Ch11 - CHAPTER 11 UNDERSTANDING THE ISSUES 1. If major cash...

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Unformatted text preview: 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 another currency is the functional currency. The company’s financing, sales, and expenditure activities should be evaluated in or- der to identify the primary currency in which the en- tity operates. For example, if a French company se- cures 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 French franc, it is not exposed to risk associated with exchange rate changes between the franc 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 parent’s or the French company’s cash flows or equity. Therefore, the translation adjustment should not be included as a component of net income. Including the adjustment in net income would suggest that exchange rate changes have an eco- nomic effect on the constituent companies when in fact they do not. 3. Because the German mark is the subsidiary’s functional currency, its financial statements will be translated rather than remeasured. The translated balance of retained earnings consists of the follow- ing: a beginning balance represented by the trans- lated balance at the end of the prior year plus net in- come translated at weighted average exchange rates less dividends declared translated at the his- torical exchange rates existing at the date of declar- ation. 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 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 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 equivalents to settle the FC denominated loan. This would result in an exchange gain that could offset the remeas- urement loss. Given a weakening FC, an FC-de- nominated loan receivable would not be an effective hedge of the net investment 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 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-equivalent measures of the accounts. In order to overcome these unusual results, two possible approaches have been proposed. The first approach would adjust the foreign entity’s trial balance for inflationary changes...
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This note was uploaded on 04/07/2008 for the course ACCT. 3533 taught by Professor Jahanian during the Spring '08 term at Temple.

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Ch11 - CHAPTER 11 UNDERSTANDING THE ISSUES 1. If major cash...

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