FOREIGN CURRENCY FINANCIAL STATEMENTS

 1218

Part 4

EM

Other Dimensions of Financial Reporting

This example shows the impact of both general and specific price changes on only one item. It is indeed a complex problem to determine and report such information for all items on a balance sheet as well as to trace the impact of real and inflationary and realized and unrealized holding gains and losses through the income statement.

Summary

For now,financial statements in the United States do not include any adjustment for inflation. Many items, particularly inventory and property, plant, and equipment, are not reported at their current values. The preceding section has given a brief overview of some of the concepts involved with the accounting for changing prices and has illustrated the factors that can cause historical cost to be a misleading number. In conducting an analysis of a company's financial statements, realize that many reported numbers do not reflect current values.When examining a company's sales trend over time,remember that the sales numbers have not been adjusted for inflation.And especially be aware that the distorting impact of changing prices does not impact all companies equally--a company with older property, plant, and equipment has financial statement numbers that differ more from current values than does a company with newer assets.

Financial statements of a U.S. company's foreign subsidiaries must be converted into U.S. dollars before they can be consolidated with the financial statements of the U.S. parent. This expanded material outlines how this conversion is done and how the resulting foreign currency translation adjustments arise. The expanded material also includes a comprehensive cash flow example that brings together many of the topics covered throughout the text.

Convert foreign currency financial statements into U.S. dollars using the translation method.

FOREIGN CURRENCY FINANCIAL STATEMENTS

In Chapter 9 (inventory purchases) and Chapter 18 (derivatives), the issues associated with foreign exchange rates and their impact on accounting for transactions were introduced. In this section, the concepts associated with foreign currency are extended to include entire foreign currency financial statements. Foreign currency financial statements are financial statements prepared in a currency other than the U.S. dollar. For example, IBM has many European subsidiaries whose internal financial statements are prepared in French francs,deutsche marks,and so forth.Those financial statements,when submitted to IBM headquarters in Armonk, New York, must be converted into U.S. dollars. There are two methods for converting foreign currency financial statements--translation and remeasurement. Translation is used when the foreign subsidiary is a relatively self-contained unit that is independent from the parent company's operations. Remeasurement is appropriate when the subsidiary does not operate independently of the parent company.The translation process simply converts the foreign currency financial statements into U.S. dollars for consolidation with the parent company's statements, while remeasurement involves remeasuring the financial statements as though the transactions had been originally recorded in U.S. dollars.

To determine the correct method of conversion, the functional currency of the foreign subsidiary must first be determined. In most instances, the functional currency is

 Analysis of Financial Statements

EM

Chapter 21

1219

the currency in which most of the subsidiary's transactions are denominated.8 If the functional currency is the local currency,the subsidiary is considered to be self-contained and its financial statements are translated into U.S. dollars. If the functional currency is the U.S. dollar, the subsidiary is considered to be just a branch office of the parent and the financial statements are remeasured into U.S. dollars. Most foreign entities are selfcontained and use their local currency as the functional currency; thus, their financial statements are converted into U.S.dollars by translation.Therefore,this chapter discusses the translation process. Coverage of remeasurement is left to an advanced accounting course.

Translation

Translation involves converting financial statement information from a subsidiary's func-

tional currency to the parent company's reporting currency using the current exchange

rate.The specifics are listed below.

? Assets and liabilities are translated using the current exchange rate prevailing as of

the balance sheet date.

? Income statement items are translated at the average exchange rate for the year. ? Dividends are translated using the exchange rate prevailing on the date the dividends

were declared.

? Capital stock is translated at the historical rate, that is, the rate prevailing on the date

the subsidiary was acquired or the stock was issued.

? Retained earnings is translated in the first year using historical rates, but in subse-

quent years, it is computed by taking the balance in retained earnings from the prior

period's translated financial statements, adding translated net income, and subtract-

ing translated dividends.

Double-entry accounting works the same for foreign subsidiaries as it does for U.S. companies--when a local currency trial balance is prepared, debits equal credits. However, as a result of the translation process, debits in the translated U.S. dollar trial balance typically will not equal credits. The balancing figure is called a translation adjustment and is recognized as part of the U.S. parent company's stockholders' equity.

To illustrate the translation process, consider the following example. USA Company purchased French Inc. on January 1, 2002, for 50,000 francs. On that date, the exchange rate for 1 French franc was $0.25, so the acquisition price was equivalent to $12,500. On December 31, 2002, the following trial balance for French Inc. is available.The current exchange rate is $0.28, and the average exchange rate for the year was $0.27. Dividends were declared and paid when the exchange rate was $0.275.

Cash ........................................ Accounts Receivable............... Inventory ................................. Equipment ............................... Cost of Goods Sold ................ Expenses ................................. Dividends ................................

Total debits ..............................

10,000 francs 35,000 65,000 90,000 60,000 30,000 10,000

300,000 francs

Accounts Payable ......................... Long-Term Debt............................. Capital Stock ................................ Retained Earnings ........................ Sales ..............................................

50,000 francs 80,000 30,000 20,000 120,000

Total credits ................................... 300,000 francs

If French Inc. determines its functional currency to be the French franc, translation is required to convert the financial statements into U.S. dollars for consolidation with USA Company's financial statements.As stated previously,the current rate is used to translate assets and liabilities,and the average rate is used to translate income statement items. The translation process is as follows:

8 Statement of Financial Accounting Standards No. 52, "Foreign Currency Translation," Stamford, CT: Financial Accounting Standards Board, 1981, Appendix A.

 1220

Part 4

EM

Other Dimensions of Financial Reporting

December 31, 2002

Cash ........................................ Accounts Receivable ............... Inventory.................................. Equipment ............................... Cost of Goods Sold ................ Expenses ................................. Dividends ................................

Accounts Payable.................... Long-Term Debt........................ Capital Stock........................... Retained Earnings ................... Sales ........................................ Translation Adjustment ............

Trial Balance (In French francs)

10,000 35,000 65,000 90,000 60,000 30,000 10,000 300,000

50,000 80,000 30,000 20,000 120,000

300,000

Exchange Rate

$0.28 0.28 0.28 0.28 0.27 0.27 0.275

$0.28 0.28 0.25 0.25 0.27

Trial Balance (In U.S. dollars)

$ 2,800 9,800

18,200 25,200 16,200

8,100 2,750

$83,050

$14,000 22,400 7,500 5,000 32,400 1,750

$83,050

FYI: For comparison, remeasurement uses historical rates in converting assets such as equipment and land. The historical rate is also used for converting the associated depreciation expense.

FYI: With remeasurement, the adjustment needed to balance the foreign subsidiary's U.S. dollar trial balance is recognized as a foreign currency gain or loss and is included in the income statement of the U.S. parent company.

In this example, French Inc. requires an additional credit of $1,750 to balance the U.S.dollar trial balance.This translation adjustment can be thought of as a deferred gain. USA Company invested 50,000 francs in French Inc. when one franc was worth $0.25. By year-end, each franc was worth $0.28, suggesting that USA Company had experienced a gain of approximately $1,500 [50,000 francs ? ($0.28 ? $0.25)].The reason the deferred gain is not exactly equal to $1,500 is that the investment just didn't sit there during the year--transactions occurred (sales, expenses, and dividends) that impacted the amount of USA Company's net franc investment.

The U.S. dollar amounts for the French Inc. financial statement items are added to USA Company's amounts as part of the consolidation process. In addition, the translation adjustment is shown as a separate item in USA Company's equity section. The translation adjustment is recognized as a deferred gain (or loss) rather than as an income statement gain or loss because the only way the foreign currency gain can be realized is through liquidation of all the assets and liabilities of the foreign subsidiary. If the foreign subsidiary is a self-contained going concern, as it is assumed to be when the functional currency is the local currency and translation is used, it makes sense to defer the translation gain (or loss) because actual liquidation and conversion of the foreign subsidiary's net assets into U.S. dollars is not expected any time soon.

Incorporate material from the entire text into the preparation of a statement of cash flows.

EXPANDED ILLUSTRATION OF STATEMENT OF CASH FLOWS

The basic techniques for preparing a statement of cash flows were explained in Chapter 5. More complex circumstances have been addressed as the topics have come up in subsequent chapters. Here we present an expanded problem that illustrates many of the cash flow issues that have been treated in the text.

The comparative balance sheet on the following page is for December 31, 2002, and December 31, 2001, is for Willard Company.

Additional information includes:

1. Net income for the year ended December 31, 2002, was $175,300. There were no extraordinary items.

2. During 2002, uncollectible accounts receivable of $43,000 were written off. Bad debt expense for the year was $32,000.

 ................
................

In order to avoid copyright disputes, this page is only a partial summary.

Google Online Preview   Download