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CHAPTER 8
TRANSLATION OF FOREIGN CURRENCY
FINANCIAL STATEMENTS
Chapter Outline
I.
II.
Under the current rate method, all assets and liabilities are translated at the current
exchange rate giving rise to a balance sheet exposure equal to the foreign subsidiarys
net assets. Stockholders equity accounts are translated at historical exchange rates.
Income statement items are translated at the average exchange rate for the current
period.
A. Appreciation of the foreign currency results in a positive translation adjustment;
depreciation of the foreign currency results in a negative translation adjustment.
B. Translating all assets and liabilities at the current exchange rate maintains the
relationships that exist in the foreign currency financial statements.
B. Translating assets carried at historical cost at the current exchange rate results in
amounts being reported on the parents consolidated balance sheet that have no
economic meaning.
III.
Under the temporal method, assets carried at current or future value (cash, marketable
securities, receivables) and liabilities are remeasured at the current exchange rate.
Assets carried at historical cost and stockholders equity accounts are remeasured at
historical exchange rates. Expenses related to assets remeasured at historical exchange
rates are remeasured using the same rates.
Other income statements items are
remeasured using the average exchange rate for the period.
A. When liabilities are greater than the sum of cash, marketable securities, and
receivables, a net liability balance sheet exposure exists. Appreciation of the foreign
currency results in a remeasurement loss; depreciation of the foreign currency results
in a remeasurement gain.
B. Remeasuring assets carried at historical cost at historical exchange rates maintains
the underlying valuation method used by the foreign operation in preparing its
financial statements.
C. Remeasuring some assets at historical exchange rates and other assets at the
current exchange rate distorts the relationships that exist among account balances in
the foreign currency financial statements.
8-1
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IV.
V.
The factors used to determine the functional currency of a foreign operation differ under
IFRS and U.S. GAAP.
A. IAS 21 indicates that two factors are of primary importance in determining a foreign
entitys functional currency. If the functional currency is not obvious after evaluating
these factors, then a secondary set of six factors should be considered.
B. The FASB provides six factors that should be considered in determining functional
currency under U.S. GAAP, but no guidance is provided with respect to how these
factors should be weighted in the analysis. As a result, it is possible that a foreign
subsidiary could be viewed as having one functional currency under IFRS and a
different functional currency under U.S. GAAP.
VI.
A substantive difference in translation rules between IFRS and U.S. GAAP relates to
foreign operations that report in the currency of a hyperinflationary economy.
A. IAS 21 requires a restate-translate method in translating the financial statements of
foreign operations located in a hyperinflationary economy. The foreign financial
statements are first restated for foreign inflation using rules in IAS 29, and then are
translated into parent company currency using the current rate method. IAS 29 does
not provide a bright-line threshold (as does U.S. GAAP) for determining whether a
foreign country is experiencing hyperinflation.
B. U.S. GAAP requires the financial statements of foreign operations in a highly
inflationary economy to be translated using the temporal method, as if the parent
currency is the functional currency. Under A country is considered highly inflationary if
its cumulative three-year inflation rate exceeds 100%.
VII. Some companies hedge their balance sheet exposures to avoid reporting
remeasurement losses in income and/or negative translation adjustments in stockholders
equity. In addition to derivative financial instruments, such as forward contracts and
options, companies often use foreign currency borrowings to hedge their net investment
in a foreign operation.
A. Both IFRS and U.S. GAAP provide that the gain or loss on a hedging instrument that
is designated and effective as a hedge of the net investment in a foreign operation
should be reported in the same manner as the translation adjustment being hedged.
B. The paradox in hedging balance sheet exposure is that by avoiding an unrealized
translation adjustment or remeasurement gain/loss, realized foreign exchange gains
and losses can arise.
8-2
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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 that are realized in cash.
3. 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.
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 subsidiarys
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 subsidiarys
monetary assets and liabilities are considered to be foreign currency cash, receivables,
and payables of the parent that 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 that exists from having both receivables and
payables in a particular foreign currency.
4. 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.
5. To determine the appropriate translation method under both IFRS and U.S. GAAP, the
functional currency of a foreign subsidiary must be identified. The functional currency is
the primary currency of the foreign entitys operating environment. It can be either the
parents reporting currency or a foreign currency (generally the local currency). The
functional currency orientation results in the following rule:
Functional Currency
Translation Method
Translation Adjustment
Parents currency
Temporal method
Gain (loss) in net income
Foreign currency
Current rate method
Separate
component
of
stockholders'
equity
(other
comprehensive income)
8-3
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6. For foreign entities that report in the currency of a hyperinflationary economy, IAS 21
requires the parent first to restate the foreign financial statements for inflation using IAS 29
rules and then translate the statements into parent company currency using the current
rate method. U.S. GAAP, on the other hand, requires financial statements of such foreign
entities to be translated using the temporal method.
U.S. GAAP specifically defines
hyperinflation as cumulative three-year inflation greater than 100%. IAS 29 provides no
specific definition for hyperinflation, but suggests that a cumulative three-year inflation rate
approaching or exceeding 100% is evidence that an economy is hyperinflationary.
7. The functional currency is the currency of the subsidiarys primary economic environment.
It is usually identified as the currency in which the company generates and expends cash.
U.S. GAAP stipulates 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 entitys functional currency. U.S. GAAP
does not provide any guidance as to how these factors are to be weighted (equally or
otherwise) when identifying an entitys functional currency. IAS 21 also provides factors to
be considered in determining the functional currency of a foreign subsidiary. Unlike U.S.
GAAP, IAS 21 provides a hierarchy of factors to consider. Two primary factors are first to
be considered. If evaluation of these primary factors does not clearly indicate a foreign
subsidiarys functional currency, then a group of six secondary factors should be
considered.
8. U.S. GAAP requires use of the temporal method for operations in highly inflationary
countries. Use of the current rate method without first restating for inflation results in a
disappearing plant problem in which fixed assets shrink in terms of their translated
carrying amount. By using the same historical rate for translation of fixed assets from one
period to the next, the temporal method avoids this problem. In developing the current
U.S. GAAP guidance on foreign currency translation, the FASB was unwilling to require
firms to restate foreign operation financial statements for foreign inflation because of the
lack of reliable inflation indices in many countries.
9. 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.
8-4
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10. 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 parents reporting currency is the functional
currency, gains and losses on the hedging instruments will be offset against the related
remeasurement gains and losses.
8-5
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Education.
9. Armetis Corporation
a. Current Rate Method
BRL
Cost of goods sold
Ending inventory
Exchange
Rate
CAD
450,000
150,000
0.420
0.380
189,000
57,000
Beginning inventory
Purchases
BRL
100,000
500,000
Exchange
Rate
0.500
0.420
CAD
50,000
210,000
Ending inventory
Cost of goods sold
(150,000)
450,000
0.400
(60,000)
200,000
Ending inventory
150,000
0.400
60,000
b. Temporal Method
8-6
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Education.
Exchange
TL
Rate
60,000,000,000 0.000007
40,000,000,000 0.000002
100,000,000,000
USD
420,000
80,000
500,000
Exchange
TL
Rate
24,000,000,000 0.000007
8,000,000,000 0.000002
32,000,000,000
USD
168,000
16,000
184,000
500,000
(184,000)
316,000
USD
60,000
Exchange
TL
Rate
32,000,000,000 0.0000006
USD
19,200
60,000
(19,200)
40,800
Equipment
Total
Accumulated
Depreciation
Total
8-7
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Education.
Marks
1,000,000
Exchange
Rate
0.15
A$
150,000
200,000
1,200,000
0.17
34,000
184,000
1,200,000
0.21
252,000
(68,000)
Pesos
1,000,000
$.09
US$
90,000
500,000
$0.85
42,500
(300,000)
(600,000)
$0.85
$0.9
(25,500)
(54,000)
(100,000)
$0.8
(8,000)
500,000
500,000
8-8
(45,000)
$0.78
(39,000)
(6,000)
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Education.
Swiss
Francs
8,200,000
8,200,000
Exchange
Rate
0.70
U.S.
Dollars
5,740,000
5,740,000
8,200,000
0.75
6,150,000
(410,000)
Swiss
Exchange
Francs
Rate
(800,000)
0.70
(800,000)
(800,000)
0.75
U.S.
Dollars
(560,000)
(560,000)
(600,000)
40,000
8-9
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Education.
$/Cz
0.84
0.80
0.75
0.72
0.71
0.70
Cz
Sales
Cost of goods sold
540,000
(310,000)
Gross profit
Operating expenses
Income before tax
Income taxes
Net income
230,000
(108,000)
122,000
(40,000)
82,000
154,000
82,000
(20,000)
216,000
8-10
Exchange
Rate
0.72
0.72
0.72
0.72
0.80
above
0.71
$
388,80
0
(223,200)
165,60
0
(77,760)
87,840
(28,800)
59,040
123,20
0
59,040
(14,200)
168,04
0
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Education.
14. (continued)
Cash
Receivables
Inventory
Plant and equipment
Less: accumulated depreciation
Total assets
Liabilities
Capital stock
Retained earnings, 12/31/Y2
Cumulative translation adjustment
Total liabilities and stockholders'
equity
Exchange
Cz
Rate
50,000
0.70
100,000
0.70
72,000
0.70
300,000
0.70
(70,000)
0.70
452,000
$
35,000
70,000
50,400
210,000
(49,000)
316,400
186,000
50,000
216,000
-
130,200
42,000
168,040
(23,840)
0.70
0.84
above
452,000
Cz
50,000
154,000
204,000
316,400
Exchange
Rate
0.84
0.80
$
42,000
123,200
165,200
204,000
0.75
153,000
204,000
82,000
(20,000)
266,000
0.75
0.72
0.71
153,000
59,040
(14,200)
197,840
266,000
0.70
186,200
12,200
11,640
23,840
8-11
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Education.
USD/ZAR
0.090
0.095
0.096
0.100
0.105
0.110
110,000
(20,000)
(20,000)
70,000
Cash
Receivables
Inventory
Plant and equipment
Less: accumulated depreciation
Total assets
80,000
150,000
270,000
500,000
(50,000)
950,000
8-12
0.095
0.105
0.110
0.110
0.110
0.110
0.110
USD
96,000
(57,600)
38,400
(4,800)
(14,400)
19,200
(8,640)
10,560
10,560
(1,900)
(2,100)
6,560
8,800
16,500
29,700
55,000
(5,500)
104,500
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Education.
15. (continued)
Accounts payable
Long-term debt
Common stock
Retained earnings, 12/31/Y1
Cumulative translation adjustment
Total liabilities and stockholders' equity
80,000
500,000
300,000
70,000
950,000
0.110
0.110
0.090
8,800
55,000
27,000
6,560
7,140
104,500
ZAR
300,000
110,000
(20,000)
(20,000)
370,000
370,000
8-13
Exchange
Rate
0.090
above
0.095
0.105
0.110
USD
27,000
10,560
(1,900)
(2,100)
33,560
40,700
(7,140)
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Education.
15. (continued)
b. U.S. dollar is functional currency (Temporal method)
Exchange
Rate
0.096
Sched. A
Sales
Cost of goods sold
Gross profit
Depreciation expense
Other operating expenses
Remeasurement gain (loss)
Income before tax
Income taxes
Net income
ZAR
1,000,000
(600,000)
400,000
(50,000)
(150,000)
200,000
(90,000)
110,000
110,000
(20,000)
(20,000)
70,000
Cash
Receivables
Inventory
Plant and equipment
Less: accumulated depreciation
Total assets
80,000
150,000
270,000
500,000
(50,000)
950,000
0.110
0.110
0.100
0.090
0.090
8,800
16,500
27,000
45,000
(4,500)
92,800
Accounts payable
Long-term debt
Common stock
Retained earnings, 12/31/Y1
Total liabilities and stockholders' equity
80,000
500,000
300,000
70,000
950,000
0.110
0.110
0.090
8,800
55,000
27,000
2,000
92,800
8-14
0.090
0.096
below
0.096
0.095
0.105
USD
96,000
(56,520)
39,480
(4,500)
(14,400)
(5,940)
14,640
(8,640)
6,000
6,000
(1,900)
(2,100)
2,000
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Education.
15. (continued)
Schedule A.
Calculation of cost of goods sold
Beginning inventory
Purchases
Ending inventory
Cost of goods sold
ZAR
870,000
(270,000)
600,000
Exchange
Rate
0.0960
0.1000
USD
83,520
(27,000)
56,520
16.
1,000,000
0.096
(870,000)
(150,000)
(90,000)
(20,000)
(20,000)
(350,000)
0.096
0.096
0.096
0.095
0.105
(350,000)
0.110
USD
(18,000)
96,000
(83,520)
(14,400)
(8,640)
(1,900)
(2,100)
(32,560)
(38,500)
5,940
The solutions to this problem will depend upon the U.S.-based MNC selected by each
student for examination.
8-15
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Education.
17.
(a)
In its 2012 Form 10-K, ExxonMobil disclosed the following in its Summary of Accounting
Policies: The Corporation selects the functional reporting currency for its international
subsidiaries based on the currency of the primary economic environment in which each
subsidiary operates. Downstream and Chemical operations primarily use the local
currency. However, the U.S. dollar is used in countries with a history of high inflation
(primarily in Latin America) and Singapore, which predominantly sells into the U.S. dollar
export market. Upstream operations which are relatively self-contained and integrated
within a particular country, such as Canada, the United Kingdom, Norway and continental
Europe, use the local currency. Some Upstream operations, primarily in Asia, West Africa,
Russia and the Middle East, use the U.S. dollar because they predominantly sell crude
and natural gas production into U.S. dollar-denominated markets (page 68). Thus, a
substantial number of ExxonMobils foreign operations have the local currency as
functional currency.
In contrast, Chevron indicated that substantially all of its foreign operations had the U.S.
dollar as functional currency (2012 Form 10-K, page FS-30).
This difference in predominant functional currency presents two kinds of comparability
problems. First, while Chevron primarily uses the temporal method of translation,
ExxonMobil primarily uses the current rate method. Second, Chevron primarily reports
translation gains/losses in net income (as remeasurement gains/losses), whereas most of
ExxonMobils translation gains/losses are deferred on the balance sheet in Accumulated
other comprehensive income.
(b)
(c)
8-16
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Education.
$/PLN
0.25
0.215
0.2
0.18
0.175
0.17
0.16
0.155
0.15
Part I (a). Polish zloty is the functional currency Current rate method
Sales
Cost of goods sold
Depreciation expense-equipment
Depreciation expense-building
Research and development expense
Other expenses (including taxes)
Net income
Plus: Retained earnings, 1/1/Y2
Less: Dividends paid
Retained earnings, 12/31/Y2
PLN
12,500,000
(6,000,000)
(1,250,000)
(900,000)
(600,000)
(500,000)
3,250,000
250,000
(750,000)
2,750,000
Cash
Accounts receivable (net)
Inventory
Equipment
Less: accumulated depreciation
Building
Less: accumulated depreciation
Land
Total assets
1,000,000
1,650,000
4,250,000
12,500,000
(4,250,000)
36,000,000
(15,150,000)
3,000,000
39,000,000
8-17
Exchange
Rate
0.175
0.175
0.175
0.175
0.175
0.175
Given
0.155
0.150
0.150
0.150
0.150
0.150
0.150
0.150
0.150
U.S. $
2,187,500
(1,050,000)
(218,750)
(157,500)
(105,000)
(87,500)
568,750
56,250
(116,250)
508,750
150,000
247,500
637,500
1,875,000
(637,500)
5,400,000
(2,272,500)
450,000
5,850,000
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Education.
1,250,000
25,000,000
2,500,000
7,500,000
2,750,000
39,000,000
0.150
0.150
0.250
0.250
Above
to balance
187,500
3,750,000
625,000
1,875,000
508,750
(1,096,250)
5,850,000
10,250,000
3,250,000
(750,000)
12,750,000
8-18
Exchange
Rate
U.S. $
0.200
0.175
0.155
2,050,000
568,750
(116,250)
2,502,500
0.150
1,912,500
given
590,000
506,250
1,096,250
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Education.
Sales
Cost of goods sold
Depreciation expense-equipment
Depreciation expense-building
Research and development expense
Other expenses (including taxes)
Income before remeasurement gain
Remeasurement gain, Year 2
Net income
Plus: Retained earnings, 1/1/Y2
Less: Dividends paid
Retained earnings, 12/31/Y2
Exchange
PLN
Rate
12,500,000
0.175
(6,000,000) Sched. A
(1,250,000) Sched. B
(900,000) Sched. C
(600,000)
0.175
(500,000)
0.175
3,250,000
3,250,000
250,000
Given
(750,000)
0.155
2,750,000
U.S. $
2,187,500
(1,233,750)
(295,000)
(213,000)
(105,000)
(87,500)
253,250
1,020,000
1,273,250
882,500
(116,250)
2,039,500
Cash
Accounts receivable (net)
Inventory
Equipment
Less: accumulated depreciation
Building
Less: accumulated depreciation
Land
Total assets
1,000,000
0.150
1,650,000
0.150
4,250,000
0.160
12,500,000 Sched. B
(4,250,000) Sched. B
36,000,000 Sched. C
(15,150,000) Sched. C
3,000,000
0.250
39,000,000
150,000
247,500
680,000
2,950,000
(1,045,000)
8,520,000
(3,775,500)
750,000
8,477,000
Accounts payable
Long-term debt
Common stock
Additional paid-in capital
Retained earnings
Total
1,250,000
25,000,000
2,500,000
7,500,000
2,750,000
39,000,000
187,500
3,750,000
625,000
1,875,000
2,039,500
8,477,000
8-19
0.150
0.150
0.250
0.250
Above
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Education.
Beginning inventory
Purchases
Ending inventory
Cost of goods sold
PLN
3,000,000
7,250,000
(4,250,000)
6,000,000
Exchange
Rate
0.215
0.175
0.160
U.S. $
645,000
1,268,750
(680,000)
1,233,750
Schedule B - Equipment
PLN
10,000,000
2,500,000
12,500,000
Exchange
Rate
0.250
0.180
U.S. $
2,500,000
450,000
2,950,000
4,000,000
250,000
4,250,000
0.250
0.180
1,000,000
45,000
1,045,000
1,000,000
250,000
1,250,000
0.250
0.180
250,000
45,000
295,000
Schedule C - Building
Exchange
Rate
0.250
0.170
PLN
30,000,000
6,000,000
36,000,000
Acc.Deprec.-Old Building
Acc.Deprec.-New Building
Total
15,000,000
150,000
15,150,000
0.250
0.170
3,750,000
25,500
3,775,500
750,000
150,000
900,000
0.250
0.170
187,500
25,500
213,000
8-20
U.S. $
7,500,000
1,020,000
8,520,000
Copyright 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education.
PLN
(18,500,000)
Exchange
Rate
0.200
12,500,000
0.175
2,187,500
(7,250,000)
(600,000)
(500,000)
(750,000)
(2,500,000)
(6,000,000)
(23,600,000)
0.175
0.175
0.175
0.155
0.180
0.170
(1,268,750)
(105,000)
(87,500)
(116,250)
(450,000)
(1,020,000)
(4,560,000)
(23,600,000)
0.150
(3,540,000)
U.S. $
(3,700,000)
(1,020,000)
8-21
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Education.
Sales
Cost of goods sold
Depreciation expense-equipment
Depreciation expense-building
Research and development
expense
Other expenses (including taxes)
Income before remeasurement gain
Remeasurement loss, Year 2
Net income
Plus: Retained earnings, 1/1/Y2
Less: Dividends paid
Retained earnings, 12/31/Y2
Exchange
PLN
Rate
12,500,000
0.175
(6,000,000) Sched. A
(1,250,000) Sched. B
(900,000) Sched. C
U.S. $
2,187,500
(1,233,750)
(295,000)
(213,000)
(600,000) 0.175
(500,000) 0.175
3,250,000
3,250,000
250,000
Given
(750,000) 0.155
2,750,000 from below
(105,000)
(87,500)
253,250
(230,000)
23,250
(367,500)
(116,250)
(460,500)
Cash
Accounts receivable (net)
Inventory
Equipment
Less: accumulated depreciation
Building
Less: accumulated depreciation
Land
Total assets
1,000,000
1,650,000
4,250,000
12,500,000
(4,250,000)
36,000,000
(15,150,000)
3,000,000
39,000,000
0.150
0.150
0.160
Sched. B
Sched. B
Sched. C
Sched. C
0.250
150,000
247,500
680,000
2,950,000
(1,045,000)
8,520,000
(3,775,500)
750,000
8,477,000
Accounts payable
Long-term debt
Common stock
Additional paid-in capital
Retained earnings
Total
1,250,000
0.150
0.150
10,000,000
0.250
25,000,000
0.250
2,750,000 to balance
39,000,000
187,500
2,500,000
6,250,000
(460,500)
8,477,000
8-22
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Education.
PLN
6,500,000
Exchange
Rate
0.200
12,500,000
0.175
(7,250,000)
(600,000)
(500,000)
(750,000)
(2,500,000)
(6,000,000)
1,400,000
0.175
0.175
0.175
0.155
0.180
0.170
(1,268,750)
(105,000)
(87,500)
(116,250)
(450,000)
(1,020,000)
440,000
1,400,000
0.150
210,000
U.S. $
1,300,000
2,187,500
230,000
Part II. Explain the negative translation adjustment in Part I (a) and remeasurement gain
or loss in Parts 1(b) and 1(c).
The negative translation adjustment in part 1(a) arises because of two factors: (1) there is a
net asset balance sheet exposure and (2) the Polish zloty has depreciated against the U.S.
dollar during Year 2 (from $.020 at 1/1/Y2 to $.0150 at 12/31/Y2). A net asset balance sheet
exposure exists because all assets are translated at the current exchange rate and exceeds
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 liability
balance sheet exposure and (2) the Polish zloty 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 PLN 2,650,000). Accounts Payable and Long-Term Debt also
are translated at the current exchange rate (total PLN 26,250,000). Because the Polish zloty
amount of liabilities translated at the current rate exceeds the Polish zloty amount of assets
translated at the current rate, a net liability balance sheet exposure exists.
The remeasurement loss in part I(c) arises because of two factors: (1) there is a net asset
balance sheet exposure and (2) the Polish zloty has depreciated against the U.S. dollar during
Year 2.
Cash and Accounts Receivable are the only assets translated at the current exchange rate
(total PLN 2,650,000). Because there is no Long-term Debt in part 1(c), Accounts Payable is
the only liability translated at the current exchange rate (total PLN 1,250,000). Because the
Polish zloty amount of the assets translated at the current rate exceeds the Polish zloty
amount of liabilities translated at the current rate, a net asset balance sheet exposure exists.
8-23
Copyright 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education.
$/pound
1.00
1.00
0.90
0.86
0.83
0.80
Sales
Cost of goods sold
Gross profit
Selling and administrative expense
Depreciation expense
Income before tax
Income taxes
Net income
Plus: Retained earnings, 1/1/Y1
Retained earnings, 12/31/Y1
Exchange
Pounds
Rate
15,000
0.900
(9,000)
0.900
6,000
(3,000)
0.900
(1,000)
0.900
2,000
(600)
0.900
1,400
1,400
Cash
Inventory
Fixed assets
Less: accumulated depreciation
Total assets
2,400
4,000
10,000
(1,000)
15,400
Current liabilities
Long-term debt
Contributed capital
Retained earnings
Translation adjustment
Total
2,000
0.800
4,000
0.800
8,000
1.000
1,400 from above
from below
15,400
8-24
0.800
0.800
0.800
0.800
U.S. $
13,500
(8,100)
5,400
(2,700)
(900)
1,800
(540)
1,260
1,260
1,920
3,200
8,000
(800)
12,320
1,600
3,200
8,000
1,260
(1,740)
12,320
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Education.
Pounds
8,000
1,400
9,400
Exchange
Rate
1.000
0.900
9,400
0.800
U.S. $
8,000
1,260
9,260
7,520
1,740
Sales
Cost of goods sold
Gross profit
Selling and administrative expense
Depreciation expense
Remeasurement gain (loss)
Income before tax
Income taxes
Net income
Plus: Retained earnings, 1/1/Y1
Retained earnings, 12/31/Y1
Exchange
Rate
0.900
Sched. A
Pounds
15,000
(9,000)
6,000
(3,000)
0.900
(1,000)
1.000
- from below
2,000
(600)
0.900
1,400
1,400
U.S. $
13,500
(8,000)
5,500
(2,700)
(1,000)
180
1,980
(540)
1,440
1,440
Cash
Inventory
Fixed assets
Less: accumulated depreciation
Total assets
2,400
4,000
10,000
(1,000)
15,400
0.800
0.830
1.000
1.000
1,920
3,320
10,000
(1,000)
14,240
Current liabilities
Long-term debt
Contributed capital
Retained earnings
Total
2,000
4,000
8,000
1,400
15,400
0.800
0.800
1.000
to balance
1,600
3,200
8,000
1,440
14,240
8-25
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Education.
Purchase, January 10
Additional purchases
Ending inventory
Cost of goods sold
Pounds
1,000
12,000
(4,000)
9,000
Exchange
Rate
1.000
0.860
0.830
U.S. $
1,000
10,320
(3,320)
8,000
Pounds
8,000
Exchange
Rate
1.000
U.S. $
8,000
15,000
0.900
13,500
(1,000)
(12,000)
(3,000)
(600)
(10,000)
(3,600)
1.000
0.860
0.900
0.900
1.000
(1,000)
(10,320)
(2,700)
(540)
(10,000)
(3,060)
(3,600)
0.800
(2,880)
(180)
3. With the pound as functional currency, the U.S. dollar net income reflected in the
consolidated income statement is $1,260. If the U.S. dollar were the functional currency,
the amount reflected in consolidated net income would be $1,560, 24% higher. The
amount of total assets reported on the consolidated balance sheet is 17% smaller than if
the U.S. dollar were functional currency [($14,360 $12,320)/$12,320].
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.
8-26
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Education.
Pounds
Current ratio:
Current assets
Current liabilities
Debt to equity ratio:
Total liabilities
Total stockholders' equity
Profit margin:
Net income
Sales
U.S. $
Current Rate
U.S $
Temporal
6,400
2,000
3.2
5,120
1,600
3.2
5,240
1,600
3.275
6,000
9,400
0.638
4,800
7,520
0.638
4,800
9,440
0.508
1,400
15,000
0.093
1,260
13,500
0.093
1,440
13,500
0.107
A comparison of the ratios calculated using pounds and using U.S.$ translated amounts shows
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). Note: 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 10,000 pounds worth of fixed
assets when the exchange rate was $1.00/pound, the parent would have had to provide the
subsidiary with $10,000.
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 pound historical cost amounts 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.
8-27
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Education.