FOREIGN CURRENCY TRANSLATION

L E A R N I N G O B J E C T I V E

Develop the necessary understanding and skills to translate the financial statements of a foreign entity into U.S. dollars using the all-current and the monetary-nonmonetary translation methods.

Business rms desiring to sell goods or services in countries other than their home country must make at least two important decisions: 1. Location of Product Creation. Should the firm create the good or service in its home country and then export (sell) abroad? Alternatively, should the firm both create and sell the good or service abroad through some foreign entity (for example, a branch office or subsidiary)? 2. Currency for Denominating Transactions. Should the firm structure transactions so that all cash flows occur in the currency of the home country? Alternatively, should the firm use the currency of the foreign country to denominate all cash ows? The manner in which a rm structures its foreign operations affects its exposure to exchange-rate changes. A brief overview of exchange rates will enhance an understanding of the effect of exchange-rate changes on a rm.
NATURE OF EXCHANGE RATES

An exchange rate is the price of one countrys currency in terms of another countrys currency. For example, the British pound might be worth U.S. $2.00 at a given time. The exchange rate would be stated as one British pound is worth two dollars, or one dollar is worth .50 (= 1/$2) British pound. Exchange rates, like the price of any good or service, reect the forces of demand and supply. Economic and political conditions, as well as prospects within a country relative to those in other countries, affect the level of exchange rates. New, unanticipated information about a countrys economic and political conditions and prospects causes exchange rates to change. For example, the exchange rate between the U.S. dollar and the British pound might change as follows:
U.S. Dollars per British Pound $2.00:1 $2.10:1 $2.20:1 British Pounds per U.S. Dollar 50:$1 48:$1 45:$1

Date January 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Average during Year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . December 31 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

In this case, the British pound increased in value relative to the U.S. dollar during the year. A purchaser of British pounds needs $2.20 to purchase one British pound on December 31 but needed only $2.00 on January 1. Alternatively, a purchaser of U.S. dollars needs only .45 to purchase one U.S. dollar on December 31 but needed .50 on January 1.
EFFECT OF EXCHANGE-RATE CHANGES

Consider now how the structure of a rms foreign operations and the currency in which it denominates transactions affect its exposure to exchange-rate changes.

Foreign Currency Translation

Example 1 Americo, Inc., a U.S. corporation, desires to expand geographically by selling its products in the United Kingdom (U.K.). It can manufacture the products in the United States and export the goods to the U.K. Americo will invest in new plant facilities in the United States to provide the necessary production capacity. It will purchase all raw materials and labor services in the United States. Americo will set selling prices for its products in U.S. dollars and will require its U.K. customers to pay in U.S. dollars. Assume that the exchange rate between the U.S. dollar and the British pound changed during the rst year of operations as shown above (that is, the British pound increased in value relative to the U.S. dollar). In this case, Americos British customers enjoy the benefits and bear the risk of exchange-rate changes between the time of sale, when Americo and its customers agree to a selling price in U.S. dollars, and the time of cash collection/payment, when the customer pays the agreed amount in U.S. dollars. Because Americo incurs costs and generates revenues in U.S. dollars, exchange-rate changes do not directly affect it. Exchangerate changes may, however, affect the willingness of U.K. customers to purchase products from Americo versus another competitor. The increased value of the British pound relative to the U.S. dollar makes Americos products less expensive for U.K. customers. Americos competitors may reduce their prices to avoid losing their customers to Americo. Example 2 Refer to Example 1. Suppose again that Americo locates its manufacturing operations in the United States and then exports finished products. Assume now, however, that Americo sets selling prices in British pounds instead of U.S. dollars. In this case, Americo enjoys the benets and bears the risk of exchange-rate changes between the time of sale and the time of cash collection. The asset at risk is Americos accounts receivable denominated in British pounds. To understand this example, assume that Americo sells goods for 120 million at a time when the exchange rate is $2.1:1. This account receivable has the U.S. dollar-equivalent value at the time of sale of $252 (= $2.10 120) million. The exchange rate on December 31 is $2.2:1. If this account receivable remains uncollected at year-end, it has the U.S. dollar-equivalent value of $264 (= $2.2 120) million. Americo prots by $12 (= $264 $252) million from the change in the exchange rate. Example 3 Refer to Example 1. Suppose now that Americo establishes a wholly-owned subsidiary in the U.K. to carry out all manufacturing and selling activities in that country. Americo will invest the necessary funds to build the plant facilities. The subsidiary will purchase raw materials and labor services in the U.K. and denominate sales to U.K. customers in British pounds. To nance future growth, the U.K. subsidiary will retain within the U.K. the net assets generated by earnings. In this case, Americo has exposed its investment in the net assets of the subsidiary (= assets liabilities, or shareholders equity) to the risk of exchange-rate changes. Investing capital in this subsidiary, both initially and through retained earnings, will result in Americos later receiving cash (from dividends and from the sale of the subsidiary) in amounts that vary as a result of changes in the value of the British pound. To understand this example, assume that Americo invested $200 million in a newly created U.K. subsidiary on January 1 in return for all of the subsidiarys stock. The exchange rate on January 1 was $2:1. Thus, the U.K. equivalent amount for this investment is 100 (= $200/$2) million. During the first year of operations, the subsidiary generated earnings of 80 million and paid no dividends to Americo. The average exchange rate during the year was $2.1:1, and the exchange rate on December 31 was $2.2:1. The increasing value of the British pound relative to the U.S. dollar alone increases the dollar valuation of Americos investment in the net assets of the subsidiary by $28 million, derived as follows:
British Pounds Initial Investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Foreign Exchange Gain . . . . . . . . . . . . . . . . . . . . . . . . 100 80 180 Exchange Rate $2.0:1 $2.1:1 $2.2:1 U.S. Dollars $200 168 $368 396 $ 28

The net assets derived from Americos initial investment and the retention of earnings total 180 million on December 31. At the exchange rate of $2.2:1 on this date, the dollar-equivalent amount of these net assets

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is $396 million. If Americo had kept the $200 million in its U.S. bank account instead of investing it in the U.K. subsidiary and had required the subsidiary to remit dividends equal to earnings throughout the year, Americo would show only $368 million in its U.S. bank account on December 31. Americo proted by $28 million from investing funds in a country whose currency increased in value relative to the U.S. dollar. Americo earned this $28 million in addition to the operating profits that the U.K. subsidiary earned on its sales. In contrast, if the British pound had decreased in value relative to the U.S. dollar, Americo would have been worse off converting its dollars into British pounds at the beginning of the year and allowing the U.K. subsidiary to retain the net assets generated by earnings during the year.
OVERVIEW OF FOREIGN CURRENCY TRANSLATION

Business firms conduct operations in countries other than their home country through branch offices, subsidiaries, affiliates, joint ventures, and other entities. Domestic rms account for their foreign investments following the same accounting principles that they use for domestic investments: 1. The market value method when the ownership percentage does not convey significant influence, usually less than 20 percent 2. The equity method when the ownership percentage does convey signicant inuence, usually between 20 percent and 50 percent 3. The consolidation method for majority-owned investments (unless government restrictions severely constrain a parent companys ability to exercise control of the foreign subsidiary) The foreign entities keep their accounting records in their local currencies. To apply the appropriate accounting method for these investments, the domestic (say, U.S.) firm must translate the foreign (say, U.K.) entitys nancial statements from the foreign currency (pound sterling, ) into the domestic currency (dollar, $), a process known as foreign currency translation. Translating the nancial statements of foreign entities requires responses to two questions: 1. Which exchange rate should a rm use to translate each account in a foreign entitys nancial statements? 2. How should the rm treat any adjustment, analogous to gain or loss, that arises from translation?

Exchange Rate Used in Translation Accounting distinguishes between the historical exchange rate and the current exchange rate. The historical exchange rate refers to the exchange rate in effect when the rm rst recorded a particular transaction. The historical exchange rate for inventories, property, plant, and equipment means the exchange rate at the time the firm acquired these items. The historical exchange rate for bonds payable and common stock means the exchange rate at the time the firm issued these securities. The current exchange rate refers to the exchange rate at the date of the balance sheet for balance sheet items and refers to the average exchange rate during the current period for income statement items. Firms could conceivably use the historical exchange rate for each financial statement item, the current exchange rate for each item, or some combination of the two. Treatment of Changes in Amounts that Result from Translation Firms may have to change the U.S. dollar amount for their foreign account amounts depending on the exchange rate they use in translation.
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When rms translate foreign currency amounts into their U.S. dollar-equivalent amounts using the historical exchange rate, changes in exchange rates do not affect the U.S. dollar valuation because, by denition, those items appear in U.S. dollars at their acquisition cost translated at the exchange rate on the date of acquisition, for assets (or on the date of issue, for equities). When firms translate foreign currency amounts into their U.S. dollar-equivalent amounts using the current exchange rate, changes in exchange rates do affect the U.S. dollar valuation because those items have dollar valuations different from those at the date of acquisition, for assets (or at the date of issue, for equities).

Foreign Currency Translation

When the reported amount of these items varies as a result of a change in the exchange rate, accountants refer to the variance as a foreign exchange adjustment. Firms might conceivably treat the foreign exchange adjustment in one of two ways: 1. Include the amount as a foreign exchange gain or loss in the computation of net income for the period, which rms then close out to retained earnings. 2. Include the amount as a foreign exchange adjustment in other comprehensive income, a separate component of the shareholders equity account, bypassing the income statement. This treatment resembles that for unrealized holding gains and losses on marketable equity securities classied as available for sale, described in Chapters 11. These two treatments result in identical total shareholders equity. They differ with respect to the effects that the foreign exchange adjustment has on net income and on particular shareholders equity accounts. Generally accepted accounting principles (GAAP) sometimes require the historical exchange rate and sometimes the current exchange rate. The choice depends both on whether the rm uses foreign or U.S. currency as the primary currency and, if the rm uses the U.S. dollar, on whether the translation applies to a nancial statement account that is monetary or nonmonetary. The next section explains these principles.
GAAP FOR FOREIGN CURRENCY TRANSLATION

GAAP in the United States require rms to identify the functional currency of each foreign unit.1 The functional currency refers to the currency in which the foreign unit conducts most of its activities. The functional currency depends on the operating characteristics of the foreign unit. Statement of Financial Accounting Standards (SFAS) No. 52 requires rms to classify each foreign unit into one of two categories: 1. Self-contained: foreign operations are contained within a particular foreign country. (That is, the firm obtains capital, acquires inventories and labor services, sells to customers, and retains earnings all within the foreign country. Example 3 illustrates a self-contained foreign operation.) The Financial Accounting Standards Board (FASB) requires that the currency of the foreign unit be the functional currency for selfcontained foreign operations. 2. Extension of U.S. operations: foreign operations are primarily an extension of the parents operations in the United States. (That is, the foreign unit obtains capital from the U.S. parent company or borrows in U.S. dollars, acquires inventories from the U.S. parent, and remits earnings back to the parent. Example 2 illustrates foreign operations that extend the operations of the U.S. parent.) The FASB requires that the U.S. dollar be the functional currency for foreign operations that extend U.S. operations. The facts need not clearly signal a unique classication: a particular foreign operation can combine aspects of the self-contained entity while still being integrated with the parent. For example, a foreign unit may acquire raw materials from the U.S. parent and remit 50 percent of its earnings back to the parent but may obtain funds within the foreign country and sell primarily to local customers. Management must weigh all of the evidence to decide which characterization better describes the foreign operation. Note on Current Practice. The FASB issued SFAS No. 52, the reporting standard for foreign currency translation, before the emergence of the global rm that sources capital and raw materials in many countries and sells to customers in many countries. In this case, the foreign operations are neither self-contained nor integrally related to the parent, so identifying the functional currency involves some arbitrariness. SFAS No. 52 requires the all-current translation method for self-contained foreign operations (functional currency = foreign currency) and the monetary-nonmonetary translation method for foreign operations integrated with those of the U.S. parent (functional currency = U.S. dollar). Foreign operations located in hyperinationary countries must also use the monetary-nonmonetary translation method. The FASB considers the foreign currency to be too unstable in hyperinationary countries to serve as a measuring unit. Firms must use the U.S. dollar as the functional currency in these cases. We discuss these two translation methods below.

1 Financial

Accounting Standards Board, Statement of Financial Accounting Standards No. 52, Foreign Currency Translation, 1981.

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Rationale. GAAP attempt to report on the two kinds of foreign operations as if they result from two different types of U.S. management control patterns.
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When a domestic parent invests in self-contained foreign operations and does not expect to recapture its investment for several years, it puts its investment at risk to exchange-rate changes. It delegates to managers in the foreign country the day-to-day management decisions. Whether those foreign managers choose highly leveraged or conservative nancing, the U.S. parent considers only its own investment at risk and has put that investment at risk for several years. The next section illustrates the method required for self-contained foreign operationsthe all-current translation accounting method. This method calculates an exchange adjustment based on the parents investment in the shareholders equity (= assets liabilities) of the foreign unit. Because the parent intends to allow the foreign unit to retain the net assets represented by its investment for many years, U.S. GAAP require firms to include the exchange adjustment in a separate shareholders account, not in periodic net income. For the U.S. investor in a self-contained foreign operation, GAAP attempt to present results as though the U.S. investor sees only its investment, not the structure of the individual assets and liabilities or the results of day-to-day operations. In contrast, management of a U.S. company extending its operations into a foreign country has day-today control of assets, liabilities, and operations. It intends to require the foreign unit to remit assets generated by earnings to the United States on an ongoing basis. Remitting assets generated by periodic earnings will likely require the foreign unit frequently to convert foreign currency into U.S. dollars. Because the parent intends to have the foreign unit regularly convert the foreign currency into U.S. dollars and then remit to its U.S. parent the assets generated by foreign earnings, U.S. GAAP require such rms to include the exchange adjustment in net income each period by using the monetary-nonmonetary translation method. The managers of the parent concern themselves with the affiliates dayto-day operations. The monetary-nonmonetary measurement basis attempts to reect, in U.S. nancial statements, this day-to-day control that managers have over their integrated and extended foreign operations.

The next section describes and illustrates these translation methods using information for Domestic Company. Data for Domestic Company Example Domestic Company, a U.S. parent company, establishes a foreign subsidiary in the U.K. by investing $200 on January 1, Year 1, in return for all of the subsidiarys common stock. The U.S. dollar and the U.K. pound exchange at the rate of $2:1 on this date. The subsidiary engages in the following transactions during Year 1: 1. Acquires property, plant, and equipment on January 2, Year 1, costing 500. It nances the acquisition with 450 of long-term debt and 50 of cash. 2. Acquires inventory on account totaling 850. The subsidiary uses a weighted-average cost ow assumption. 3. Sells on account, for 1,000, inventory costing 700. 4. Pays selling and administrative expenses of 80, interest expense of 50, and income tax expense of 40. 5. Collects 880 from customers for sales on account and pays 680 to suppliers for purchases of inventory on account. 6. Recognizes 50 as depreciation expense for Year 1. 7. Pays no dividends to the U.S. parent company. The average exchange rate during Year 1 was $2.1:1, and the exchange rate on December 31, Year 1, is $2.2:1. The increase in the number of U.S. dollars required to purchase one U.K. pound means that the U.S. dollar declined in value relative to the U.K. pound during the year. Exhibit 1 translates the balance sheet, and Exhibit 2 translates the income statement, both exhibits showing the all-current method and the monetary-nonmonetary method.

Foreign Currency Translation ALL-CURRENT TRANSLATION METHOD

Self-contained foreign operations (where functional currency = foreign currency) must, to follow GAAP, use the all-current translation method. The all-current method translates assets and liabilities using the exchange rate on the date of the balance sheet. It translates revenues, expenses, and net income using the average exchange rate during the period. The foreign exchange adjustment that results from applying the all-current method appears in other comprehensive income, a separate shareholders equity account, and does not affect net income each period. The rationale for the all-current method for self-contained foreign operations results from the fact that the U.S. investor views only its investment in (= net assets of) the foreign unit as being at risk to exchange-rate changes. That is, the U.S. investor has put at risk an amount equal to the shareholders equity of the foreign unit. A decision to invest in a foreign unit and to permit the foreign unit to retain, for internal growth, assets generated by earnings means that the parent will not realize the benet or incur the loss from exchange-rate changes inherent in its net asset position until either the foreign unit remits a dividend or the parent sells the foreign unit. Because such events will not likely occur for many years, net income excludes the foreign exchange adjustment each period. Refer to Exhibits 1 and 2. The all-current method translates assets and liabilities using the exchange rate on December 31, Year 1, of $2.2:1. The all-current method translates common stock using the exchange rate of $2.0:1 on January 1, Year 1, the date the domestic parent company established the subsidiary by investing $200. Retained earnings at the end of Year 1 equal net income for Year 1 because the subsidiary paid no dividends. The translation of revenues, expenses, and net income uses the average exchange rate during Year 1 of $2.1:1. The foreign exchange adjustment is $28, the amount by which the U.S. investors investment, when translated into dollars from the foreign books, exceeds the dollar amount carried on the U.S. books. Exhibit 3 calculates this $28 amount, a credit because it resembles a gain, although the all-current method will not report it as a gain. The net assets of the subsidiary on January 1, Year 1, equal the 100 (or $200) invested by Domestic Company. The U.K. pound increased in value relative to the U.S. dollar during Year 1. If the subsidiary

EXHIBIT 1 DOMESTIC COMPANY Translation of Balance Sheet December 31, Year 1 All-Current Method Pounds ASSETS Cash . . . . . . . . . . . . . . . . . . . . . . . . . 80 Accounts Receivable. . . . . . . . . . . . . . . 120 Inventories. . . . . . . . . . . . . . . . . . . . . . 150 Property, Plant, and Equipment . . . . . . . 450 Total Assets . . . . . . . . . . . . . . . . . . 800 LIABILITIES AND SHAREHOLDERS EQUITY Accounts Payable . . . . . . . . . . . . . . . . . 170 Bonds Payable . . . . . . . . . . . . . . . . . . . 450 Common Stock . . . . . . . . . . . . . . . . . . 100 Foreign Exchange . . . . . . . . . . . . . . . . . Retained Earnings . . . . . . . . . . . . . . . . 80 Total Liabilities and Shareholders Equity . . . . . . . . . . 800 Exchange Rate Dollars Monetary-Nonmonetary Method Pounds Exchange Rate Dollars

$2.2:1 $2.2:1 $2.2:1 $2.2:1

$ 176 264 330 990 $1,760

80 120 150 450 800

$2.2:1 $2.2:1 $2.1:1 $2.0:1

$ 176 264 315 900 $1,655

$2.2:1 $2.2:1 $2.0:1 See Exh. 3 See Exh. 2

$ 374 990 200 28 168 $1,760

170 450 100 80 800

$2.2:1 $2.2:1 $2.0:1

$ 374 990 200 91 $1,655

See Exh. 2

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EXHIBIT 2 DOMESTIC COMPANY Translation of Income Statement for Year 1 All-Current Method Pounds Sales. . . . . . . . . . . . . . . . . . . . . . . . Cost of Goods Sold. . . . . . . . . . . . . . Selling and Administrative . . . . . . . . . . . . . . . Depreciation . . . . . . . . . . . . . . . . . . Interest . . . . . . . . . . . . . . . . . . . . . . Income Taxes. . . . . . . . . . . . . . . . . . Foreign Exchange Loss . . . . . . . . . . . Net Income . . . . . . . . . . . . . . . . . . . 1,000 (700) (80) (50) (50) (40) 80 Exchange Rate $2.1:1 $2.1:1 $2.1:1 $2.1:1 $2.1:1 $2.1:1 Dollars $ 2,100 (1,470) (168) (105) (105) (84) $ 168 Monetary-Nonmonetary Method Pounds 1,000 (700) (80) (50) (50) (40) 80 Exchange Rate $2.1:1 $2.1:1 $2.1:1 $2.0:1 $2.1:1 $2.1:1 See Exh. 4 $ Dollars $ 2,100 (1,470) (168) (100) (105) (84) (82) 91

EXHIBIT 3 DOMESTIC COMPANY Calculation of Foreign Exchange Adjustment All-Current Method for Year 1

Pounds Net Assets Position, January 1, Year 1 . . . . . . . . . . . . . . . . . . . 100 Increase in Net Assets during Year 1 from Net Income. . . . . . . . 80 Net Asset Position, December 31, Year 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180 ............................................... Foreign Exchange Adjustment for Year 2 . . . . . . . . . . . . . . . . . .

Exchange Rate $2.0:1 $2.1:1

Dollars $200 168

$2.2:1

368 396 $ 28

converted net assets of 100 on December 31, Year 1, into U.S. dollars and remitted them to its parent company, Domestic Company would receive net assets of $220 (= 100 2.2:1). The parent company has enjoyed an increase in wealth of $20 by the end of Year 1 from placing the $200 in a subsidiary whose currency increased in value relative to the U.S. dollar. That is, the $220 exceeds by $20 the amount the firm would have on deposit if it had left the funds in its U.S. bank account. During Year 1, the net assets of the subsidiary increased by 80 from earnings. Domestic Company permitted net assets equal to this 80 of earnings to remain in the subsidiary when it could have required the subsidiary to remit them to the parent company as a dividend. Had the foreign subsidiary remitted the dividend in U.K. pounds and had the U.S. parent converted those pounds to dollars on receiving them, the U.S. parent would have had U.S. dollars of $168 (= 80 $2.1:1). By leaving the assets in the foreign company rather than taking them out via dividends, the parent had a year-end total of assets denominated in U.K. pounds with a U.S. dollar equivalent value on December 31, Year 1, of $176 (= 80 $2.2:1). Domestic Company has increased its wealth by $8 (= $176 $168) from leaving the net assets generated by earnings in the U.K. subsidiary instead of transferring them back to the United States. The total foreign exchange adjustment for Year 1 totals $28 [= $20 (on initial investment) + $8 (on earnings retention)].
MONETARY-NONMONETARY TRANSLATION METHOD

The accounting for foreign operations highly integrated with the U.S. parent company must, to follow GAAP, use the monetary-nonmonetary translation method. The monetary-nonmonetary translation method provides translated amounts for a foreign unit similar to the amounts that the parent would report if it engaged

Foreign Currency Translation

in export transactions to carry out its foreign operations (that is, if it manufactured goods in the United States and then sold them to customers abroad) instead of operating through a foreign unit. Because the operations of integrally related foreign units resemble export activities, domestic rms achieve comparable reported amounts for both types of activities by using the monetary-nonmonetary translation method. The monetary-nonmonetary method translates monetary assets and liabilities using the current exchange rate and translates nonmonetary assets and liabilities using the historical exchange rate. Monetary items represent claims receivable or payable in a fixed number of foreign currency units regardless of changes in exchange rates. Monetary items include cash, accounts receivable, accounts payable, bonds payable, and most liabilities other than Advances from Customers. Because firms translate monetary items using the current exchange rate, a foreign exchange adjustment arises for these items when exchange rates change. The firm includes the foreign exchange adjustment as an exchange gain or loss in measuring net income each period under the monetary-nonmonetary method. The rationale results from noting that the foreign unit must regularly convert currency (from dollars to pounds or vice versa) to settle its receivables or payables and will therefore realize the gain or loss in the near term. This near-term realization contrasts with the longer-term realizability of the foreign exchange adjustment from self-contained foreign operations translated using the all-current method. Nonmonetary items include inventories, prepayments, property, plant and equipment, intangible assets, advances from customers, and common stock. Unlike monetary items, nonmonetary items do not result in a xed future cash inow or outow. Translating nonmonetary items using the historical exchange rate results in reporting them at their U.S. dollar-equivalent amounts regardless of changes in the exchange rate. Refer to Exhibits 1 and 2. The monetary-nonmonetary method translates monetary items at the exchange rate of $2.2:1 on December 31. Monetary items include cash, accounts receivable, accounts payable, and bonds payable. The accountant translates nonmonetary items at the historical exchange rate. The subsidiary acquired inventory items evenly during Year 1 and uses a weighted-average cost ow assumption. Thus, the ending inventory translates using the average exchange rate of $2.1:1. A FIFO cost ow assumption requires the use of an exchange rate later in the year for inventory items. A LIFO cost ow assumption requires the use of the exchange rate for the year of each LIFO inventory layer. The property, plant, and equipment translate using the exchange rate at the time of their acquisition of $2.0:1. The common stock translates at the exchange rate at the time of its issue of $2.0:1. Most revenues and expenses result from transactions recorded evenly during Year 1 and therefore translate using the average exchange rate of $2.1:1. Cost of goods sold represents an allocation of a cost initially recorded when the subsidiary purchased the inventory items. Because the subsidiary uses a weighted-average cost flow assumption, cost of goods sold translates at the average exchange rate of $2.1:1. A FIFO cost flow assumption in this illustration requires the use of an exchange rate earlier in the year for cost of goods sold. A LIFO cost ow assumption requires the use of an exchange rate later in the year (unless a rm dips into LIFO layers of earlier years). Depreciation expense likewise represents an allocation of a cost initially recorded when the subsidiary purchased the depreciable assets. Depreciation expense translates at the historical exchange rate of $2.0:1. The foreign exchange loss for the year, computed in Exhibit 4, is $82. The U.K. subsidiary held a net monetary liability position (that is, its monetary liabilities exceeded its monetary assets) during most of the year as a result of its long-term borrowing to nance purchases of property, plant, and equipment. The U.S. dollars needed to repay this net liability position in pounds increased during Year 1 as a result of the decline in the value of the U.S. dollar. This causes a foreign exchange loss. Exhibit 4 demonstrates the calculation of the foreign exchange loss. Translating each transaction affecting the net monetary position at the exchange rate at the time of the transaction results in a net monetary liability of $842 at the end of the year. The actual net monetary liability position at the end of the year in pounds comprises cash (80) plus accounts receivable (120) minus accounts payable (170) minus bonds payable (450), or a negative 420. The U.S. dollar-equivalent of the net monetary liability at the end of the year is $924. That is, the U.S. dollar amount needed at year-end to discharge the net monetary liability would be $924. Had the U.S. rm discharged each net U.K. pound monetary liability with dollars as it arose, the U.S. rm would have $82 more at year-end than if it discharged the net monetary liability all at year-end. By letting the liabilities accumulate in pounds while the dollar was losing value relative to the pound, the U.S. firm lost $82. Note that the issuance of bonds, the collection of accounts receivable, and the payment of accounts payable cause no change in the net monetary position because each of these transactions involves simultaneous increases (or decreases) in both monetary assets and monetary liabilities. For example, the issuance of bonds increases the monetary asset Cash while it increases the monetary liability Bonds Payable.

Foreign Currency Translation

EXHIBIT 4 DOMESTIC COMPANY Calculation of Foreign Exchange Adjustment Monetary-Nonmonetary Method for Year 1

Pounds Net Monetary Asset (Liability) Position, January 1, Year 1. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 Increases in Net Monetary Assets Cash or Accounts Receivable from Sales . . . . . . . . . . . . . . . . 1,000 Decreases in Net Monetary Assets Purchase of Property, Plant, and Equipment . . . . . . . . . . . . . . (500) Purchase of Inventory on Account. . . . . . . . . . . . . . . . . . . . . . (850) Payment of Selling and Administrative Expenses . . . . . . . . . . . (80) Payment of Interest Expenses . . . . . . . . . . . . . . . . . . . . . . . . (50) Payment of Income Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . (40) Net Monetary Asset (Liability) Position, December 31, Year 1. . . . . . . . . . . . . . . . . . . . . . . . . . . . (420) ........................................... Foreign Exchange Loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Exchange Rate

Dollars

$2.0:1 $2.1:1 $2.0:1 $2.1:1 $2.1:1 $2.1:1 $2.1:1

200 2,100 (1,000) (1,785) (168) (105) (84)

$2.2:1 $

(842) 924 82

AN INTERNATIONAL PERSPECTIVE

The International Accounting Standards Committee (IASC) recommends foreign currency translation methods similar to those described and illustrated above.2 Most countries outside of the United States similarly distinguish self-contained from integrally related foreign units and require the all-current method for the self-contained and the monetary-nonmonetary translation method for the integrally related foreign units. Countries differ as to whether the exchange adjustment under the monetary-nonmonetary method affects net income or appears in a separate shareholders equity account.

PROBLEM FOR SELF-STUDY

Translating foreign currency financial statements. Refer to the preceding illustration for Domestic Company and its U.K. subsidiary for Year 1. The following information relates to the U.K. subsidiary for Year 2. All transactions occur evenly during Year 2. 1. Acquires inventory on account totaling 850. 2. Sells inventory costing 800 on account for 1,200. 3. Pays selling and administrative expenses of 160, interest expense of 50, and income tax expense of 45. 4. Collects 1,160 from customers for sales on account and pays 820 to suppliers for purchases of inventory on account. 5. Pays dividends of 25 evenly during Year 2. 6. Recognizes 50 of depreciation expense. The exchange rates were as follows:

2 International

Accounting Standards Committee, International Accounting Standard No. 21, The Effects of Changes in Foreign Exchanges Rates, 1993.

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10

When Subsidiary Issued Bonds and Common Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . When Subsidiary Acquired Property, Plant, and Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . December 31, Year 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Average during Year 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . When Subsidiary Acquired Inventory Available for Sale during Year 2 . . . . . . . . . . . . . . . . . . . . . December 31, Year 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$2.0:1 $2.0:1 $2.2:1 $2.0:1 $2.015:1 $1.8:1

a. Prepare a balance sheet for the U.K. subsidiary in U.K. pounds and in U.S. dollars on December 31, Year 2, using (1) the all-current translation method and (2) the monetary-nonmonetary translation method. Follow U.S. accounting principles by including the foreign exchange adjustment in a separate shareholders equity account under the all-current method and in net income (and, therefore, retained earnings) under the monetary-nonmonetary method. b. Prepare a statement of net income and retained earnings for the U.K. subsidiary for Year 2 in U.K. pounds and U.S. dollars using (1) the all-current translation method and (2) the monetary-nonmonetary translation method. This statement should reconcile the change in retained earnings during Year 2 in both U.K. pounds and U.S. dollars. Note that retained earnings on January 1, Year 2, is $168 under the all-current method and $91 under the monetary-nonmonetary method (see Exhibit 1). c. Prepare analyses that show the calculation of the foreign exchange adjustment for Year 2 under the allcurrent method and the monetary-nonmonetary method. Refer to Exhibits 3 and 4 for the formats for these analyses.

SUGGESTED SOLUTION TO PROBLEM FOR SELF-STUDY

(Domestic Company; translating foreign currency nancial statements.) a. Exhibit 5 presents the translated balance sheet. b. Exhibit 6 presents the translated income statement. c. Exhibit 7 presents the calculation of the foreign exchange adjustment under the all-current method, and Exhibit 8 presents the calculation of the foreign exchange gain or loss under the monetary-nonmonetary method.

KEY TERMS AND CONCEPTS Foreign currency translation Historical exchange rate Current exchange rate Foreign exchange adjustment Functional currency All-current translation method Monetary-nonmonetary translation method Monetary items Nonmonetary items International Accounting Standards Committee (IASC)

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EXHIBIT 5 Translation of Balance Sheet December 31, Year 2 (Problem for Self-Study) All-Current Method Pounds ASSETS Cash . . . . . . . . . . . . . . . . . . . . . . . . . . 140 Accounts Receivable. . . . . . . . . . . . . . . 160 Inventories. . . . . . . . . . . . . . . . . . . . . . 200 Property, Plant, and Equipment (net) . . . . . . . . . . . . . . . 400 Total Assets . . . . . . . . . . . . . . . . . . 900 LIABILITIES AND SHAREHOLDERS EQUITY Accounts Payable . . . . . . . . . . . . . . . . . 200 Bonds Payable . . . . . . . . . . . . . . . . . . . 450 Common Stock . . . . . . . . . . . . . . . . . . 100 Foreign Exchange Adjustment . . . . . . . . Retained Earnings . . . . . . . . . . . . . . . . 150 Total Liabilities and Shareholders Equity . . . . . . . . . . 900 Exchange Rate Dollars Monetary-Nonmonetary Method Pounds Exchange Rate Dollars

$1.8:1 $1.8:1 $1.8:1 $1.8:1

$ 252 288 360 720 $1,620

140 160 200 400 900

$1.8:1 $1.8:1 $2.015:1 $2.0:1

$ 252 288 403 800 $1,743

$1.8:1 $1.8:1 $2.0:1 Exh. 7 Exh. 6

$ 360 810 200 (58) 308

200 450 100 150

$1.8:1 $1.8:1 $2.0:1 Exh. 6

$ 360 810 200 373

$1,620

900

$1,743

EXHIBIT 6 Translation of Income Statement and Retained Earnings for Year 2 (Problem for Self-Study) All-Current Method Pounds Sales . . . . . . . . . . . . . . . . . . . . . . . . 1,200 Cost of Goods Sold . . . . . . . . . . . . . . (800) Selling and Administrative . . . . . . . . . (160) Depreciation . . . . . . . . . . . . . . . . . . . (50) Interest . . . . . . . . . . . . . . . . . . . . . . . (50) Income Taxes . . . . . . . . . . . . . . . . . . (45) Exchange Gain or Loss. . . . . . . . . . . . Net Income . . . . . . . . . . . . . . . . . . . . 95 Less Dividends . . . . . . . . . . . . . . . . . Increase in Retained Earnings . . . . . . Retained Earnings, January 1, Year 2 . (25) 70 80 Exchange Rate $2.0:1 $2.0:1 $2.0:1 $2.0:1 $2.0:1 $2.0:1 Dollars $ 2,400 (1,600) (320) (100) (100) (90) $ 190 (50) $ Exh. 1 $ 140 168 308 Monetary-Nonmonetary Method Exchange Pounds 1,200 (800) (160) (50) (50) (45) 95 (25) 70 80 Rate $2.0:1 $2.015:1 $2.0:1 $2.0:1 $2.0:1 $2.0:1 Exh. 8 Dollars $ 2,400 (1,612) (320) (100) (100) (90) 154 $ 332 (50) $ Exh. 1 $ 282 91 373

$2.0:1

$2.0:1

December 31, Year 2 . . . . . . . . . . 150

150

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EXHIBIT 7 Calculation of Foreign Exchange Adjustment for Year 2 All-Current Method (Problem for Self-Study) Pounds Net Assets Position, January 1, Year 2 . . . . . . . . . . . . . . . . . . Net Income for Year 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net Assets, December 31, Year 2 . . . . . . . . . . . . . . . . . . . . . .............................................. Change in Foreign Exchange Adjustment for Year 2 . . . . . . . . . Foreign Exchange Adjustment, January 1, Year 2. . . . . . . . . . . Foreign Exchange Adjustment, December 31, Year 2 . . . . . . . . 180 95 (25) 250 $1.8:1 Exchange Rate $2.2:1 $2.0:1 $2.0:1 Dollars $396 190 (50) $536 450 $ (86) 28 $ (58)

EXHIBIT 8 Calculation of Foreign Exchange Adjustment Monetary-Nonmonetary Method for Year 2 (Problem for Self-Study) Pounds January 1, Year 2. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Increases in Net Monetary Assets Cash and Accounts Receivable from Sales . . . . . . . . . . . . Decreases in Net Monetary Assets Purchase of Inventory on Account . . . . . . . . . . . . . . . . . . . Payment of Selling and Administrative Expenses . . . . . . . . Payment of Interest Expense . . . . . . . . . . . . . . . . . . . . . . Payment of Investments . . . . . . . . . . . . . . . . . . . . . . . . . . Payment of Dividends. . . . . . . . . . . . . . . . . . . . . . . . . . . . Net Monetary Asset (Liability) Position, December 31, Year 2. . . . . . . . . . . . . . . . . . . . . . . . . . . . ........................................... Foreign Exchange Gain, Year 2. . . . . . . . . . . . . . . . . . . . . . . . (420) Exchange Rate $2.2:1 Dollars $ (924)

1,200

$2.0:1

2,400

(850) (160) (50) (45) (25)

$2.0:1 $2.0:1 $2.0:1 $20:1 $2.0:1

(1,700) (320) (100) (90) (50)

(350) $1.8:1

$ (784) 630 $ 154

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QUESTIONS, EXERCISES, PROBLEMS, AND CASES

QUESTIONS

FORCUR 1. Review the meaning of the terms and concepts listed above in Key Terms and Concepts. FORCUR 2. a. The all-current translation method assumes that exchange-rate changes affect a foreign entitys net assets position (= assets minus liabilities = shareholders equity). Why are net assets the appropriate base for measuring exchange rate exposure when a foreign entitys operations are self-contained within the foreign country? b. The monetary-nonmonetary translation method assumes that exchange-rate changes affect a foreign entitys monetary assets and monetary liabilities. Why are net monetary items the appropriate base for measuring exchange-rate exposure when a foreign entitys operations are an integrated extension of the U.S. parent company? FORCUR 3. The foreign exchange adjustment using the all-current translation method does not affect net income each period but appears in other comprehensive income, a separate shareholders equity account. The foreign exchange adjustment using the monetary-nonmonetary translation method affects net income and retained earnings each period. Why do these two translation methods treat the exchange adjustment differently? FORCUR 4. The foreign currency of a foreign unit may increase or decrease in value relative to the U.S. dollar during a particular year. Which direction of change in the value of the foreign currency relative to the U.S. dollar will result in a credit change in other comprehensive income under the all-current translation method? Which direction of change results in a debit change in other comprehensive income? Explain. FORCUR 5. The foreign currency of a foreign unit may increase or decrease in value relative to the U.S. dollar during a particular period. Under what circumstances will a foreign exchange gain arise from the translation of a foreign units financial statements into U.S. dollars using the monetary-nonmonetary translation method? Under what circumstance will a foreign exchange loss arise? Explain. FORCUR 6. a. One can convert an income statement based on the all-current translation method into an income statement based on the monetary-nonmonetary translation method simply by including in net income the change during the period in the foreign exchange adjustment account under the all-current method. Do you agree? Why or why not? b. One can convert a balance sheet based on the all-current translation method into a balance sheet based on the monetary-nonmonetary method simply by reclassifying the exchange adjustment under the all-current method from a separate shareholders equity account into the retained earnings account. Do you agree? Why or why not? FORCUR 7. Translating the nancial statements of a particular foreign entity into U.S. dollars results in a debit change in other comprehensive income under the all-current translation method but a foreign exchange gain under the monetary-nonmonetary translation method for a particular period. Why does the direction of the foreign exchange adjustment differ for these two translation methods?
EXERCISES

FORCUR 8. Selecting the exchange rate for foreign currency translation. Firms might translate nancial statement items using the historical exchange rate (H), the average exchange rate during the current period (CA), or the exchange rate at the end of the current period (CE). Indicate the exchange rate used for each nancial statement item below under (1) the all-current translation method and (2) the monetary-nonmonetary translation method.

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a. Cash b. Accounts Receivable c. Inventories d. Prepaid Rent e. Investment in Securities (10 percent ownership) f. Land g. Building h. Accumulated Depreciation i. Patent j. Goodwill k. Accounts Payable l. Bank Loan Payable m. Bonds Payable n. Common Stock o. Sales p. Cost of Goods Sold q. Depreciation Expense r. Interest Expense s. Income Tax Expense FORCUR 9. Identifying the foreign currency translation method. Indicate whether each of the statements below refers to the all-current translation method (C), the monetary-nonmonetary translation method (MN), to both translation methods (B), or to neither translation method (N). a. Firms use this translation method when the foreign entity engages in frequent transactions with its U.S. parent company. b. Firms use this translation method when the foreign entity acquires and sells goods and services within the foreign country and pays no dividends to its U.S. parent company. c. Firms use this translation method when the foreign entity operates in a highly inationary environment. d. A foreign exchange gain or loss will not likely appear in the income statement each period when rms use this translation method. e. Firms use the current exchange rate to translate accounts receivable under this translation method. f. Firms use the current exchange rate to translate inventories under this translation method. g. Firms use the historical exchange rate to translate bonds payable under this translation method. h. Firms include cumulative foreign exchange gains and losses in retained earnings under this translation method. i. Firms use the current exchange rate to translate common stock under this translation method. j. Firms use the average exchange rate during the current period to translate income tax expense under this translation method. FORCUR 10. Identifying the nature of a foreign exchange adjustment. A condensed balance sheet for a foreign subsidiary for Year 6 appears in Exhibit 9. a. Assume that the foreign currency (FC) increased in value relative to the U.S. dollar during Year 6. What is the likely sign of the foreign exchange adjustment under the all-current translation method (adjustment included in other comprehensive income) and under the monetary-nonmonetary translation method (adjustment included in net income) for Year 6? Explain. b. Repeat part a, but assume that the foreign currency decreased in value relative to the U.S. dollar. FORCUR 11. Interpreting translated financial statements. Exhibit 10 presents the translated financial statements of Foreign Sub for its first year of operations. The first column shows the statements using the all-current translation method, and the second column shows the statements using the monetary-nonmonetary translation method. a. Did the foreign currency increase or decrease in value relative to the U.S. dollar during the year? Explain. b. Describe the cause of the negative foreign exchange adjustment of $25,200 on the balance sheet. c. Describe the cause of the foreign exchange gain of $10,000 on the income statement.

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EXHIBIT 9 Balance Sheet for Foreign Subsidiary (Exercise 10)

January 1, Year 6 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accounts Receivable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Inventories. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fixed Assets (net). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Current Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Long-term Debt. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Shareholders Equity. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total Liabilities and Shareholders Equity . . . . . . . . . . . . . . . . . . . . FC 10 50 40 100 FC 200 FC 80 50 70 FC 200

December 31, Year 6 FC 15 60 55 110 FC 240 FC 110 50 80 FC 240

EXHIBIT 10 FOREIGN SUB Translated Financial Statements (Exercise 11) All-Current Translation Method BALANCE SHEET Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Inventories (FIFO). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Property, Plant, and Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . Total Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accounts Payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Long-term Debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Common Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Foreign Exchange Adjustment . . . . . . . . . . . . . . . . . . . . . . . . . . . Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total Liabilities and Shareholders Equity . . . . . . . . . . . . . . . . INCOME STATEMENT Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Selling and Administrative . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Foreign Exchange Gain . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Monetary-Nonmonetary Translation Method

$ 12,000 48,000 36,000 80,000 $176,000 $60,000 48,000 80,000 (25,200) 13,200 $176,000

$ 12,000 48,000 40,000 100,000 $200,000 $60,000 48,000 80,000 12,000 $200,000

$152,000 (72,000) (36,000) (12,800) (4,000) (14,000) $ 13,200

$152,000 (80,000) (36,000) (16,000) (4,000) (14,000) 10,000 $ 12,000

PROBLEMS

FORCUR 12. Translating foreign currency nancial statements. U.S. Manufacturing, Inc., established a wholly-owned subsidiary in South America on January 2, Year 4, by contributing $600 for the subsidiarys common stock. The subsidiary issued long-term bonds for FC200 and acquired plant and equipment costing

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FC500 on January 2, Year 4. Exhibit 11 presents a balance sheet on December 31, Year 4, and a statement of income and retained earnings for Year 4 for this subsidiary. The subsidiary accrued revenues and expenses evenly during Year 4 and uses a weighted-average cost flow assumption for inventories and cost of goods sold. The exchange rates on various dates appear below:
Average Year 4 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . December 31, Year 4 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1.50:FC1 $1.00:FC1

a. Prepare a balance sheet as of December 31, Year 4, and a statement of income and retained earnings for Year 4 in U.S. dollars using the all-current translation method. Include a separate schedule showing the calculation of the foreign exchange adjustment included in other comprehensive income for Year 4. b. Repeat part a using the monetary-nonmonetary translation method. Include a separate calculation of the foreign exchange gain or loss for Year 4. c. Why is the sign (debit or credit) of the foreign exchange adjustment for Year 4 under the all-current translation method different from the sign under the monetary-nonmonetary translation method? d. Compute the ratio of net income to sales (1) in the foreign currency of the subsidiary, (2) in U.S. dollars using the all-current translation method, and (3) in U.S. dollars using the monetary-nonmonetary translation method. Why are the ratios under (1) and (2) the same? Why do the ratios under (2) and (3) differ?
EXHIBIT 11 SOUTH AMERICAN SUBSIDIARY Financial Statement Data (Problem 12) BALANCE SHEET Assets Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fixed Assets (net) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Liabilities and Shareholders Equity Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Common Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Retained Earnings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total Shareholders Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total Liabilities and Shareholders Equity. . . . . . . . . . . . . . . . . . . . . . . . STATEMENT OF INCOME AND RETAINED EARNINGS Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cost of Goods Sold. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Selling and Administrative Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Depreciation Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest Expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income Tax Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Dividends (Declared and Paid on December 31, Year 4) . . . . . . . . . . . . . . . Retained Earnings, December 31, Year 4 . . . . . . . . . . . . . . . . . . . . . . . . . . December 31, Year 4

100 200 300 400 FC 1,000

FC

FC FC FC FC FC

400 200 600 300 100 400 1,000

For Year 4 FC 2,000 (1,200) (400) (100) (20) (120) FC 160 (60) FC 100

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FORCUR 13. Translating foreign currency financial statements using the all-current method. Casey Corporation, a multinational U.S. corporation, established McGann Corporation, a wholly-owned Irish subsidiary, by contributing $300,000 on January 1, Year 1. Exhibit 12 presents the financial statements of McGann Corporation for Year 1 and Year 2 measured in Irish pounds. The exchange rates on various dates appear below:
January 1, Year 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Average, Year 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . December 31, Year 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Average, Year 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . December 31, Year 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1.50:1 $1.48:1 $1.45:1 $1.49:1 $1.52:1

a. Prepare a balance sheet as of December 31, Year 1, and an income statement and retained earnings statement for Year 1 in U.S. dollars using the all-current translation method. Include a separate calculation of the foreign exchange adjustment for Year 1. b. Repeat part a for Year 2. c. Explain the reason for the sign (debit versus credit) of the foreign exchange adjustment for Year 1. d. Explain the reason for the sign (debit versus credit) of the foreign exchange adjustment for Year 2. e. Compute the ratio of net income to sales revenue for each year using financial data expressed in Irish pounds and in U.S. dollars. Why is this ratio the same in each year regardless of whether the calculation uses Irish pounds or U.S. dollars?

EXHIBIT 12 MCGANN CORPORATION Financial Statement Data (Problem 13) December 31, Year 1 BALANCE SHEET Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fixed Assets (net) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ............................................ Account Payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Notes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Common Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ............................................ INCOME STATEMENT Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Depreciation Expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . RETAINED EARNINGS STATEMENT Balance, Beginning of Year . . . . . . . . . . . . . . . . . . . . . . . . . . . Net Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Dividends (declared and paid December 31) . . . . . . . . . . . . . . Balance, End of Year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . December 31, Year 2

40,000 80,000 90,000 125,000 335,000 120,000 200,000 15,000 335,000

75,000 110,000 200,000 100,000 485,000 150,000 100,000 200,000 35,000 485,000

500,000 (300,000) (25,000) (155,000) 20,000

600,000 (360,000) (25,000) (185,000) 30,000

20,000 (5,000) 15,000

15,000 30,000 (10,000) 35,000

Foreign Currency Translation

18

FORCUR 14. Translating foreign currency financial statements. U.S. Rental Properties, Inc., established Canadian Subsidiary on January 2, Year 1, by contributing U.S.$500,000 for all of the subsidiarys common stock. Canadian Subsidiary invested C$500,000 in a building with an expected useful life of 20 years and rented it to tenants. Exhibit 13 presents balance sheets and income statements for Canadian Subsidiary for Year 1 and Year 2. Revenues and expenses accrued evenly over each year. Canadian Subsidiary declared and paid dividends of $30,000 on December 31, Year 1, and $39,000 on December 31, Year 2. The exchange rates on various dates appear below:
January 2, Year 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Average, Year 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . December 31, Year 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Average, Year 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . US$.90:C$1.00 US$.85:C$1.00 US$.80:C$1.00 US$.82:C$1.00

a. Prepare a balance sheet as of December 31, Year 1, and an income statement and retained earnings statement for Year 1 in U.S. dollars using the all-current translation method. Include a separate calculation of the foreign exchange adjustment for Year 1. b. Repeat part a using the monetary-nonmonetary translation method. Include a separate calculation of the foreign exchange gain or loss for Year 1. c. Repeat part a using the all-current translation method for Year 2. d. Repeat part a using the monetary-nonmonetary translation method for Year 2.
EXHIBIT 13 CANADIAN SUBSIDIARY Financial Statement Data (Problem 14)

December 31 BALANCE SHEET Assets Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Rent Receivable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Building (net) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Liabilities and Shareholders Equity Accounts Payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Salaries Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Common Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total Liabilities and Shareholders Equity . . . . . . . . . . . . . . . . Year 1 Year 2

C$

77,555 25,000 475,000 C$ 577,555

C$ 116,555 30,000 450,000 C$ 596,555

C$

6,000 4,000 555,555 12,000 C$ 577,555

C$

7,500 5,500 555,555 28,000 C$ 596,555

INCOME STATEMENT Rent Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Operating Expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Depreciation Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income Tax Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

For the Year Ended December 31 Year 1 Year 2 C$ 125,000 (28,000) (25,000) (30,000) C$ 42,000 C$ 150,000 (34,000) (25,000) (36,000) C$ 55,000