 3/5/09 Net monetary assets, 12/31/09 Net monetary assets, 12/31/09 at current exchange rate Remeasurement loss—2009 KCS ER 13,000,000 0.040520,000 US$ 25,000,000 0.035 875,000 (14,500,000) (1,200,000) (1,000,000) (1,500,000) (5,000,000) (12,000,000) 2,800,000 0.035 0.035 0.035 0.031 0.036 0.034 (507,500) (42,000) (35,000) (46,500) (180,000) (408,000) 176,000 2,800,000 0.030 84,000 92,000 Part II. Explanation of the negative translation adjustment in Part I (a), remeasurement gain in Part I (b), and remeasurement loss in Part I (c). The negative translation adjustment in Part I (a) arises because of two factors: (1) there is a net asset balance sheet exposure and (2) the Czech koruna has depreciated against the U.S. dollar during 2009 (from $.040 at 1/1/09 to $.030 at 12/31/09). A net asset balance sheet exposure exists because all assets are translated at the current exchange rate and exceed total liabilities which are also translated at the current exchange rate. The remeasurement gain in Part I (b) arises because of two factors: (1) there is a net monetary liability balance sheet exposure and (2) the Czech koruna has depreciated against the U.S. dollar. Under the temporal method, Cash and Accounts Receivable are the only assets translated at the current exchange rate (total KCS 5,300,000). Accounts Payable and Long-term Debt are also translated at the current exchange rate (total KCS 52,500,000). Because the Czech koruna amount of liabilities translated at the current rate exceeds the Czech koruna amount of assets translated at the current rate, a net monetary liability balance sheet exposure exists. The remeasurement loss in Part I (c) arises because of two factors: (1) there is a net monetary asset balance sheet exposure and (2) the Czech koruna has depreciated against the U.S. dollar during 2009. Cash and Accounts Receivable are the only assets translated at the current exchange rate (total KCS 5,300,000). Because there is no Long-term Debt in part 1(c), Accounts Payable is the only liability translated at the current exchange rate (total KCS 2,500,000). Because the Czech koruna amount of assets translated at the current rate exceeds the Czech koruna amount of liabilities translated at the current rate, a net monetary asset balance sheet exposure exists. TRANSLATION OF FOREIGN CURRENCY FINANCIAL STATEMENTS Chapter Outline I. In today's global economy, many companies have invested in operations in foreign countries. A. In preparing consolidated financial statements on a worldwide basis, the foreign currency accounts prepared by foreign operations must be restated into the parent company's reporting currency. B. There are two major issues related to the translation of foreign currency financial statements. 1. Which method should be used? 2. How should the resulting translation adjustment be reported on the consolidated financial statements? C. Translation methods differ on the basis of which accounts are translated at the current exchange rate and which are translated at a historical exchange rate. Translating accounts at the current exchange rate creates a translation adjustment. D. Historically, accountants have experimented with a number of different translation methods. The dominant methods currently in use are the temporal method and the current rate method. E. Translation adjustments can be either (1) reported as a gain or loss in income or (2) deferred in the stockholders' equity section of the balance sheet. II. The primary objective of the temporal method is to maintain the underlying valuation method used by the foreign entity to account for its assets and liabilities. A. Assets and liabilities carried at current or future value are translated at the current exchange rate. Assets and liabilities carried at cost and stockholders' equity items are translated at a historical exchange rate. B. By translating some assets at the current exchange rate and others at historical rates the temporal method distorts financial ratios calculated in the foreign currency. C. Most income statement items are translated at average-for-the-period rates. However, costof-goods-sold, depreciation, and amortization expense are translated at relevant historical exchange rates. D. Balance sheet exposure under the temporal method is defined as cash, marketable securities, and receivables minus total liabilities. A net liability exposure often exists. 1. When a liability balance sheet exposure exists, depreciation of the foreign currency results in a positive translation adjustment (gain) and appreciation of the foreign currency results in a negative translation adjustment (loss). 2. Reporting a translation loss when the foreign currency appreciates is thought to be inconsistent with economic reality. III. With the current rate method, the net investment in a foreign operation is considered to be exposed to foreign exchange risk. A. Assets and liabilities are translated at the current exchange rate; equity is translated at historical rates. B. Translating assets which are carried at cost using the current exchange rate results in a translated value which is not readily interpretable; it is neither a current value nor a historical cost. C. However, translating all assets at the current rate does maintain underlying ratios and relationships that exist in the foreign currency statements. D. Revenues and expenses which occur evenly throughout the period are translated at the average-for-the-period exchange rate. Income items, such as gains and losses, which are the result of a discrete event, are translated at the actual exchange rate on the date of occurrence. E. Balance sheet exposure under the current rate method is equal to the foreign entity's net assets (stockholders' equity). 1. Appreciation in the foreign currency results in a positive translation adjustment (gain); depreciation results in a negative translation adjustment (loss). IV. FASB Statement No. 52 provides guidelines for the translation of foreign currency financial statements by U.S.-based multinational corporations. The appropriate translation method and disposition of translation adjustment depends upon the functional currency of the foreign entity. A. The functional currency is the primary currency of the foreign entity's operating environment. It can be either the U.S. dollar or a foreign currency. 1. SFAS 52 lists six indicators that are to be used in determining an entity's functional currency. There are no guidelines as to how these indicators are to be weighted. B. If a foreign currency is the functional currency, the foreign entity's financial statements are "translated" using the current rate method and the resulting translation adjustment is reported as a separate component of equity. The average-for-the-period exchange rate is used to translate the foreign entity's income statement. 1. Upon the sale or liquidation of a specific foreign entity, the cumulative translation adjustment related to that entity is taken to income as an adjustment to the gain or loss on sale or liquidation. C. If the U.S. dollar is the functional currency, foreign currency financial statements are "remeasured" using the temporal method with "remeasurement" gains and losses reported in operating income. D. If a foreign entity operates in a highly inflationary economy (cumulative three-year inflation greater than 100%), its financial statements are remeasured into U.S. dollars using the temporal method and remeasurement gains and losses are reported in income. V. Some companies hedge the balance sheet exposures of their foreign entities so as to avoid adverse effects on income and/or stockholders' equity. A. SFAS 133 refers to this as a hedge of a net investment in a foreign operation and stipulates that gains and losses on hedging instruments used in this manner should be treated in the same fashion as the translation adjustment (remeasurement gain/loss) being hedged. B. The paradox of hedging balance sheet exposure is that by avoiding a translation adjustment (remeasurement gain/loss), realized foreign exchange gains and losses can arise. Learning Objectives Having completed Chapter 10 of this textbook, "Translation of Foreign Currency Financial Statements," students should be able to fulfill each of the following learning objectives: 1. Describe the procedures of the current rate and temporal methods of translation. 2. Understand the method by which the retained earnings balance of a foreign subsidiary is translated. 3. Discuss the theoretical underpinnings and limitations of the current rate and temporal methods. 4. Understand balance sheet exposure and explain how it differs from transaction exposure to foreign exchange risk. 5. Discuss SFAS 52 guidelines as to when foreign currency financial statements are to be "translated" using the current rate method and when they are to be "remeasured" using the temporal method. 6. Translate a foreign subsidiary's financial statements into its parent's reporting currency using the guidelines of SFAS 52. 7. Determine the amount and placement of the translation adjustment that is reported as a result of the translation process. 8. Remeasure a foreign subsidiary's financial statements using the guidelines of SFAS 52 and calculate the associated remeasurement gain or loss. 9. Explain the reason for using the temporal method to translate financial statements of operations in highly inflationary environments. 10. Understand the rationale for hedging a net investment in a foreign operation and describe the treatment of gains and losses on forward contracts used for this purpose. 11. Prepare a consolidation worksheet for a parent and its foreign subsidiary. Answer to Discussion Question How Do We Report This? This case represents the ongoing debate as to the proper reporting of foreign currency balances. Southwestern has invested the equivalent of $30,000 (150,000 vilseks) in each of three assets. The relative value of the vilsek has now changed. Thus, 150,000 vilseks now can be converted into $34,500. However, the subsidiary does not have vilseks --only land, inventory, and investments. Although the current exchange rate is given, the company has no apparent plans to convert its assets into dollars. Instead, these three assets are being held, each with a historical cost of 150,000 vilseks. Under the temporal method, these assets (except for the investments if carried at market value) would be reported in the parent's balance sheet at the original cost of $30,000. Unfortunately, as the Finance Director points out, an old, outdated rate is being utilized if the $30,000 figure is reported. (Of course, given that prices tend to change over time, the same can be said for any asset reported at historical cost.) Conversely, the current rate method requires that each of the three assets be reported at $34,500 based on the current exchange rate. As the controller indicates, though, $34,500 was not the original cost expended by Southwestern. In addition, using the current rate means that each of the assets will constantly report a "floating" value, one that will change with each exchange rate fluctuation. Finally, the $34,500 figure is based on the current value of the vilsek ($.23) and the historical cost in vilseks (150,000 vilseks) for the three assets. The current exchange rate is only significant if the assets are sold with the proceeds being converted into U.S. dollars. Since an imminent sale is not indicated, the validity of reporting the $34,500 might again be questioned. In addition, even if the assets were sold, $34,500 does not accurately reflect the proceeds in U.S. dollars because 150,000 vilseks is the historical cost and not the current market value of each of these assets. As a classroom exercise or written assignment, students could be required to select a reported value for each of the three assets and then defend their position. What figure is actually the fairest representation of each of the three assets? What figure is the best conveyor of information to an outside party? There is no single best answer to these questions. The purpose of this type of exercise is to force students to consider the objectives of financial reporting. Students should not just assume that the current official pronouncement is correct. One possible approach to the case is to assign several students to represent banks or stockholders and discuss the types of information that is most needed by these users. Another group of students can take the position of the company responsible for preparing the information and discuss management's preference for providing one type of information over another. Yet another group could take a purely theoretical approach and discuss the goals that accounting has attempted to reach. Although a final resolution may not be achieved, some excellent class discussion is possible. The temporal and current rate methods of translation differ primarily with regard to the exchange rate used to translate those assets that are reported at historical cost --inventories, prepaids, fixed assets, and intangibles. The debate regarding the appropriate exchange rate for translating assets exists only because some assets are reported at historical cost. If all assets were reported at their current value, there would be no need to use the historical exchange rate for translating assets in order to maintain the asset's historical cost in U.S. dollar terms. All assets would be translated at the current exchange rate. The differences between the temporal method and current rate method would disappear. Answers to Questions 1. The two major issues related to the translation of foreign currency financial statements are: (a) which method should be used and (b) where should the resulting translation adjustment be reported in the consolidated financial statements. The first issue relates to determining the appropriate exchange rate (historical, current, or average for the current period) for the translation of foreign currency balances. Those items translated at the current exchange rate are exposed to translation adjustment. The second issue relates to whether the translation adjustment should be treated as a gain or loss in income, or should be deferred as a separate component of stockholders’ equity. 2. Balance sheet exposure arises when a foreign currency balance is translated at the current exchange rate. By translating at the current exchange rate, the foreign currency item in essence is being revalued in U.S. dollar terms on the consolidated financial statements. There will be either a net asset balance sheet exposure or net liability balance sheet exposure depending upon whether assets translated at the current rate are greater or less than liabilities translated at the current rate. Balance sheet exposure generates a translation adjustment which does not result in an inflow or outflow of cash. Transaction exposure, which results from the receipt or payment of foreign currency, generates foreign exchange gains and losses which are realized in cash. 3. Although balance sheet exposure does not result in cash inflows and outflows, it does nevertheless affect amounts reported in consolidated financial statements. If the foreign currency is the functional currency, translation adjustments will be reported in stockholders’ equity. If translation adjustments are negative and therefore reduce total stockholders’ equity, there is an adverse (inflationary) impact on the debt to equity ratio. Companies with restrictive debt covenants requiring them to stay below a maximum debt to equity ratio, may find it necessary to hedge their balance sheet exposure so as to avoid negative translation adjustments being reported. If the U.S. dollar is the functional currency or an operation is located in a high inflation country, remeasurement gains and losses are reported in income. Companies might want to hedge their balance sheet exposure in this situation to avoid the adverse impact remeasurement losses can have on consolidated income and earnings per share. The paradox in hedging balance sheet exposure is that, by agreeing to receive or deliver foreign currency in the future under a forward contract, a transaction exposure is created. This transaction exposure is speculative in nature, given that there is no underlying inflow or outflow of foreign currency that can be used to satisfy the forward contract. By hedging balance sheet exposure, a company might incur a realized foreign exchange loss to avoid an unrealized negative translation adjustment or unrealized remeasurement loss. 4. The gains and losses arising from financial instruments used to hedge balance sheet exposure are treated in a similar manner as the item the hedge is intended to cover. If the foreign currency is the functional currency, gains and losses on hedging instruments will be taken to other comprehensive income. If the U.S. dollar is the functional currency, gains and losses on the hedging instruments will be offset against the related remeasurement gains and losses. 5. The major concept underlying the temporal method is that the translation process should result in a set of translated U.S. dollar financial statements as if the foreign subsidiary’s transactions had actually been carried out using U.S. dollars. To achieve this objective, assets carried at historical cost and stockholders’ equity are translated at historical exchange rates; assets carried at current value and liabilities (carried at current value) are translated at the current exchange rate. Under this concept, the foreign subsidiary’s monetary assets and liabilities are considered to be foreign currency cash, receivables, and payables of the parent which are exposed to transaction risk. For example, if the foreign currency appreciates, then the foreign currency receivables increase in U.S. dollar value and a gain is recognized. Balance sheet exposure under the temporal method is analogous to the net transaction exposure which exists from having both receivables and payables in a particular foreign currency. The major concept underlying the current rate method is that the entire foreign investment is exposed to foreign exchange risk. Therefore all assets and liabilities are translated at the current exchange rate. Balance sheet exposure under this concept is equal to the net investment. 6. The Retained Earnings balance is created by a multitude of transactions: all revenues, expenses, gains, losses, and dividends since the company’s inception. Identifying each component of this account (so that a separate translation can be made) would be virtually impossible. Therefore, in the initial year that Statement 52 was applied, the ending balance calculated under Statement 8 was merely brought forward. Thereafter, the ending balance translated each year for retained earnings becomes the beginning figure to be reported for the following year. 7. The major differences relate to non-monetary assets carried at historical cost and related expenses, i.e., inventory and cost of goods sold; property, plant, and equipment and depreciation expense; and intangible assets and amortization expense. Under the temporal method, these items are all translated at historical exchange rates. Under the current rate method, the assets are translated at the current exchange rate and the related expenses are translated at the average exchange rate for the current period. 8. The functional currency is the currency of the subsidiary’s primary economic environment. It is usually identified as the currency in which the company generates and expends cash. SFAS 52 recommends that several factors such as the location of primary sales markets, sources of materials and labor, the source of financing, and the amount of intercompany transactions should be evaluated in identifying an entity’s functional currency. SFAS 52 does not provide any guidance as to how these factors are to be weighted (equally or otherwise) when identifying an entity’s functional currency. 9. The foreign subsidiary's net asset position in foreign currency at the beginning of the period is first determined. Changes in net assets are determined to explain the net asset balance in foreign currency at the end of the period. The beginning net asset position and changes in net assets are translated at appropriate exchange rates and the ending net asset position in dollars is determined. The ending net asset balance in foreign currency is then translated at the current rate and this result is subtracted from the ending net asset position in dollars (already calculated). The difference is the translation adjustment. It is positive if the actual dollar net asset position is less than the net asset position based on the current exchange rate. The translation adjustment is negative if the actual dollar net asset position is greater than if translated at the current rate. 10. One theory mentioned by the FASB identifies the translation adjustment as a measure of unrealized increases and decreases that have occurred in the value of the foreign subsidiary because of exchange rate changes. A second theory argues that this adjustment is no more than a mechanically derived number that must be included to keep the balance sheet in equilibrium although the figure has no intrinsic meaning. The FASB did not indicate in Statement 52 that either theory is considered more appropriate. 11. Remeasurement is required in two situations: a. The U.S. dollar is the functional currency. b. The foreign subsidiary operates in a highly inflationary country. Translation is required when a foreign currency is the functional currency. Remeasurement is carried out using the temporal method, with remeasurement gains and losses reported in consolidated income. Translation is done using the current rate method and the resulting translation adjustment is carried as a separate component of stockholders’ equity. 12. The temporal method must be used to remeasure the financial statements of operations in highly inflationary countries. One reason for mandating the use of the temporal method is that it avoids the disappearing plant problem that exists when the current rate method is used. Under the current rate method, fixed assets are translated at current exchange rates. With high rates of inflation, the foreign currency will depreciate significantly. When the historical cost of fixed assets is translated at a significantly lower current exchange rate, the dollar value of fixed assets “disappears.” This problem is avoided by translating at the historical exchange rate as is done under the temporal method.