Profitability Analysis and Analytical Issues Paper 8
U.S. GAAP state that transaction gains and losses have direct cash flow effects when foreign-denominated monetary assets are settled in amounts greater or less than the functional currency equivalent of the original transactions. These transaction gains and losses should be reflected in income
Answer (C) is correct. A foreign currency transaction is one whose terms are denominated in a currency other than the entity’s functional currency When a foreign currency transaction gives rise to a receivable or a payable that is fixed in terms of the amount of foreign currency to be received or paid, a change in the exchange rate between the functional currency and the currency in which the transaction is denominated results in a gain or loss that is included as a component of income from continuing
operations in the period in which the exchange rate changes.
U.S. GAAP define foreign currency transactions as those denominated in other than an entity’s functional currency. Transaction gains and losses are reported as
Answer (D) is correct. When a foreign currency transaction gives rise to a receivable or a payable, a change in the exchange rate between the measurement currency and the currency in which the transaction is denominated is a foreign currency transaction gain or loss that should be included as a component of income from continuing operations.
Unrealized foreign currency gains and losses included in the other comprehensive income section of a consolidated balance sheet represent
Answer (B) is correct. U.S. GAAP require that foreign currency translation adjustments resulting from translation of an entity’s financial statements into the reporting currency be reported on the balance sheet in other comprehensive income.
When restating financial statements originally recorded in a foreign currency,
Answer (C) is correct. Foreign currency transaction gains or losses are ordinarily recognized in the income statement of the period in which the exchange rate changes. Accordingly, the aggregate transaction gain or loss included in earnings should be disclosed.
Formerly, there was significant disagreement among informed observers regarding the basic nature, information content, and meaning of results produced by various methods of translating amounts from foreign currencies into the reporting currency. Current U.S. GAAP direct that organizations
Answer (D) is correct. The functional currency translation approach is appropriate for use in accounting for and reporting the financial results and relationships of foreign subsidiaries in consolidated statements. It involves identifying the functional currency of the entity (the currency of the primary economic environment in which the entity operates) and measuring all elements of the financial statements in the functional currency. Assets and liabilities as restated using the current exchange rate on the reporting date and revenues, expenses, gains and losses are restated using historical rates in effect at the time they were recognized (a weighted-average rate can be used if impractical to use historical rates).
The Brinjac Company owns a foreign subsidiary Included among the subsidiary’s liabilities for the year just ended are 400,000 drongos of revenue received in advance, recorded when $.50 was the dollar equivalent per drongo, and a deferred tax liability for 187,500 drongos, recognized when $.40 was the dollar equivalent per drongo. The rate of exchange in effect at year-end was $.35 per drongo. If the U.S. dollar is the functional currency, what total should be included for these two liabilities on Brinjac’s consolidated balance sheet at year end?
Answer (D) is correct. When a foreign entity’s functional currency is the U S dollar the financial statements of the entity recorded in a foreign currency must be remeasured in terms of the U.S. dollar. Revenue received in advance (deferred income) is considered a nonmonetary balance sheet item and is translated at the applicable historical rate (400,000 drongos × $.50 per drongo = $200,000). Deferred charges and credits (except policy acquisition costs for life insurance companies) are also remeasured at historical exchange rates. The deferred tax liability (a deferred credit) should be remeasured at the historical rate (187,500 drongos × $.40 per drongo = $75,000). The total for these liabilities is therefore $275,000 ($200,000 + $75,000).
FreezeIt, Inc., is a manufacturer of refrigeration systems based out of the United States with one subsidiary in Canada. The Canadian subsidiary exports all of its manufactured products to the United States and does not currently sell any of its manufactured products in Canada. The Canadian subsidiary incurs all of its expenses in Canadian dollars, and all of its revenues are in U.S. dollars. The U.S. operations are conducted only in U.S. dollars. What financial impact will a rise in the Canadian dollar against the U.S. dollar have on the Canadian subsidiary assuming no operational changes?
Answer (B) is correct. A rise in the Canadian dollar against the U.S. dollar will cause a reduction in revenues. Because the Canadian subsidiary exports all of its manufactured products to the U.S., does not currently sell any of its products in Canada, and has all of its revenues in U.S. dollars, the functional currency can be said to be the U.S. dollar. A rise in the Canadian dollar against the U.S. dollar means that the Canadian dollar has appreciated in value against the U.S. dollar. This also means that the U.S. dollar has depreciated in value against the Canadian dollar. The rise in the Canadian dollar against the U.S. dollar will cause a reduction in revenues because the U.S. dollar has depreciated in value and the subsidiary’s revenues are stated in U.S. dollars.
Willow World is a privately-held manufacturer of home furnishings based out of the United
States. Willow World has one subsidiary in Mexico that exports all of its manufactured products to the United States and does not currently sell any of its manufactured products in Mexico. The Mexican subsidiary incurs all of its expenses in Mexican pesos and all of its revenues are in U.S. dollars. The U.S. operations are conducted only in U.S. dollars. What will be the financial impact on the company’s return on investment (ROI) if the Mexican peso rises against the U.S. dollar assuming no operational changes?
Answer (A) is correct. Since expenses are incurred in Mexican pesos and revenues are in U.S. dollars, a rise in the peso against the dollar will increase expenses without a corresponding increase in revenues which will lower business unit profit. Therefore, Willow World will experience a decrease in ROI
A U.S.-based company has transaction exposure if it has an account
Answer (C) is correct. A domestic company has transaction exposure if its payable or receivable is denominated in a foreign currency.
Which one of the following statements best reflects the relationship between the results of financial ratios calculated in a local currency versus those where a functional currency is used?
Answer (D) is correct.
Financial ratio results are different under translation and remeasurement, and ratios under translation are also often different from those in the local currency.