Case 8-2 Palmerstown Company
Exchange Rates
January 1, Year 1
January 1-31, Year 1
Average Year 1
When inventory purchases made
When ending inventory acquired
December 31, Year 1
$/pound
1.00
1.00
0.90
0.86
0.83
0.80
1. Pound is the functional currency – Current rate method
Sales
Cost of goods sold
Gross profit
Selling and administrative expense
Depreciation expense
Income before tax
Income taxes
Net income
Plus: Retained earnings, 1/1/Y1
Retained earnings, 12/31/Y1
Exchange
Pounds
Rate
15,000
0.900
(9,000)
0.900
6,000
(3,000)
0.900
(1,000)
0.900
2,000
(600)
0.900
1,400
1,400
U.S. $
13,500
(8,100)
5,400
(2,700)
(900)
1,800
(540)
1,260
1,260
Cash
Inventory
Fixed assets
Less: accumulated depreciation
Total assets
2,400
4,000
10,000
(1,000)
15,400
0.800
0.800
0.800
0.800
1,920
3,200
8,000
(800)
12,320
Current liabilities
Long-term debt
Contributed capital
Retained earnings
Translation adjustment
Total
2,000
4,000
8,000
1,400
15,400
0.800
0.800
1.000
from above
from below
1,600
3,200
8,000
1,260
(1,740)
12,320
Case 8-2 Palmerstown Company (continued)
Calculation of Cumulative Translation Adjustment
Net assets, 1/1/Y1
Net income, Year 1
Net assets, 12/31/Y1
Net assets, 12/31/Y1 at
current exchange rate
Translation adjustment, Year 1 (negative)
Pounds
8,000
1,400
9,400
Exchange
Rate
1.000
0.900
9,400
0.800
U.S. $
8,000
1,260
9,260
7,520
1,740
2. U.S. dollar is the functional currency – Temporal method
Sales
Cost of goods sold
Gross profit
Selling and administrative expense
Depreciation expense
Remeasurement gain (loss)
Income before tax
Income taxes
Net income
Plus: Retained earnings, 1/1/Y1
Retained earnings, 12/31/Y1
Pounds
15,000
(9,000)
6,000
(3,000)
(1,000)
2,000
(600)
1,400
1,400
Exchange
Rate
0.900
Sched. A
0.900
1.000
from below
0.900
U.S. $
13,500
(8,000)
5,500
(2,700)
(1,000)
180
1,980
(540)
1,440
1,440
Cash
Inventory
Fixed assets
Less: accumulated depreciation
Total assets
2,400
4,000
10,000
(1,000)
15,400
0.800
0.830
1.000
1.000
1,920
3,320
10,000
(1,000)
14,240
Current liabilities
Long-term debt
Contributed capital
Retained earnings
Total
2,000
4,000
8,000
1,400
15,400
0.800
0.800
1.000
to balance
1,600
3,200
8,000
1,440
14,240
Case 8-2 Palmerstown Company (continued)
Schedule A - Cost of goods sold
Purchase, January 10
Additional purchases
Ending inventory
Cost of goods sold
Pounds
1,000
12,000
(4,000)
9,000
Exchange
Rate
1.000
0.860
0.830
U.S. $
1,000
10,320
(3,320)
8,000
Calculation of Remeasurement Gain
Net monetary assets, 1/1/Y1
Increase in monetary assets:
Sales
Decrease in monetary assets:
Acquisition of beginning inventory
Purchase of inventory during year
Selling and administrative expenses
Income taxes
Purchase of fixed assets
Net monetary liabilities, 12/31/Y1
Net monetary liabilities, 12/31/Y1 at
current exchange rate
Remeasurement gain - Year 1
Pounds
8,000
Exchange
Rate
1.000
U.S. $
8,000
15,000
0.900
13,500
(1,000)
(12,000)
(3,000)
(600)
(10,000)
(3,600)
1.000
0.860
0.900
0.900
1.000
(1,000)
(10,320)
(2,700)
(540)
(10,000)
(3,060)
(3,600)
0.800
(2,880)
(180)
3. With the pound as functional currency, the U.S. dollar net income reflected in the
consolidated income statement is $1,260. If the U.S. dollar were the functional currency, the
amount reflected in consolidated net income would be $1,560, 24% higher. The amount of
total assets reported on the consolidated balance sheet is 17% smaller than if the U.S.
dollar were functional currency [($14,360 – $12,320)/$12,320].
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.
Pounds
Current ratio:
Current assets
Current liabilities
Debt to equity ratio:
Total liabilities
Total stockholders' equity
Profit margin:
Net income
Sales
U.S. $
Current Rate
U.S $
Temporal
6,400
2,000
3.2
5,120
1,600
3.2
5,240
1,600
3.275
6,000
9,400
0.638
4,800
7,520
0.638
4,800
9,440
0.508
1,400
15,000
0.093
1,260
13,500
0.093
1,440
13,500
0.107
A comparison of the ratios calculated using pounds and using U.S.$ translated amounts shows
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). Note: 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 10,000 pounds worth of fixed
assets when the exchange rate was $1.00/pound, the parent would have had to provide the
subsidiary with $10,000.
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 pound historical cost amounts 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.