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Unformatted text preview: CHAPTER 7 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 another currency is the functional currency. The company’s fin- ancing, sales, and expenditure 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 financing 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 cur- rency is the euro, it is not exposed to risk associated with exchange rate changes between the euro and the U.S. dollar (the par- ent’s currency). Changes in the exchange rates will not have a current or known eco- nomic effect on either the parent’s or the French company’s cash flows or equity. Therefore, the translation adjustment should not be included as a component of net in- come. Including the adjustment in net income would suggest that exchange rate changes have an economic effect on the constituent companies when in fact they do not. 3. Because the euro is the subsidiary’s functional currency, its financial statements will be trans- lated rather than remeasured. The translated balance of retained earnings consists of the following: a beginning balance represented by the translated balance at the end of the prior year plus net income translated at weighted- average exchange rates less dividends de- clared 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 strengthening dollar). The remeasurement loss would be in- cluded 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 currency 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 equival- ents to settle the FC denominated loan. This would result in an exchange gain that could offset the remeasurement loss. Given a weak- ening FC, an FC denominated loan receivable would not be an effective hedge of the net in- vestment 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 stability. Therefore, the currency would not serve as a useful func- tional currency. If the functional currency were translated, rather than remeasured, the results might be quite unusual and not very useful....
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This note was uploaded on 12/17/2011 for the course ACC 400 STBSBA73 taught by Professor Gilbertrodriguez during the Spring '09 term at University of Phoenix.

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