Foreign Currency Financial Statements

1. Foreign CurrencyFinancial Statements Chapter 13

2. Learning Objective 1 Understand the functional currency concept.

3. Application of the FunctionalCurrency Concept A foreign subsidiary’s foreign currency statements must be in conformity with U.S. GAAP before translation into U.S. dollars. Adjustments are required before translation is performed.

4. Application of the FunctionalCurrency Concept All account balances on the balance sheet date denominated in a foreign currency (from the foreign entity’s point of view) are adjusted to reflect current exchange rates.

5. Application of the FunctionalCurrency Concept Under the functional currency concept, a foreign entity’s assets, liabilities, and operations must be measured in its functional currency.

6. $ £ ¥ € Application of the FunctionalCurrency Concept Subsequently, the foreign entity’s balance sheet and income statement are consolidated (subsidiary) or combined (branch) with those of the reporting enterprise’s currency.

7. Learning Objective 2 Determine a subsidiary’s functional currency.

8. Translation Translation involves expressing functional currency measurements in the reporting currency. Current rate method

9. Remeasurement When the foreign entity’s books are not maintained in its functional currency, the foreign currency financial statements must be remeasured into the functional currency. Temporal method

10. Remeasurement Monetary assets and liabilities Current exchange rates Nonmonetary items Historical rates

11. Learning Objective 3 Produce financial statements using translation or remeasurement, or both.

12. Translation and Remeasurement ofForeign Currency Financial Statements Patriot Corporation, a U.S. company, has a wholly-owned subsidiary, Regal Corporation, that operates in England.

13. Currency of Required Procedures Functional Accounting for Consolidating Currency Records or Combining Case 1 British pounds British pounds Translation Case 2 U.S. dollar British pounds Remeasurement Case 3 Euro British pounds Remeasurement and translation Translation and Remeasurement ofForeign Currency Financial Statements Regal's translation-remeasurement possibilities:

14. Intercompany ForeignCurrency Transactions These transactions are foreign currency transactions if they produce receivable or payable balances denominated in a currency other than the entity’s (parent’s or subsidiary’s) functional currency.

15. Loan Functional Foreign Currency Denominated Currency of Transaction of Currency Subsidiary Subsidiary? Parent? Case 1 British pound British pound No Yes Case 2 British pound U.S. dollar Yes Yes Case 3 U.S. dollar British pound Yes No Case 4 U.S. dollar U.S. dollar No No Intercompany ForeignCurrency Transactions A U.S. parent company borrows $1,600,000 (£1,000,000) from its British subsidiary.

16. Foreign Entities Operating inHighly Inflationary Economies Price-level-adjusted financial statements are not basic financial statements under GAAP. The reporting currency (the U.S. dollar) is used to remeasure the financial statements of foreign entities in highly inflationary economies.

17. Foreign Entities Operating inHighly Inflationary Economies Statement No. 52defines a “highly inflationary economy” as one with a cumulative three-year inflation rate of 100% or more.

18. Business Combinations The assets and liabilities of a foreign entity are translated into U.S. dollars using the current exchange rate in effect on the date of the business combination. Cost/book value differential Minority interest

19. Learning Objective 4 Apply the current rate translation method.

20. Translation Under Statement No. 52 On December 31, 2003, Pat Corporation, a U.S. firm, paid $525,000 cash to acquire all the stock of the British firm, Star Company. The book value of Star’s net assets was $375,000, which was equal to the fair value. The British pound exchange rate was $1.50.

21. British Exchange U.S. (000) Pounds Rate Dollars Assets Cash 140 $1.50 210 Accounts receivable 40 1.50 60 Inventories (cost) 120 1.50 180 Plant assets 100 1.50 150 Less: Accumulated depr. –20 1.50 –30 Total assets 380 570 Translation Under Statement No. 52 Star's assets and equities on December 31, 2003:

22. Translation Under Statement No. 52 Star's assets and equities on December 31, 2003: British Exchange U.S. (000) Pounds Rate Dollars Equities Accounts payable 30 $1.50 45 Bonds payable 100 1.50 150 Capital stock 200 1.50 300 Retained earnings 50 1.50 75 Total equities 380 570

23. Translation Under Statement No. 52 The 2004 year-end exchange rate was $1.40. Average exchange rates for 2004 were $1.45. Star paid £30,000 dividends on December 1, 2004, when the exchange rate was $1.42 per British pound. The only intercompany transaction was an $84,000 (£56,000) non-interest-bearing advance by Star to Pat made on January 4, 2004, when the exchange rate was still $1.50.

24. Translation Under Statement No. 52 What is Star’s adjustment at year end? Advance to Pat £4,000 Exchange Gain £4,000 To adjust receivable denominated in dollars [($84,000 ÷ $1.40) – £56,000 per books]

25. ₤ Trial Translation $ Trial Debits (000) Balance Rate Balance Cash 110 $1.40 154.0 Accounts receivable 80 1.40 112.0 Inventories (FIFO) 120 1.40 168.0 Plant assets 100 1.40 140.0 Advance to Pat 60 1.40 84.0 Cost of sales 270 1.45 391.5 Depreciation 10 1.45 14.5 Wages and salaries 120 1.45 174.0 Other expenses 60 1.45 87.0 Dividends 30 1.42 42.6 Accumulated income – 28.6 960 1,396.2 Star Company TranslationWorksheet for 2004

26. Star Company TranslationWorksheet for 2004 ₤ Trial Translation $ Trial Credits (000) Balance Rate Balance Accumulated depreciation 30 $1.40 42.0 Accounts payable 36 1.40 50.4 Bonds payable 100 1.40 140.0 Capital stock 200 1.50 300.0 Retained earnings 50 computed 75.0 Sales 540 1.45 783.0 Exchange gain (advance) 4 1.45 5.8 960 1,396.2

27. Star Company Income and RetainedEarnings Statement for the Year 2004 Sales $783,000 Less costs and expenses Cost of sales $391,500 Depreciation 14,500 Wages and salaries 174,000 Other expenses 87,000 667,000 Operating income $116,000 Exchange gain 5,800 Net income $121,800 Retained earnings January 1, 2004 75,000 $196,800 Less: Dividends 42,600 Retained earnings December 31, 2004 $154,200

28. Star Company Balance Sheetat December 31, 2004 Assets Cash $154,000 Accounts receivable 112,000 Inventories 168,000 Plant assets 140,000 Less: Accumulated depreciation – 42,000 Advance to Pat 84,000 $616,000 Equities Accounts payable $ 50,400 Bonds payable 140,000 Capital stock 300,000 Retained earnings 154,200 Accumulated other comprehensive income – 28,600 $616,000

29. Equity Method of Accounting What is Pat’s entry to record receipt of the £30,000 ($42,600) dividend ? Cash $42,600 Investment in Star $42,600 To record dividend received

30. Patent Amortization $525,000 – $375,000 = $150,000 $150,000 ÷ $1.50 = £100,000 £100,000 ÷ 10 years × $1.45 = $14,500 Pat’s Books Income from Star 14,500 Other Comprehensive Income: Equity Adjustment from Translation 9,500 Investment in Star 24,000

31. Equity Adjustment Alternatively, the $9,500 equity adjustment can be computed as follows: £10,000 amortization × ($1.50 – $1.45) exchange rate decline to midyear $ 500 £90,000 unamortized patent × ($1.50 – $1.40) exchange rate decline for the year 9,000 Equity adjustment $9,500

32. Investment in Foreign Subsidiary(Summary) Changes is Pat’s investment in Star account during 2004: Investment cost December 31, 2003 $525,000 Less: Dividends received 2004 – 42,600 Add: Equity in Star’s net income 121,800 Less: Unrealized loss on translation – 28,600 Less: Patent amortization – 14,500 Less: Unrealized translation loss on patent – 9,500 Investment balance December 31, 2004 $551,600

33. Income Statement (000) Adjustments/ Consol- Pat Star Eliminations idated Sales Income from Star Cost of sales Depreciation Wages and salaries Other expenses Exchange gain Net income Retained earnings – Pat Retained earnings – Star Dividends Retained earnings 12/31/04 $1,218.3 107.3 (600) (40) (300) (150) $ 235.6 $ 245.5 (100) $ 381.1 $783 (391.5) (14.5) (174) (87) 5.8 $121.8 $ 75 (42.6) $154.2 a 107.3 c 14.5 b 75 a 42.6 $2,001.3 (991.5) (54.5) (474) (251.5) 5.8 $ 235.6 $ 245.5 (100) $ 381.1 Consolidation Working Papers for theYear Ended December 31, 2004

34. Consolidation Working Papers for theYear Ended December 31, 2004 Balance Sheet (000) Adjustments/ Consol- Pat Star Eliminations idated Cash Accounts receivable Inventories Plant assets Accumulated depreciation Advance to Pat Investment – Star Patent Accounts payable Advance from Star Bonds payable Capital stock retained earnings Other income $ 317.6 150 300 400 (100) 551.6 $1,619.2 $ 142.2 84 250 800 381.1 (38.1) $1,619.2 $154 112 168 140 (42) 84 $616 $ 50.4 140 300 154.2 (28.6) $616 d 84 a 64.7 b 486.9 b 140.5 c 14.5 d 84 b 300 b 28.6 $ 471.6 262 468 540 (142) 126 $1,725.6 $ 192.6 390 800 381.1 (38.1) $1,725.6

35. Learning Objective 5 Apply the temporal translation method.

36. Remeasurement UnderStatement No. 52 The objective of remeasurement is to produce the same results as if the books had been maintained in the U.S. dollar. Remeasurement Temporal method Translation Current rate method

37. Remeasurement UnderStatement No. 52 Under remeasurement procedures, the $150,000 patent value is not adjusted for subsequent changes in exchange rates. Annual amortization = $15,000

38. Remeasurement UnderStatement No. 52 The £56,000 ($84,000) advance to Pat is not a foreign currency transaction of either Pat or Star. Star’s monetary items other than the intercompany advance are remeasured at current exchange rates.

39. The Equity Method Pat's Books Investment in Star $525,000 Cash $525,000 To record acquisition on December 31, 2003

40. The Equity Method Cash $42,600 Investment in Star $42,600 To record dividends received on December 1, 2004 Investment in Star $87,600 Income from Star $87,600 To record investment income for 2004 equal to Star’s $102,600 net income less $15,000 patent amortization

41. Consolidated Translation Remeasurement Sales $2,001,300 $2,001,300 Less: Cost of sales 991,500 1,001,100 Wages and salaries 474,000 474,000 Other expenses 237,000 237,000 Depreciation 54,500 55,000 Patent amortization 14,500 15,000 Operating income $ 229,800 $ 219,200 Exchange gain (loss) 5,800 – 3,300 Net income $ 235,600 $ 215,900 Retained earnings 01/01/04 245,500 245,500 $ 481,100 $ 461,400 Less: Dividends 100,000 100,000 Retained earnings 12/31/04 $ 381,100 $ 361,400 Income and Retained EarningsStatements for the Year Ended 12/31/04

42. Consolidated Translation Remeasurement Assets Cash $ 471,600 $ 471,600 Accounts receivable 262,000 262,000 Inventories 468,000 470,400 Plant assets 540,000 550,000 Less: Accumulated depreciation – 142,000 – 145,000 Patent 126,000 135,000 Total assets $1,725,600 $1,744,000 Balance Sheetsfor the Year Ended 12/31/04

43. Balance Sheetsfor the Year Ended 12/31/04 Consolidated Translation Remeasurement Liabilities Accounts payable $ 192,600 $ 192,600 Bonds payable 390,000 390,000 Total liabilities $ 582,600 $ 582,600 Stockholders’ Equity Capital stock $ 800,000 $ 800,000 Retained earnings 381,100 361,400 Other income – 38,100 – Total stockholders’ equity $1,143,000 $1,161,400 Total liabilities and stockholders’ equity $1,725,600 $1,744,000

44. Translation With Minority Interest On January 1, 2003, Pacific Corporation, a U.S. firm, paid $232,500 cash to acquire a 90% interest in Sea, a foreign company. Sea’s stockholders’ equity consisted of 1,000,000 LCU capital stock and 500,000 LCU retained earnings. The exchange rate was $0.15. Pacific designated Sea’s functional currency to be the subsidiary’s local currency unit.

45. 10% to 90% to Minority Pacific Interests Total Stockholders’ equity January 1 $202,500 $22,500 $225,000 Net income 21,600 2,400 24,000 Dividends – 14,400 – 1,600 – 16,000 Equity adjustment 27,450 3,050 30,500 Stockholders’ equity December 31 $237,150 $26,350 $263,500 Minority Interest

46. End of Chapter 13