14_Fischer10e_SM_Ch11_final

14_Fischer10e_SM_Ch11_final - CHAPTER 11 UNDERSTANDING THE...

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CHAPTER 11 UNDERSTANDING THE ISSUES 1. If major cash inflows and/or outflows are not denominated in the entity’s domestic currency, this is a strong indicator that an- other currency is the functional currency. The company’s financing, sales, and ex- penditure activities should be evaluated in order to identify the primary currency in which the entity operates. For example, if a French company secures most of its finan- cing from a U.S. bank with the debt to be serviced with dollars, this suggests that the functional currency is the U.S. dollar. 2. Because the French company’s functional currency is the euro, it is not exposed to risk associated with exchange rate changes between the euro and the U.S. dollar (the parent’s currency). Changes in the exchange rates will not have a current or known economic effect on either the par- ent’s or the French company’s cash flows or equity. Therefore, the translation adjust- ment should not be included as a compon- ent of net income. Including the adjustment in net income would suggest that ex- change rate changes have an economic ef- fect on the constituent companies when, in fact, they do not. 3. Because the euro is the subsidiary’s func- tional currency, its financial statements will be translated rather than remeasured. The translated balance of retained earnings consists of the following: a beginning bal- ance represented by the translated balance at the end of the prior year plus net income translated at weighted-average exchange rates less dividends declared translated at the historical exchange rates existing at the date of declaration. 4. In order for there to be a remeasurement loss, the foreign currency (FC) would have to weaken against the dollar (a strengthen- ing dollar). The remeasurement loss would be included in current-period earnings, and the U.S. parent would want to hedge against this loss in reporting earnings. The U.S. company could borrow foreign cur- rency and designate the loan as a hedge of its net investment in the foreign subsidiary. As the foreign currency weakened, it would take fewer dollar equivalents to settle the FC-denominated loan. This would result in an exchange gain that could offset the re- measurement loss. Given a weakening FC, an FC-denominated loan receivable would not be an effective hedge of the net invest- ment in the subsidiary. 5. If a foreign entity’s functional currency is highly inflationary, there is an assumption that the currency has lost its utility as a measure of a store of value and lacks sta- bility. Therefore, the currency would not serve as a useful functional currency. If the functional currency were translated, rather than remeasured, the results might be quite unusual and not very useful. The results will not represent reasonable dollar-equival- ent measures of the accounts. In order to overcome these unusual results, two pos- sible approaches have been proposed. The first approach would adjust the foreign en-
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14_Fischer10e_SM_Ch11_final - CHAPTER 11 UNDERSTANDING THE...

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