Charles Edward Company established a subsidiary in a foreign country on January 1, 2011, by investing FC 3,200,000 when the exchange rate was $0.50/FC. Charles Edward negotiated a bank loan of FC 3,000,000 on January 5, 2011, and purchased plant and equipment in the amount of FC 6,000,000 on January 8, 2011. It depreciated plant and equipment on a straight-line basis over a 10-year useful life. It purchased its beginning inventory of FC 1,000,000 on January 10, 2011, and acquired additional inventory of FC 4,000,000 at three points in time during the year at an average exchange rate of $0.43/FC. It uses the first-in, first-out (FIFO) method to determine cost of goods sold. Additional exchange rates per FC 1 during the year 2011 follow:
January 1–31, 2011 . . . . . . . . . . . . . . $0.50
Average 2011 . . . . . . . . . . . . . . . . . . . 0.45
December 31, 2011 . . . . . . . . . . . . . . 0.38
The foreign subsidiary’s income statement for 2011 and balance sheet at December 31, 2011, follow:
INCOME STATEMENT
For the Year Ended December 31, 2011
FC (in thousands)
Sales. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . FC 5,000
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000
Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000
Selling expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400
Depreciation expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600
Income before tax. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000
Income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300
Net income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 700
Retained earnings, 1/1/11. . . . . . . . . . . . . . . . . . . . . . . . . . . –0–
Retained earnings, 12/31/11 . . . . . . . . . . . . . . . . . . . . . . . FC 700
BALANCE SHEET
At December 31, 2011
FC (in thousands)
Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .FC 1,000
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000
Fixed assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000
Less: Accumulated depreciation . . . . . . . . . . . . . . . . . . . . . (600)
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .FC 8,400
Current liabilities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . FC 1,500
Long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000
Contributed capital. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3,200
Retained earnings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 700
Total liabilities and stockholders’ equity . . . . . . . . . . . FC 8,400
As the controller for Charles Edward Company, you have evaluated the characteristics of the foreign subsidiary to determine that the FC is the subsidiary’s functional currency.
Required
a. Use an electronic spreadsheet to translate the foreign subsidiary's FC financial statements into U.S. dollars at December 31, 2011, in accordance with U.S. GAAP. Insert a row in the spreadsheet after retained earnings and before total liabilities and stockholders' equity for the cumulative translation adjustment. Calculate the translation adjustment separately to verify the amount obtained as a balancing figure in the translation worksheet.
b. Use an electronic spreadsheet to remeasure the foreign subsidiary's FC financial statements in U.S. dollars at December 31, 2011, assuming that the U.S. dollar is the subsidiary's functional currency. Insert a row in the spreadsheet after depreciation expense and before income before taxes for the remeasurement gain (loss).
c. Prepare a report for James Edward, CEO of Charles Edward, summarizing the differences that will be reported in the company's 2011 consolidated financial statements because the FC, rather than the U.S. dollar, is the foreign subsidiary's functional currency. In your report, discuss the relationship 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. Also discuss the meaning of the translated U.S. dollar amounts for inventory and for fixed assets.
SOLUTION
a. Spreadsheet for the translation (current rate method) and remeasurement (temporal method) of the FC financial statements of Charles Edward Company’s foreign subsidiary.
| | | Temporal Method | Temporal Method | Temporal Method | Temporal Method | Temporal Method | Temporal Method | Current Rate Method | Current Rate Method | Current Rate Method | Current Rate Method | Current Rate Method | Current Rate Method |
|---|
| December 31, 2011 | FC | FC | Rate | Rate | | | USD | USD | Rate | Rate | | | USD | USD |
| Sales | 5,000 | 5,000 | $0.45 | $0.45 | A | A | $2,250 | $2,250 | $0.45 | $0.45 | A | A | $2,250 | $2,250 |
| Cost of goods sold | (3,000) | (3,000) | calculation | calculation | | | (1,360) | (1,360) | $0.45 | $0.45 | A | A | (1,350) | (1,350) |
| Gross profit | 2,000 | 2,000 | subtotal | subtotal | | | 890 | 890 | subtotal | subtotal | | | 900 | 900 |
| Selling expense | (400) | (400) | $0.45 | $0.45 | A | A | (180) | (180) | $0.45 | $0.45 | A | A | (180) | (180) |
| Depreciation expense | (600) | (600) | $0.50 | $0.50 | H | H | (300) | (300) | $0.45 | $0.45 | A | A | (270) | (270) |
| Remeasurement gain/loss | 0 | 0 | to balance | to balance | | | 355 | 355 | n/a | n/a | | | 0 | 0 |
| Income before tax | 1,000 | 1,000 | subtotal | subtotal | | | 765 | 765 | subtotal | subtotal | | | 450 | 450 |
| Income taxes | (300) | (300) | $0.45 | $0.45 | A | A | (135) | (135) | $0.45 | $0.45 | A | A | (135) | (135) |
| Net income | 700 | 700 | subtotal | subtotal | | | 630 | 630 | subtotal | subtotal | | | 315 | 315 |
| Retained earnings, 1/1/11 | 0 | 0 | | | | | 0 | 0 | | | | | 0 | 0 |
| Retained earn, 12/31/11 | 700 | 700 | from B/S | from B/S | | | 630 | 630 | total | total | | | 315 | 315 |
| Cash | 1,000 | 1,000 | $0.38 | $0.38 | C | C | 380 | 380 | $0.38 | $0.38 | C | C | 380 | 380 |
| Inventory | 2,000 | 2,000 | $0.43 | $0.43 | H | H | 860 | 860 | $0.38 | $0.38 | C | C | 760 | 760 |
| Fixed assets | 6,000 | 6,000 | $0.50 | $0.50 | H | H | 3,000 | 3,000 | $0.38 | $0.38 | C | C | 2,280 | 2,280 |
| Less: accum/deprec | (600) | (600) | $0.50 | $0.50 | H | H | (300) | (300) | $0.38 | $0.38 | C | C | (228) | (228) |
| Total assets | 8,400 | 8,400 | total | total | | | 3,940 | 3,940 | total | total | | | 3,192 | 3,192 |
| Current liabilities | 1,500 | 1,500 | $0.38 | $0.38 | C | C | 570 | 570 | $0.38 | $0.38 | C | C | 570 | 570 |
| Long-term debt | 3,000 | 3,000 | $0.38 | $0.38 | C | C | 1,140 | 1,140 | $0.38 | $0.38 | C | C | 1,140 | 1,140 |
| Contributed capital | 3,200 | 3,200 | $0.50 | $0.50 | H | H | 1,600 | 1,600 | $0.50 | $0.50 | H | H | 1,600 | 1,600 |
| Cum. trans. adjust. | 0 | 0 | n/a | n/a | | | 0 | 0 | to balance | to balance | | | (433)* | (433)* |
| Retained earnings | 700 | 700 | to balance | to balance | | | 630 | 630 | from I/S | from I/S | | | 315 | 315 |
| Total liab and stock equity | 8,400 | 8,400 | A=L+SE | A=L+SE | | | 3,940 | 3,940 | A=L+SE | A=L+SE | | | 3,192 | 3,192 |
| Exchange Rates | | | Temporal method—COGS (on a FIFO basis) | Temporal method—COGS (on a FIFO basis) | Temporal method—COGS (on a FIFO basis) | Temporal method—COGS (on a FIFO basis) | Temporal method—COGS (on a FIFO basis) | Temporal method—COGS (on a FIFO basis) | Temporal method—COGS (on a FIFO basis) | Temporal method—COGS (on a FIFO basis) | Temporal method—COGS (on a FIFO basis) | Temporal method—COGS (on a FIFO basis) | Temporal method—COGS (on a FIFO basis) | Temporal method—COGS (on a FIFO basis) |
| January 1-31, 2011 | $0.50 | $0.50 | BI | BI | | | 1,000 | 1,000 | $0.50 | $0.50 | H | H | $500 | $500 |
| Average 2011 | $0.45 | $0.45 | P | P | | | 4,000 | 4,000 | $0.43 | $0.43 | H | H | 1,720 | 1,720 |
| December 31, 2011 | December 31, 2011 | $0.38 | $0.38 | EI | EI | | | (2,000) | (2,000) | $0.43 | $0.43 | H | H | (860) | (860) |
| Inventory purchases | Inventory purchases | $0.43 | $0.43 | COGS | COGS | | | 3,000 | 3,000 | | | | | $1,360 | $1,360 |
| Key: | Key: | | | | | | | | | | | | | | |
| Average Exchange Rate | Average Exchange Rate | A | A | | | | | | | | | | | | |
| Current Exchange Rate | Current Exchange Rate | C | C | | | | | | | | | | | | |
| Historical Exchange Rate | Historical Exchange Rate | H | H | | | | | | | | | | | | |
| *Computation of Translation Adjustment | *Computation of Translation Adjustment | *Computation of Translation Adjustment | |
|---|
| FC | | USD |
| Net assets, 1/1/11 | 3,200 | $0.50 | 1,600 |
| Net income, 2011 | 700 | $0.45 | 315 |
| Net assets, 12/31/11 | 3,900 | | 1,915 |
| Net assets, 12/31/11 | | | |
| at current exchange rate | 3,900 | $0.38 | 1,482 |
| Translation adjustment (negative) | Translation adjustment (negative) | | 433 |
| 2. | With the FC as functional currency, the U.S. dollar net income reflected in the consolidated income statement is $315. If the U.S. dollar were the functional currency, the amount would be twice as much—$630. The amount of total assets reported on the consolidated balance sheet is 23.4% smaller than if the U.S. dollar were functional currency [($3,940 – $3,192)/$3,192]. | | |
| The relations between the current ratio, the debt to equity ratio, and profit margin calculated from the FC financial statements and from the translated U.S. dollar financial statements are shown below. | | |
| FC | Temporal | Current Rate |
|---|
| Current ratio | | | |
| CA | 3,000 | 1,240 | 1,140 |
| CL | 1,500 | 570 | 570 |
| 2.0 | 2.1754 | 2.0 |
| Debt to equity ratio | | | |
| Total liabilities | 4,500 | 1,710 | 1,710 |
| Total stockholders’ equity | 3,900 | 2,230 | 1,482 |
| 1.15385 | 0.76682 | 1.15385 |
| Profit margin | | | |
| NI | 700 | 630 | 315 |
| Sales | 5,000 | 2,250 | 2,250 |
| 0.14 | 0.28 | 0.14 |
| Return on equity | | | |
| NI | 700 | 630 | 315 |
| Average TSE | 3,550 | 1,915 | 1,541 |
| 0.19718 | 0.32898 | 0.20441 |
| Inventory turnover | | | |
| COGS | 3,000 | 1,360 | 1,350 |
| Average Inventory | 1,000 | 430 | 380 |
| 3 | 3.16279 | 3.55263 |
| c. | These results show that the temporal method distorts all ratios as calculated from the original foreign currency financial statements. The current rate method maintains all ratios that use numbers in the numerator and denominator from the balance sheet only (current ratio, debt-to-equity ratio) or the income statement only (profit margin). For ratios that combine numbers from the income statement and balance sheet (return on equity, inventory turnover), even the current rate method creates distortions. | | |
The U.S. dollar amounts reported under the temporal method for inventory and fixed assets reflect the equivalent U.S. dollar cost of those assets as if the parent had sent dollars to the subsidiary to purchase the assets. For example, to purchase FC 6,000 worth of fixed assets when the exchange rate was $.50/FC, the parent would have had to provide the subsidiary with $3,000.
The U.S. dollar amounts reported under the current rate method for inventory and fixed assets reflect neither the equivalent U.S. dollar cost of those assets nor their U.S. dollar current value. By multiplying the FC historical cost by the current exchange rate, these assets are reported at what they would have cost in U.S. dollars if the current exchange rate had been in effect when they were purchased. This is a hypothetical number with little, if any, meaning.