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Financial Reporting and Analysis【 Reading 24】Sample

eborah Ortiz, CFA®, is the director of Global Research for F.E. Horton & Co. Ortiz recently hired two junior analysts, Tina Hirauye and Dominique Wilkins to assist in the financial statement analysis of global conglomerates. Hirauye and Wilkins are both Level II candidates in the CFA® Program, so Ortiz thought they would be the ideal people to work on a project dealing with consolidating the results of foreign operating units in the financial statements of the global parent.
Before starting on the project, Ortiz has a meeting with Hirayue and Wilkins to discuss the use of different currencies in a company’s operations. At the meeting, Hirayue states that when analyzing multinational firms, there cannot be a difference between local and functional currencies. Wilkins disagrees with her and states that there can be a difference between local and functional currencies, but only if the parent of the subsidiary operates in a hyperinflationary environment. After another 30 minutes of discussion, Ortiz concludes the meeting by telling them to make sure they understand the different accounting rules for remeasurement and translation, under SFAS 52.
Hirauye and Wilkins are given projects involving three different firms:
  • Molsan Industries is a Canadian multinational firm with a subsidiary in Japan. The subsidiary has operations in both Japan and Singapore.
  • Tylo Corporation is a multinational firm based in France. Tylo does business on a global basis, but prepares and issues consolidated financial statements in U.S. dollars. Tylo has a subsidiary that does business in the United Kingdom. The majority of the cash that the subsidiary generates and expends is denominated in British Pounds (GBP).
  • Neslarone is based in Switzerland and generates the majority of its cash in Swiss Francs (CHF). The firm issues and prepares its consolidated financial statements in U.S. dollars.

Hirauye and Wilkins spend the morning reviewing the details of their assignment and decide to take a break for lunch at a restaurant across the street from F.E. Horton & Co.’s headquarters. They agree that they have a challenging task and both are nervous about turning in their consolidated financial statements to Ortiz on the following day. At the restaurant, the two junior analysts run into two F.E. Horton senior analysts, Brad Windbigler and Elizabeth Alvarez, and the four of them decide to eat lunch together. Windbigler and Alvarez recently found out that they both passed Level III of the CFA® Exam, and, upon hearing about the task assigned by Ortiz, they are eager to help their two junior colleagues. Windbigler states that the current exchange rate is defined as the exchange rate between functional and reporting currencies at the balance sheet date, excluding all of a firm’s hedging activities. Alvarez also tries to offer assistance by stating that the correct exchange rate to use for monetary assets and liabilities when applying the temporal method is the average rate. When lunch is over, Hirauye and Wilkins thank their colleagues for their advice and go back to work to finish their assignment.Regarding the statements made at the meeting:
A)
Hirauye’s statement is incorrect; Wilkins’ statement is correct.
B)
Hirauye’s statement is incorrect; Wilkins’ statement is incorrect.
C)
Hirauye’s statement is correct; Wilkins’ statement is correct.



The basis for using the current rate method is when Functional Currency is NOT the same as Parent's Presentation (reporting) Currency. The basis for using the temporal method is when Functional Currency = Parent's Presentation Currency.

Hirauye and Wilkins both make incorrect statements regarding local and functional currencies. A foreign subsidiary may have a local currency but designate another currency as its functional currency. The functional currency is defined as the currency of the primary environment in which the subsidiary generates and expends cash, but the choice of the functional currency is ultimately a function of management’s judgment. Wilkins is also incorrect because the rate of inflation does not necessarily have an impact on designated currencies. (Study Session 6, LOS 24.a)

Hirauye is working on consolidating the financial statements of Molsan Industries’ Japanese subsidiary. Under SFAS 52, regarding Foreign Currency Translation, if:
A)
more than half of the subsidiary's revenue is from Japanese sources, then the results of the Singapore operation are translated into Japanese yen and then translated into Canadian dollars.
B)
management determines that the subsidiary's functional currency is the Japanese yen, the results of the Singapore operation are first remeasured into Japanese yen and then translated into Canadian dollars.
C)
management determines that the subsidiary's functional currency is the Singapore dollar, then the results of the Singapore operation are remeasured into Canadian dollars.



The functional currency is determined by management. Financial data are remeasured into the functional currency chosen by management and then translated into the reporting currency. (Study Session 6, LOS 24.a)

Wilkins has been tasked with analyzing Tylo Corporation, and is trying to distinguish between the various currencies employed in Tylo’s operations. Concerning the UK subsidiary's functional and reporting currencies the:
A)
functional currency and reporting currency are the U.S. dollar.
B)
functional currency is the British Pound; reporting currency is the U.S. dollar.
C)
parent firm (Tylo) is headquartered in France, therefore the functional currency is the Euro, and the reporting currency is the U.S. dollar.



The functional currency is defined as the currency of the primary economic environment in which the subsidiary generates and expends cash. Although the functional currency can be chosen by management, because we are told that Tylo's UK subsidiary generates and expends cash in British Pounds, the British Pound is the best choice for the functional currency. The reporting currency is the currency in which the parent firm prepares final consolidated statements, which in this case is the U.S. dollar. (Study Session 6, LOS 24.a)

Ortiz had told the junior analysts to make sure they understand the different accounting rules under SFAS 52. When referring to foreign exchange rates, the difference between remeasurement and translation is that remeasurement:
A)
and translation refer to the same process of translating the functional currency into the reporting currency.
B)
is used to describe historical exchange rates while translation is used for current rates.
C)
refers to the conversion of local currency into the functional currency; translation is the conversion of the functional currency into the reporting currency.



Translation is between functional and reporting currency. Remeasurement occurs between local and functional currencies. (Study Session 6, LOS 24.a)

Regarding the statements made at lunch:
A)
Windbigler’s statement is correct; Alvarez’s statement is incorrect.
B)
Windbigler’s statement is incorrect; Alvarez’s statement is incorrect.
C)
Windbigler’s statement is correct; Alvarez’s statement is correct.



Windbigler’s statement is correct. The current rate is defined as the market rate in effect at the balance sheet date. Hedging activities do not affect the rate, but affect the gain or loss from changes in exchange rates. Alvarez’s statement is incorrect. The correct exchange rate to use for monetary assets and liabilities when applying the temporal method is the current rate. (Study Session 6, LOS 24.b)

Wilkins and Hirauye are working on constructing the consolidated statements for Neslarone. They know that after they convert from Swiss Francs (CHF) to U.S. dollars (USD), they will be left with a foreign currency adjustment that needs to be included on the financial statements. To convert from CHF to USD, the analysts should use the:
A)
current rate method and they should record the foreign currency adjustment on the balance sheet.
B)
temporal method and they should record the foreign currency adjustment on the income statement.
C)
current rate method and they should record the foreign currency adjustment on the income statement.



Neslarone is based in Switzerland and generates the majority of its cash in CHF, meaning the local and functional currencies are both CHF. The firm issues financial reports in USD, so the dollar is the reporting currency. The process of converting from the functional currency to the reporting currency is translation and the correct method to use is the current rate method. When using the current rate method, the foreign currency adjustment is recorded in the equity section of the balance sheet. (Study Session 6, LOS 24.c)

Which of the following statements describing the choice of the functional currency is least accurate? The functional currency should be the same as the parent’s reporting currency if the subsidiary is:
A)
highly integrated with the parent where the local currency, prices, and some costs are controlled or restricted.
B)
highly integrated with the parent where the local currency, prices, and some costs are not controlled or restricted.
C)
mostly independent from the parent.



The preferred functional currency for subsidiaries that are mostly independent of the parent is the local currency. For highly integrated subsidiaries (regardless of local conditions), or for subsidiaries operating in high-inflation environments

TOP

The local currency is best characterized as:
A)
the preferred functional currency for subsidiaries that are highly integrated with the parent.
B)
translated into the functional currency under the current rate method.
C)
the currency of the country in which the foreign subsidiary is located.



The local currency is best described as the currency of the country in which the foreign subsidiary is located. If a subsidiary is highly integrated with its parent or operating in a high-inflation environment, the functional currency is the parent’s currency. Local currencies are remeasured under the temporal method

TOP

Which of the following statements regarding the functional currency is least accurate? The functional currency:
A)
is determined by management.
B)
is remeasured into the reporting currency under the temporal method.
C)
is the currency of the primary economic environment in which the foreign subsidiary generates and expends cash.



The basis for using the current rate method is when Functional Currency is NOT the same as Parent's Presentation (reporting) Currency. The basis for using the temporal method is when Functional Currency = Parent's Presentation Currency.

The local currency is remeasured into the functional currency under the temporal method. The functional currency is translated into the reporting currency using the current rate method.

TOP

A Canadian firm owns a foreign subsidiary in the U.S. In 2002, sales were USD1,000,000 and the USD/CAD exchange rate was 0.6329. In 2003, sales were also USD1,000,000 but the exchange rate was 0.7484. What is the impact of the change in the value of the CAD on the parent company’s translated sales? Sales will:
A)
increase by 18%.
B)
decline by 15%.
C)
decrease by 18%.



While sales were flat at USD 1,000,000 in local currency terms, after translation the parent firm would report sales of CAD 1,336,184 for 2003 (= USD 1,000,000 / 0.7484) versus sales of CAD 1,580,028 for 2002 (= USD 1,000,000 / 0.6329). The 15% sales decline reported by the Canadian firm (CAD 1,336,184 versus CAD 1,580,028) is a flow effect. Even though there was no sales growth in the subsidiary, the parent firm still shows a 15% decrease in revenues from the subsidiary due solely to exchange rate effects. Note that because the subsidiary sales are constant the total exchange rate effect can be measured as (0.6329 / 0.7484) − 1 = −0.15.

TOP

Edmonton Oilfield Supply has made an equipment sale in Venezuela in the amount of VEF 15,000,000. On the day of the sale, the exchange rate is 1.7519 VEF per 1 Canadian dollar. 90 days later, when the Venezuelan firm pays for the equipment, the exchange rate is 1.6326. As a result of the change in the exchange rate, Edmonton will recognize a:
A)
loss of $1,789,500.
B)
gain of $1,096,104.
C)
gain of $625,666.



On the day of the sale, Edmonton will record an account receivable of 15m/1.7519 = $8,562,133. When the payment is received and converted to CAD, the realized amount will be 15m/1.6326 = $9,187,799. As a result of the appreciating VEF, Edmonton will realize a gain of $9,187,799 − 8,562,133 = CAD 625,666.

TOP

A German company owns a foreign subsidiary in the U.S. If the results below are reported in Euros, after translation what is the effect of the change in the exchange rate on revenues? Round to the nearest dollar and/or percent.

Year

Sales

$ per 1 Euro

Exchange Rate

2001

$10,000

0.9

2002

$10,000

0.8

A)
The company shows a 12.5% growth in revenues in 2002.
B)
The company shows a 0.1% decline in revenues in 2002.
C)
There is no change is revenue growth between 2001 and 2002.



While sales were flat in terms of local currency, after translation the reported revenue increased 12.5%. 10,000/0.9 = 11,111; 10,000/0.8 = 12,500; 12,500/11,111 = 12.5% increase due to exchange rate effects.

TOP

A U.S. firm owns a foreign subsidiary in France. In 2002, sales were EUR 1,000,000 and the USD/EUR exchange rate was 1.0620. In 2003, sales were EUR 1,100,000 and the exchange rate was 1.1417. What is the impact of the change in the value of the USD on the parent company’s translated sales?
A)
Sales will decrease by 7.5%.
B)
Sales will increase by 18.25%.
C)
Sales will increase by 7.5%.



The increase in sales due to the appreciating EUR is measured as 7.5% [= (1.1417 / 1.0620) − 1]. Sales for the subsidiary rose 10% [= (1,100,000 / 1,000,000) – 1] in the local currency (EUR). After translation the parent firm will report sales of USD 1,062,000 (= EUR 1,000,000 × 1.0620) for 2002 and USD 1,255,870 (= EUR 1,100,000 × 1.1417) for 2003.
Growth measured from the parent’s perspective suggests sales rose 18.25% [= (1,255,870 / 1,062,000) − 1], but this includes the growth rate in sales measured in the local currency and the rate of appreciation in the foreign currency, or (1.10 × 1.075) − 1 = 0.1825. The question only asks for the impact of the change in the value of the USD.

TOP

The U.S. Deter Company operates a subsidiary in the UK, and the functional currency is the British pound. The subsidiary’s 2001 income statement shows £500 of net income and a £50 dividend that was paid on December 31, when the exchange rate was $1.50 per pound. The current exchange rate is $1.65 per pound, and the average rate is $1.58 per pound. What is the change in retained earnings for the period in U.S. dollars under U.S. GAAP?
A)
$725.
B)
$715.
C)
$750.



The basis for using the current rate method is when Functional Currency is NOT the same as Parent's Presentation (reporting) Currency. The basis for using the temporal method is when Functional Currency = Parent's Presentation Currency.

Since the functional currency is the local currency, use the current rate method. The net income is translated at the average rate, and dividends are translated at the rate that applied when they were paid. Hence: 1.58(£500) − 1.50(£50) = $715.

TOP

Giant Company is a U.S. Company with a subsidiary, Grande, Inc., that operates in Mexico. Giant Company uses either the temporal or the current rate method of foreign currency translation for its subsidiaries.
  • Grande, Inc., began operations January 1, 2001.

  • Common Stock and Fixed Assets were acquired January 1, 2000.

  • Inventory is accounted for under the last in, first out (LIFO) cost flow assumption, with a slow rate of turnover.

  • The beginning U.S. dollar value of Giant's retained earnings was $2,600,000.
  • The inventory in the January 1, 2001, Balance Sheet was acquired on January 1, 2001.

Exchange Rates were:

January 1, 2000

$0.14/M peso


January 1, 2001

$0.12/M peso


June 30, 2001

$0.11/M peso (this is the 2001 average rate)


December 31, 2001

$0.10/M peso



Grande, Inc.


Balance Sheet (in M Pesos)


Jan. 1, 2001

Dec. 31, 2001

Cash

5,000,000

20,000,000

Accounts Receivable (A/R)

20,000,000

35,000,000

Inventory

15,000,000

15,000,000

Fixed Assets (net)

90,000,000

60,000,000




Accounts Payable (A/P)

10,000,000

10,000,000

Long Term Debt

40,000,000

35,000,000

Common Stock

80,000,000

80,000,000

Retained Earnings


5,000,000





2001 Income Statement


(in M Pesos)

Sales

60,000,000

Cost of Goods Sold (COGS)

(45,000,000)

Depreciation

(10,000,000)

Net Income

5,000,000


Assume that Giant Company considers the Mexican peso to be the local currency and the functional currency of Grande, Inc.Giant Company should use the following method to reflect the results of Grande, Inc., in its financial statements:
A)
the current rate method followed by the temporal method.
B)
the current rate method.
C)
the temporal method.



The basis for using the current rate method is when Functional Currency is NOT the same as Parent's Presentation (reporting) Currency. The basis for using the temporal method is when Functional Currency = Parent's Presentation Currency.
The current rate method is used when the local currency and functional currency are the same.


The Net Income of Grande, Inc., expressed in U.S. dollars for the year ended December 31, 2001, is:
A)
$500,000.
B)
$550,000.
C)
$250,000.



Using the current rate method, the income statement is translated using the average rate for all income statement accounts: Sales − COGS − Depreciation = Net Income. (60,000,000 × $0.11) − (45,000,000 × $0.11) − (10,000,000) × $0.11) = $550,000.

What is the change in exposure for Grande, Inc., for the year ended December 31, 2001?
A)
+$5,000,000 pesos.
B)
+$85,000,000 pesos.
C)
+$35,000,000 pesos.



Exposure under the current rate method is simply equity.
Beginning exposure = 80,000,000 pesos
Ending exposure = 85,000,000 pesos
Change in exposure = 85,000,000 pesos − 80,000,000 pesos = +5,000,000 pesos


The translation gain or loss from the activities of Grande, Inc., should be reported in:
A)
the statement of cash flows.
B)
the income statement.
C)
the equity accounts.



Under the current rate method, translation gains or losses are accumulated on the balance sheet in the equity section.

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