Solution Manual Advanced Accounting Part 2

Answers to Develop Your Skills Cases Research Case 1—Foreign Currency Translation and Hedging Activities The responses to this assignment will depend upon the company selected by the student for analysis. It is unlikely that the company selected will disclose the amount of any remeasurement gains and losses. The amount of translation adjustment reported in other comprehensive income usually can be found in a statement of stockholders’ equity. A positive translation adjustment indicates that the foreign currency in which the company operates, on average, increased in dollar value during the year. A negative translation adjustment indicates the opposite. Research Case 2—Foreign Currency Translation Disclosures in the Computer Industry a. In 2005, IBM provided information in the annual report related to foreign currency translation and hedging activities in the following locations: i. Management Discussion. ii. Note A. Significant Accounting Policies, under Translation of Non-U.S Currency Amounts. iii. Note L. Derivatives and Hedging Transactions. In its Form 10-K for the year ended January 28, 2006, Dell provided information related to foreign currency translation and hedging activities in the following locations: i. Item 1A. Risk Factors. ii. Item 7. Management Discussion and Analysis of Financial Condition and Results of Operations, under Market Risk. iii. Note 1. Description of Business and Summary of Significant Accounting Policies. iv. Note 2. Financial Instruments. b. IBM’s foreign operations do not have a predominant functional currency. The company indicates that it operates in multiple functional currencies. The majority of Dell’s foreign operations have the U.S. dollar as their functional currency. Most of IBM’s foreign operations probably have the foreign currency as functional currency and therefore are translated into dollars using the current rate method with translation adjustments reflected in stockholders’ equity. Dell’s foreign operations, on the other hand, are remeasured into dollars using the temporal method with remeasurement gains and losses reflected in net income. These differences in translation method and disposition of the translation adjustment reduces the comparability of information provided by the two companies. c. From the Statement of Stockholders’ Equity, it can be seen that IBM reported translation adjustments as follows over the period 2003-2005: 2003 positive $1,768 million 2004 positive $1,055 million 2005 negative $1,153 million The positive signs of the translation adjustments in 2003 and 2004 indicate that, on average, the foreign currency functional currencies of IBM’s foreign operations increased in value against the U.S. dollar in those years. The negative sign of the translation adjustment in 2005 indicates that, on average, the foreign currency functional currencies of IBM’s foreign operations decreased in value against the U.S. dollar in that year. Dell reported translation adjustments in other comprehensive income as follows: Fiscal 2003 negative $35 million Fiscal 2004 positive $1 million Fiscal 2005 negative $8 million On average, the foreign currency functional currencies of Dell’s foreign operations decreased in value against the U.S. dollar in 2003 and 2005, and increased in value in 2004. The magnitude of the translation adjustments reported in stockholders’ equity is much larger for IBM than for Dell. This undoubtedly occurs because Dell has a much smaller balance sheet exposure related to foreign currency functional currency operations. For Dell, the magnitude of the remeasurement gain/loss reported in net income is probably larger (unless hedged away) than the translation adjustment in stockholders’ equity. Dell indicates that remeasurement gains/losses are reported in Investment and Other Income, Net on the income statement but does not disclose the amount. d. In Note L. Derivatives and Hedging Transactions, IBM indicates that a significant portion of the company’s foreign currency denominated debt is designated as a hedge of its foreign currency balance sheet exposures. The company also uses currency swaps and forward contracts to hedge its net investments in foreign operations. Although Dell hedges foreign currency transactions, firm commitments, and forecasted transactions, the company makes no mention of hedging its balance sheet exposures. e. The response to this requirement will vary from student to student. Much of the information provided in requirements a. – d. above can be included in a formal report to satisfy this requirement. FARS Case 1—More than One Functional Currency a. Using the advanced query function in the FARS database to search for the phrase ―different functional currencies‖ returns two hits: FAS 52, paragraphs 7 and 43. Paragraph 43 is part of Appendix A: Determination of the Functional Currency. b. FAS 52, paragraph 7 indicates that if an entity has more than one distinct and separable operation, each operation may be considered a separate entity. If those operations are conducted in different economic environments, they might have different functional currencies. FARS Case 2—Change in Functional Currency a. Using the advanced query function in the FARS database to search for the phrase ―functional currency has changed‖ returns two hits: FAS 52, paragraphs 9 and 45. Paragraph 45 is part of Appendix A: Determination of the Functional Currency. A search for the phrase ―change in the functional currency‖ returns one hit: FAS 52, paragraph 9. b. FAS 52, paragraph 9 indicates that once the functional currency for a foreign entity is determined, that determination shall be used consistently. A change in functional currency is appropriate if significant changes in economic facts and circumstances indicate clearly that the functional currency has changed. There is no restatement of previously issued financial statements for changes in the functional currency. Analysis Case—BellSouth Corporation a. The Brazilian operations are equity method investments, which means that BellSouth must report investment income (loss) for its percentage ownership interest in the U.S. dollar translated income (loss) of the operations. The company states that its Brazilian operations had net U.S. dollar denominated liabilities. The U.S. dollar liabilities were revalued upward by the Brazilian operations with offsetting foreign exchange losses reported in Brazilian real (BRL) income. The foreign exchange loss on U.S. dollar liabilities might have been large enough to cause negative net income (a net loss) in BRL terms, which when translated at the average exchange rate for the quarter (under the current rate method) resulted in a U.S. dollar loss being reported by BellSouth. Alternatively, the temporal method of translation was used, the Brazilian operations had net BRL asset exposures, and the devaluation caused a large enough remeasurement loss that a net U.S. dollar loss resulted. Given that liabilities were denominated in U.S. dollars, it is likely that BRL assets exceed BRL liabilities generating a net BRL asset exposure. b. The company appears to be saying that the exchange loss is not yet realized. If, subsequent to the January 1999 devaluation, the Brazilian real appreciates against the U.S. dollar, the unrealized loss will become smaller. On the other hand, the loss will become even larger if the real continues to depreciate. c. The objective of reporting normalized net income is to remove from net income the effect of one-time only events that do not qualify under U.S. GAAP as extraordinary items or discontinued operations, and therefore are not reported separately in the income statement. The company appears to be signaling its belief that the foreign currency loss is a nonrecurring (extraordinary) item. d. This assessment is valid if one compares normalized diluted EPS in the first quarter of 1999, which excluded a large loss, with normalized diluted EPS in the first quarter of 1998, which excluded a large gain. Whether financial analysts would use normalized EPS rather than reported EPS in making decisions about BellSouth is an empirical question. Excel Case—Translating Foreign Currency Financial Statements a.b. Spreadsheet for the translation (current rate method) and remeasurement (temporal method) of the FC financial statements of Charles Edward Company’s foreign subsidiary. Temporal Method December 31, 2009 FC Rate Sales Cost of goods sold Gross profit Selling expense Depreciation expense Remeasurement gain/loss Income before tax Income taxes Net income Retained earnings, 1/1 /09 Retained earn, 12/31 /09 5,000 (3,000) 2,000 (400) (600) 0 1,000 (300) 700 0 700 $0.45 calculation subtotal $0.45 $0.50 to balance subtotal $0.45 subtotal Cash Inventory Fixed assets Less: accum/deprec Total assets 1,000 2,000 6,000 (600) 8,400 $0.38 $0.43 $0.50 $0.50 total Current liabilities Long-term debt Contributed capital Cum. trans. adjust. Retained earnings Total liab and stock equity 1,500 3,000 3,200 0 700 8,400 Exchange Rates January 1-31, 2009 Average 2009 December 31, 2009 Inventory purchases Key: Average Exchange Rate Current Exchange Rate Historical Exchange Rate $0.50 $0.45 $0.38 $0.43 A C H USD A A H A from B/S C H H H $0.38 C $0.38 C $0.50 H n/a to balance A=L+SE Current Rate Method Rate $2,250 (1,360) 890 (180) (300) 355 765 (135) 630 0 630 $0.45 $0.45 subtotal $0.45 $0.45 n/a subtotal $0.45 subtotal 380 860 3,000 (300) 3,940 $0.38 $0.38 $0.38 $0.38 total 570 1,140 1,600 0 630 3,940 USD A $2,250 A (1,350) 900 A (180) A (270) 0 450 A (135) 315 0 total 315 C C C C $0.38 C $0.38 C $0.50 H to balance from I/S A=L+SE 380 760 2,280 (228) 3,192 570 1,140 1,600 (433)* 315 3,192 Temporal method—COGS (on a FIFO basis) BI 1,000 $0.50 H $500 P 4,000 $0.43 H 1,720 EI (2,000) $0.43 H (860) COGS 3,000 $1,360 *Computation of Translation Adjustment FC Net assets, 1/1/09 3,200 Net income, 2009 700 Net assets, 12/31/09 3,900 Net assets, 12/31/09 at current exchange rate 3,900 Translation adjustment (negative) $0.50 $0.45 $0.38 USD 1,600 315 1,915 1,482 433 c. With the FC as functional currency, the U.S. dollar net income reflected in the consolidated income statement is $315. If the U.S. dollar were the functional currency, the amount would be twice as much —$630. The amount of total assets reported on the consolidated balance sheet is 23.4% smaller than if the U.S. dollar were functional currency [($3,940 – $3,192)/$3,192]. The relations between the current ratio, the debt to equity ratio, and profit margin calculated from the FC financial statements and from the translated U.S. dollar financial statements are shown below. FC Current ratio CA CL Debt to equity ratio Total liabilities Total stockholders’ equity Profit margin NI Sales Return on equity NI Average TSE Inventory turno ver COGS Average Inventory Temporal Current Rate 3,000 1,500 2.0 1,240 570 2.1754 1,140 570 2.0 4,500 3,900 1,710 2,230 1,710 1,482 1.15385 0.76682 1.15385 700 5,000 0.14 630 2,250 0.28 315 2,250 0.14 700 3,550 0.19718 630 1,915 0.32898 315 1,541 0.20441 3,000 1,000 3 1,360 430 3.16279 1,350 380 3.55263 These results show that the temporal method distorts all ratios as calculated from the original foreign currency financial statements. The current rate method maintains all ratios that use numbers in the numerator and denominator from the balance sheet only (current ratio, debt-to-equity ratio) or the income statement only (profit margin). For ratios that combine numbers from the income statement and balance sheet (return on equity, inventory turnover), even the current rate method creates distortions. The U.S. dollar amounts reported under the temporal method for inventory and fixed assets reflect the equivalent U.S. dollar cost of those assets as if the parent had sent dollars to the subsidiary to purchase the assets. For example, to purchase FC 6,000 worth of fixed assets when the exchange rate was $.50/FC, the parent would have had to provide the subsidiary with $3,000. The U.S. dollar amounts reported under the current rate method for inventory and fixed assets reflect neither the equivalent U.S. dollar cost of those assets nor their U.S. dollar current value. By multiplying the FC historical cost by the current exchange rate, these assets are reported at what they would have cost in U.S. dollars if the current exchange rate had been in effect when they were purchased. This is a hypothetical number with little, if any, meaning. Excel and Analysis Case—Parker Inc. and Suffolk PLC This assignment requires translation of foreign currency financial statements under three different sets of assumptions regarding changes in the U.S. dollar value of the British pound. Under the first set of assumptions, the British pound appreciates steadily from $1.60 at 1/1 /08 to $1.68 at 12/31/09. Under the second set of assumptions, the exchange rate remains $1.60 from 1/1 /08 to 12/31/09. Under the third set of assumptions, the British pound depreciates steadily from $1.60 at 1/1/08 to $1.52 at 12/31/09. Part I—Appreciating Foreign Currency Relevant exchange rates: January 1, 2008 2008 Average December 31, 2008 $1.64 January 30, 2009 2009 Average December 31, 2009 $1.68 $1.60 $1.62 $1.65 $1.66 a. Translation of Suffolk’s December 31, 2009 trial balance from British pounds to U.S. dollars. Suffolk PLC Trial Balance December 31, 2009 Cash £ Accounts receivable Inventory Property, plant, & equipment (net) Accounts payable Long-term debt Common stock Retained earnings, 1/1 /09 Sales Cost of goods sold Depreciation Other expenses Dividends paid (1/30/09) Cumulative translation adjustment—positive (credit balance) Pounds 1,500,000 5,200,000 18,000,000 36,000,000 (1,450,000) (5,000,000) (44,000,000) (8,000,000) (28,000,000) 16,000,000 2,000,000 6,000,000 1,750,000 Exchange Rate Dollars $1.68 $ 2,520,000 $1.68 8,736,000 $1.68 30,240,000 $1.68 60,480,000 $1.68 (2,436,000) $1.68 (8,400,000) $1.60 (70,400,000) Schedule A (12,840,000) $1.66 (46,480,000) $1.66 26,560,000 $1.66 3,320,000 $1.66 9,960,000 $1.65 2,887,500 £ 0 Note: Amounts in parentheses are credit balances. Schedule A Retained earnings, 1/1 /08 Net income, 2008 Retained earnings, 12/31/08 Pounds £(6,000,000) (2,000,000) £(8,000,000) $ Exchange Rate $1.60 $1.62 (4,147,500) 0 Dollars $ (9,600,000) (3,240,000) $(12,840,000) b. Schedule detailing the change in Suffolk’s cumulative translation adjustment for 2008 and 2009. Determination of Cumulative Exchange Exchange Translation Adjustment Pounds Rate Rate Dollars £50,000,000 $1.64 $1.60 $2,000,000 Net assets, 1/1/08 2,000,000 $1.64 $1.62 40,000 Net income, 2008 Translation adjustment, 2008 $2,040,000 (positive) £52,000,000 $1.68 $1.64 2,080,000 Net assets, 1/1/09 4,000,000 $1.68 $1.66 80,000 Net income, 2009 (1,750,000) $1.68 $1.65 (52,500) Dividends, 2009 Translation adjustment, 2009 2,107,500 (positive) Net assets, 12/31/09 £ 54,250,000 Cumulative Translation $4,147,500 Adjustment, 12/31/0 9(positive) Consideration Paid Allocation Schedule Consideration paid (equal to fair value) Book value Excess of fair value over book value Translation Adjustment Related to Excess of Fair Value Over Book Value Excess of fair value over book value U.S. dollar value at 12/31/09 U.S. dollar value at 1/1/08 Translation adjustment related to excess, 12/31/09—positive Pounds £52,000,000 50,000,000 £ 2,000,000 Pounds £2,000,000 Exchange Rate $1.60 $1.60 Exchange Rate $1.68 $1.60 Dollars $83,200,000 80,000,000 $ 3,200,000 Dollars $3,360,000 3,200,000 $ 160,000 c. Consolidation Worksheet—December 31, 2009 Parker Suffolk ($70,000,000) ($46,480,000) Cost of goods sold 34,000,000 26,560,000 60,560,000 Depreciation 20,000,000 3,320,000 23,320,000 Other expenses 6,000,000 9,960,000 Dividend income (2,887,500) Sales Adjustments & Eliminations ($12,887,500) ($6,640,000) Ret. earnings, 1/1/09 ($48,000,000) ($12,840,000) (12,887,500) (6,640,000) 4,500,000 2,887,500 Net income Dividends 15,960,000 2,887,500 Net income Consolidated ($116,480,000) 0 ($16,640,000) 12,840,000 3,240,000 ($51,240,000) (16,640,000) 2,887,500 4,500,000 ($56,387,500) ($16,592,500) ($63,380,000) Cash $3,687,500 $2,520,000 $6,207,500 Accounts receivable 10,000,000 8,736,000 18,736,000 Inventory 30,000,000 30,240,000 Investment in Suffolk 83,200,000 Prop, plant & eq (net) 105,000,000 Ret. earnings, 12/31/09 60,240,000 3,240,000 83,240,000 0 3,200,000 60,480,000 3,200,000 168,840,000 160,000 Accounts payable (25,500,000) (2,436,000) Long-term debt (50,000,000) (8,400,000) Common stock (100,000,000) (70,400,000) (56,387,500) (16,592,500) Ret. earnings, 12/31/09 (27,936,000) (58,400,000) 70,400,000 (63,380,000) (4,147,500) Cum. trans. adj. $0 $0 (100,000,000) 160,000 $92,727,500 $92,727,500 (4,307,500) $0 d. Consolidated income statement and balance sheet —2009. Parker, Inc. Consolidated Income Statement For the year ended December 31, 2009 Sales Cost of goods sold Depreciation Other expenses Net income $ 116,480,000 (60,560,000) (23,320,000) (15,960,000) $ 16,640,000 Parker, Inc. Consolidated Balance Sheet December 31, 2009 Assets Cash Accounts receivable Inventory Property, plant & equipment (net) Total $ 6,207,500 18,736,000 60,240,000 168,840,000 $254,023,500 Liabilities and Shareholders' Equity Accounts payable $ 27,936,000 58,400,000 Long-term debt 100,000,000 Common stock Retained earnings 63,380,000 Other comprehensive income 4,307,500 $254,023,500 Total Part II—Stable Foreign Currency Relevant exchange rates: January 1, 2008 2008 Average December 31, 2008 $1.60 January 30, 2009 2009 Average December 31, 2009 $1.60 $1.60 $1.60 $1.60 $1.60 1. Translation of Suffolk’s December 31, 2009 trial balance from British pounds to U.S. dollars. Suffolk PLC Trial Balance December 31, 2009 Cash £ Accounts receivable Inventory Property, plant, & equipment (net) Accounts payable Long-term debt Common stock Retained earnings, 1/1 /09 Sales Cost of goods sold Depreciation Other expenses Dividends paid, 1/30/09 Cumulative translation adjustment Pounds 1,500,000 5,200,000 18,000,000 36,000,000 (1,450,000) (5,000,000) (44,000,000) (8,000,000) (28,000,000) 16,000,000 2,000,000 6,000,000 1,750,000 Exchange Rate $1.60 $1.60 $1.60 $1.60 $1.60 $1.60 $1.60 Schedule A $1.60 $1.60 $1.60 $1.60 $1.60 £ 0 Note: Amounts in parentheses are credit balances. Schedule A Retained earnings, 1/1 /08 Net income, 2008 Retained earnings, 12/31/08 Pounds £(6,000,000) (2,000,000) £(8,000,000) Exchange Rate $1.60 $1.60 Dollars 2,400,000 8,320,000 28,800,000 57,600,000 (2,320,000) (8,000,000) (70,400,000) (12,800,000) (44,800,000) 25,600,000 3,200,000 9,600,000 2,800,000 0 $ 0 $ Dollars $ (9,600,000) (3,200,000) $(12,800,000) 2. Schedule detailing the change in Suffolk’s cumulative translation adjustment for 2008 and 2009. Determination of Cumulative Translation Adjustment Net assets, 1/1/08 Net income, 2008 Translation adjustment, 2008 Net assets, 1/1/09 Net income, 2009 Dividends, 2009 Translation adjustment, 2009 Net assets, 12/31/09 Cumulative Translation Adjustment, 12/31/09 Pounds £50,000,000 2,000,000 Exchange Exchange Rate Rate $1.60 $1.60 $1.60 $1.60 Dollars $0 0 $0 £52,000,000 4,000,000 (1,750,000) $1.60 $1.60 $1.60 $1.60 $1.60 $1.60 0 0 0 0 £ 54,250,000 Consideration Paid Allocation Schedule Consideration paid (equals fair value) Book value Excess of fair value over book value $0 Pounds £52,000,000 50,000,000 £ 2,000,000 Translation Adjustment Related to Excess of Fair Value Over Book Value Pounds Excess of fair value over book value £2,000,000 U.S. dollar value at 12/31/09 U.S. dollar value at 1/1/08 Translation adjustment related to excess, 12/31/09 Exchange Rate $1.60 $1.60 Exchange Rate $1.60 $1.60 Dollars $83,200,000 80,000,000 $ 3,200,000 Dollars $3,200,000 3,200,000 $0 3. Consolidation Worksheet—December 31, 2009 Parker Suffolk Adjustments & Eliminations Consolidated ($70,000,000) ($44,800,000) Cost of goods sold 34,000,000 25,600,000 59,600,000 Depreciation 20,000,000 3,200,000 23,200,000 Other expenses 6,000,000 9,600,000 Dividend income (2,800,000) Sales ($12,800,000) ($6,400,000) Ret. earnings, 1/1/09 ($48,000,000) ($12,800,000) (12,800,000) (6,400,000) 4,500,000 2,800,000 Dividends 15,600,000 2,800,000 Net income Net income ($114,800,000) 0 ($16,400,000) 12,800,000 3,200,000 ($51,200,000) (16,400,000) 2,800,000 4,500,000 ($56,300,000) ($16,400,000) ($63,100,000) Cash $3,600,000 $2,400,000 $6,000,000 Accounts receivable 10,000,000 8,320,000 18,320,000 Inventory 30,000,000 28,800,000 Investment in Suffolk 83,200,000 Prop, plant & eq (net) 105,000,000 Ret. earnings, 12/31/09 58,800,000 3,200,000 83,200,000 0 3,200,000 57,600,000 3,200,000 165,800,000 0 Accounts payable (25,500,000) (2,320,000) Long-term debt (50,000,000) (8,000,000) Common stock (100,000,000) (70,400,000) (56,300,000) (16,400,000) $0 $0 Ret. earnings, 12/31/08 (27,820,000) (58,000,000) 70,400,000 (63,100,000) 0 Cum. Trans. adj. (100,000,000) $92,400,000 0 0 $92,400,000 $0 d. Consolidated income statement and balance sheet —2009. Parker, Inc. Consolidated Income Statement For the year ended December 31, 2009 Sales Cost of goods sold Depreciation Other expenses Net income $114,800,000 (59,600,000) (23,200,000) (15,600,000) $ 16,400,000 Parker, Inc. Consolidated Balance Sheet December 31, 2009 Assets Cash Accounts receivable Inventory Property, plant & equipment (net) Total $ 6,000,000 18,320,000 58,800,000 165,800,000 $248,920,000 Liabilities and Shareholders' Equity Accounts payable $ 27,820,000 58,000,000 Long-term debt 100,000,000 Common stock Retained earnings 63,100,000 Other comprehensive income 0 $248,920,000 Total Part III—Depreciating Foreign Currency Relevant exchange rates: January 1, 2008 2008 Average December 31, 2008 $1.56 January 30, 2009 2009 Average December 31, 2009 $1.52 $1.60 $1.58 $1.55 $1.54 a. Translation of Suffolk’s December 31, 2009 trial balance from British pounds to U.S. dollars. Suffolk PLC Trial Balance December 31, 2009 Cash £ Accounts receivable Inventory Property, plant, & equipment (net) Accounts payable Long-term debt Common stock Retained earnings, 1/1 /09 Sales Cost of goods sold Depreciation Other expenses Dividends paid (1/30/09) Cumulative translation adjustment—negative (debit balance) Pounds 1,500,000 5,200,000 18,000,000 36,000,000 (1,450,000) (5,000,000) (44,000,000) (8,000,000) (28,000,000) 16,000,000 2,000,000 6,000,000 1,750,000 Exchange Rate $1.52 $1.52 $1.52 $1.52 $1.52 $1.52 $1.60 Schedule A $1.54 $1.54 $1.54 $1.54 $1.55 £ 0 Note: Amounts in parentheses are credit balances. Schedule A Retained earnings, 1/1 /08 Net income, 2008 Retained earnings, 12/31/08 Pounds £(6,000,000) (2,000,000) £(8,000,000) $ $ Exchange Rate $1.60 $1.58 Dollars 2,280,000 7,904,000 27,360,000 54,720,000 (2,204,000) (7,600,000) (70,400,000) (12,760,000) (43,120,000) 24,640,000 3,080,000 9,240,000 2,712,500 4,147,500 0 Dollars $ (9,600,000) (3,160,000) $(12,760,000) 2. Schedule detailing the change in Suffolk’s cumulative translation adjustment for 2008 and 2009. Determination of Cumulative Exchange Exchange Translation Adjustment Pounds Rate Rate Dollars £50,000,000 $1.56 $1.60 $(2,000,000) Net assets, 1/1/08 2,000,000 $1.56 $1.58 (40,000) Net income, 2008 Translation adjustment, 2008 $(2,040,000) (negative) £52,000,000 $1.52 $1.56 (2,080,000) Net assets, 1/1/09 4,000,000 $1.52 $1.54 (80,000) Net income, 2009 (1,750,000) $1.52 $1.55 52,500 Dividends, 2009 Translation adjustment, 2009 (2,107,500) (negative) Net assets, 12/31/09 £ 54,250,000 Cumulative Translation $(4,147,500) Adjustment, 12/31/0 9 (negative) Consideration Paid Allocation Schedule Consideration paid (equal to fair value) Book value Excess of fair value over book value Translation Adjustment Related to Excess of Fair Value Over Book Value Excess of cost over book value U.S. dollar value at 12/31/09 U.S. dollar value at 1/1/08 Translation adjustment related to excess, 12/31/09—negative Pounds £52,000,000 50,000,000 £ 2,000,000 Pounds £2,000,000 Exchange Rate $1.60 $1.60 Exchange Rate $1.52 $1.60 Dollars $83,200,000 80,000,000 $ 3,200,000 Dollars $3,040,000 3,200,000 $(160,000) c. Consolidation Worksheet—December 31, 2009 Parker Suffolk ($70,000,000) ($43,120,000) Cost of goods sold 34,000,000 24,640,000 58,640,000 Depreciation 20,000,000 3,080,000 23,080,000 Other expenses 6,000,000 9,240,000 Dividend income (2,712,500) Sales Adjustments & Eliminations ($12,712,500) ($6,160,000) Ret. earnings, 1/1/09 ($48,000,000) ($12,760,000) (12,712,500) (6,160,000) 4,500,000 2,712,500 Net income Dividends 15,240,000 2,712,500 Net income Consolidated ($113,120,000) 0 ($16,160,000) 12,760,000 3,160,000 ($51,160,000) (16,160,000) 2,712,500 4,500,000 ($56,212,500) ($16,207,500) ($62,820,000) Cash $3,512,500 $2,280,000 $5,792,500 Accounts receivable 10,000,000 7,904,000 17,904,000 Inventory 30,000,000 27,360,000 Investment in Suffolk 83,200,000 Prop, plant & eq (net) 105,000,000 Ret. earnings, 12/31/09 57,360,000 3,160,000 83,160,000 0 3,200,000 54,720,000 3,200,000 162,760,000 160,000 Accounts payable (25,500,000) (2,204,000) Long-term debt (50,000,000) (7,600,000) Common stock (100,000,000) (70,400,000) (56,212,500) (16,207,500) Ret. earnings, 12/31/09 Cum. Trans. adj. $0 (27,704,000) (57,600,000) 70,400,000 (100,000,000) (62,820,000) 4,147,500 160,000 $0 $92,392,500 4,307,500 $92,392,500 $0 d. Consolidated income statement and balance sheet —2009. Parker, Inc. Consolidated Income Statement For the year ended December 31, 2009 Sales Cost of goods sold Depreciation Other expenses Net income $ 113,120,000 (58,640,000) (23,080,000) (15,240,000) $ 16,160,000 Parker, Inc. Consolidated Balance Sheet December 31, 2009 Assets Cash Accounts receivable Inventory Property, plant & equipment (net) Total $ 5,792,500 17,904,000 57,360,000 162,760,000 $243,816,500 Liabilities and Shareholders' Equity Accounts payable $ 27,704,000 57,600,000 Long-term debt 100,000,000 Common stock Retained earnings 62,820,000 Other comprehensive income (4,307,500) $243,816,500 Total Part IV—Risk Assessment Report and Financial Management Recommendations Consolidated net income Percentage difference Cash flow from dividends Percentage difference Total Liabilities Total Stockholders’ equity Debt-to-equity ratio Percentage difference December 31, 2009 Exchange Rate $1.68 $1.60 $1.52 $16,640,000 $16,400,000 $16,160,000 101.5% 100% 98.5% + 1.5% -- 1.5% $2,887,500 103% + 3% $2,800,000 100% -- $2,712,500 97% - 3% $86,336,000 $167,687,500 51.5% 98% - 2% $85,820,000 $163,100,000 52.6% 100% -- $85,304,000 $158,512,500 53.8% 102% + 2% Appreciation of the British pound from $1.60 to $1.68 results in consolidated net income being 1.5% higher, cash flow from dividends being 3% higher, and the debt-to-equity ratio being 2% lower than if there had been no change in exchange rates. Depreciation of the British pound from $1.60 to $1.52 would have resulted in income being 1.5% lower, cash flow from dividends being 3% lower, and the debt-to-equity ratio being 2% higher than if there had been no change in exchange rates. An increase in the dollar value of the British pound results in higher profitability, greater cash inflow, and an improved debt-to-equity ratio. The opposite is true for a decrease in the dollar value of the British pound. If the British pound is expected to appreciate, Parker should not hedge its British pound exposure associated with its investment in Suffolk. However, if the British pound is expected to depreciate, Parker may wish to hedge its British pound net asset and cash flow exposure in some way. The decline in dollar value of future British pound dividend payments could be hedged by selling British pounds forward or by purchasing a British pound put option. The negative translation adjustment reported in other comprehensive income could be avoided using an option or forward contract, or by taking out a loan in British pounds.