土豆妮

Dell Air Lines has recently acquired Australian Puddle Jumpers, Inc., a small airline located in Sydney. The Australian dollar has been chosen by Dell as the functional currency for APJ. The Balance Sheet of APJ is given below as of Dec. 31, 2004 in Australian dollars.

Assets			Liabilities and Equity
Cash	200		A/P	180
A/R	240		Common Stock	720
Maintenance Supplies	180
Fixed Assets	280
Total Assets	900		Total Liab & Equity	900

APJ's income statement for the year ending Dec. 31, 2005 is expressed in Australian dollars as:

Sales	3,500
Total Costs	2,900
Net Income	600

The Australian dollar has steadily depreciated against the U.S. dollar. At Dec. 31, 2004, the exchange rate was 2 Australian dollars = $1 but at Dec. 31, 2005, the exchange rate had deteriorated to 3 Australian dollars = $1.

The Dec. 31, 2005 Balance Sheet for APJ is given in Australian dollars as follows:

Assets			Liabilities and Equity
Cash	441		A/P	210
A/R	330		Common Stock	720
Supplies	291		Retained Earnings	600
Fixed Assets	468
Total Assets	1,530		Total Liab. & Equity	1,530

On APJ's 2005 income statement, the level of net income in U.S. dollars would be:

A) $240.

B) $300.

C) $200.

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The basis for using the all current 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 Australian dollar is both the local and the functional currency, use the current rate method. The items in the income statement are translated at the average exchange rate. The average rate is (2 + 3) / 2 = 2.5 Australian dollars = $1. (Study Session 6, LOS 24.d)

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On APJ's 2005 balance sheet, the level of common stock (not including retained earnings) in U.S. dollars would be:

A) $360.

B) $288.

C) $240.

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Since the Australian dollar is the local and the functional currency, use the current rate method. 

In the balance sheet, all accounts are translated at the current exchange rate, except for the common stock account, which is translated at the historical rate.

Common Stock (720 / 2) = 360

(Study Session 6, LOS 24.d)

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On APJ's 2005 balance sheet, the level of retained earnings in U.S. dollars would be:

A) $200.

B) $240.

C) $300.

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Since there is no mention of dividends being paid, the retained earnings will equal net income (RE = NI ? Div). The items in the income statement are translated at the average exchange rate under SFAS 52. The average rate is (2 + 3) / 2 = 2.5 Australian dollars = $1.

Income Statement (in $)

Sales (3,500 / 2.5)	$1,400
Costs (2,900 / 2.5)	$1,160
Net Income	$240

(Study Session 6, LOS 24.d)

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On APJ's 2005 balance sheet, the foreign currency translation adjustment in U.S. dollars would be:

A) ?$220.

B) ?$160.

C) ?$280.

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Since the Australian dollar is both the local and the functional currency, use the current rate method. 

When using the current rate method, all assets and liabilities are translated at the current rate. Total assets = 1530/3 = 510 and accounts payable = 210/3 = 70. The common stock is translated at the historical rate on the date of purchase = 720/2 = 360. Beginning retained earnings = 0, so ending retained earnings = translated net income = 240. The cumulative translation adjustment is the plug figure that makes the balance sheet balance = 510 ? 70 ? 360 ? 240 = -160. (Study Session 6, LOS 24.d)

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Which one of the following is a condition under which the temporal method should be used to account for foreign currency translations?

A) The Australian dollar is chosen as the functional currency.

B) The cumulative Australian inflation rate over the last three years would have to be less than 100%.

C) APJ would have to be a mere operational extension of Dell's main operations.

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The conditions necessary for implementation of the temporal method are:

1. APJ would have to be a mere operational extension of Dell's main operations. If the operations of the subsidiary are well integrated with the parent’s then the parent’s currency (in this case, the U.S. dollar) would be the functional currency.
2. The cumulative Australian inflation rate over the last 3 years would have to exceed 100%. (Hyperinflation)
   

(Study Session 6, LOS 24.c)

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Which one of the following statements correctly describes the effect on Dell's financial statements if the U.S. dollar had been chosen as the functional currency?

A) The translation adjustment would appear as a line item on Dell's income statement.

B) The current rate method would apply.

C) The translation adjustment would appear as a line item on Dell's balance sheet.

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If the U.S. dollar had been chosen as the functional currency, then the provisions of the temporal method would apply. Under the temporal method, the translation adjustment would appear as a line item on Dell's income statement and not as an element of equity. Hence, earnings may become more volatile as a result. (Study Session 6, LOS 24.c)

土豆妮

Giant Company is a U.S. firm that produces parts for nuclear reactors. Giant Company has a subsidiary, Grande, Inc., that operates in Mexico and is responsible for designing and manufacturing connection fittings that are vital for the proper operation of its parent company’s reactors.

• Giant Company considers the U.S. dollar to be the functional currency of Grande, Inc.
• 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 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	20,000,000	35,000,000
Inventory	15,000,000	15,000,000
Fixed Assets (net)	70,000,000	60,000,000
Accounts Payable	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	(45,000,000)
Depreciation	(10,000,000)
Net Income	5,000,000

Giant Company should use the following method to reflect the results of Grande, Inc., in its financial statements:

A) the temporal method followed by the all-current method.

B) the temporal method.

C) the all-current method.

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The basis for using the all current 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 temporal method is used when the functional currency is the parent’s currency. (Study Session 6, LOS 24.c)

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The Cost of Goods Sold for Grande, Inc., for the year ended December 31, 2001, expressed in U.S. dollars is:

A) $4,950,000.

B) $5,400,000.

C) $5,250,000.

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Both the beginning and ending inventory under LIFO cost flow assumptions and a slow inventory turnover are translated at the $0.12 rate as of the date the original inventory was acquired, January 1, 2001. Because beginning and ending inventories expressed in Mexican pesos are equal, the purchases for the year will equal the Cost of Goods Sold, which is remeasured at the average cost of acquiring the goods during the year: $0.11. (45,000,000 * $0.11) = $4,950,000. (Study Session 6, LOS 24.c)

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What is the translation gain or loss for Grande, Inc., for the year ended December 31, 2001?

A) $200,000.

B) $150,000.

C) -$600,000.

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When using the temporal method, only cash, accounts receivable, accounts payable, current debt, and long-term debt are translated at the current rate. This means that exposure under the temporal method is:

(cash + accounts receivable) – (accounts payable + current debt + long-term debt)

The currency translation adjustment (CTA) is calculated as the sum of the flow effect and holding effect.

Flow effect (in $) = change in exposure (in LC) × (ending rate – average rate)

Holding gain/loss effect (in $) = beginning exposure (in LC) × (ending rate – beginning rate)

Going back to our data in the example:

Beginning exposure = (5,000,000 + 20,00,000) – (10,000,000 + 0 + 40,000,000) = -25,000,000

Ending exposure = (20,000,000 + 35,000,000) – (10,000,000 + 0 + 35,000,000) = 10,00,000

Change in exposure = 10,000,000 – (-25,000,000) = 35,000,000

Flow effect (in $) = 35,000,000 × [$0.10 – $0.11] = 35,000,000 × [– $0.01] = -$350,000

Holding gain/loss effect (in $) = -25,000,000 × [$0.10 – $0.12] = -25,000,000 × [-$0.02] = $500,000

Translation gain (in $) = flow effect + holding gain/loss effect = -$350,000 + $500,000 = $150,000

(Study Session 6, LOS 24.d)

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The translation gain or loss from the activities of Grande, Inc., should be reported in:

A) the income statement.

B) the statement of cash flows.

C) the statement of shareholder’s equity.

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Under the temporal method, translation gains and losses are included in the income statement. (Study Session 6, LOS 24.d)

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Revenues for 2001 translated into U.S. dollars amount to:

A) $6,000,000.

B) $6,600,000.

C) $7,800,000.

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Under the temporal method, revenues are translated at the average rate during the reporting period.

60,000,000 × 0.11 = $6,600,000

(Study Session 6, LOS 24.d)

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As a result of making the appropriate currency adjustments to the financial statements, Grande Inc.’s December 31, 2001 quick ratio will be:

A) higher, and the current ratio will be higher.

B) unchanged, and the current ratio will be higher.

C) unchanged, and the current ratio will be unchanged.

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Since the functional currency is the reporting currency, the temporal method must be used. Since it is taking fewer dollars to buy a peso, the peso is depreciating.

The quick ratio is a liquidity ratio that does not include inventory. The quick ratio is calculated as [(cash + accounts receivable) / accounts payable]. Since monetary assets and liabilities are translated at the current rate, the quick ratio will be unchanged. The current ratio however is calculated as [(cash + accounts receivable + inventory) / accounts payable]. Since inventory is accounted for under LIFO, inventory is translated at the historical rate while the other components of the ratio are translated at the current rate. Using the historical rate for inventory will lead to a higher numerator and a higher current ratio. (Study Session 6, LOS 24.d)