Structure and Functions of Commercial Bank free essay sample

Chapter 15 Accounting in a Global Market QUESTIONS 1. Foreign currency exchange rates are used to express transactions in local currency in terms of U. S. dollars and vice versa. For example, if the exchange rate is $1 = 1. 65 DM (Deutsche mark), and if one wishes to change 100 U. S. dollars into Deutsche marks, one will receive $100 ( 1. 65 = 165 DM, and if one wishes to change 100 DM to U. S. dollars, one will receive 100 DM/1. 65 = $60. 61. 2. A foreign currency transaction occurs when a transaction is denominated in a currency other than that of the firm. For example, a foreign currency transaction occurs when a U. S. firm purchases electronics components from a Japanese firm and must make payment in yen. 3. This easiest way for a U. S. company to avoid foreign exchange risk is to denominate all transactions in U. S. dollars. Alternatively, there are a variety of methods for hedging foreign currency risk. One method is to enter into a foreign exchange forward or futures contract. See Chapter 12 for more details about hedging. 4. If the purchase is denominated in British pounds, the purchase of the oil is recorded at $144,900, or 5,000 barrels at ? 18 per barrel equals ? 90,000 at $1. 61 equals $144,900. . In this situation the British pound increased in value from $1. 50 to $1. 53. This means the currency received in payment of the account will amount to more money in U. S. dollars. The exchange gain is $1,500 (? 50,000 ( [$1. 53–$1. 50]). 6. According to U. S. accounting standards, foreign currency transaction gains and losses are included in income in the period in which the exchange rate changes. Any gains or losses that result from these changing exchange rates are measured and recognized separately from the underlying sale or purchase and are recorded as separate income statement items. . U. S. firms must consolidate all their majority-owned subsidiaries when preparing financial statements. Foreign currency statements can be consolidated only aft er they have been translated into U. S. dollars. 8. The two methods available for converting foreign currency financial statements into U. S. dollar financial statements are (a) translation and (b) remeasurement. a. For foreign subsidiaries whose operations are well contained in the host country and that conduct most of their operations in the foreign currency, translation is used to convert the statements into U. S. dollars. Translation requires that all assets and liabilities be converted at the current exchange rate at the date of the financial statements. Income statement items are converted at the average exchange rate for the period. b. Some foreign subsidiaries are simply an extension of the parent company’s operations. Most of their operations are conducted in U. S. dollars. For these companies, remeasurement is used to convert the statements into U. S. dollars. Remeasurement requires that monetary assets and liabilities be converted at current rates and nonmonetary assets and liabilities be translated at the rates prevailing when the particular item was acquired. Income statement items are converted at the average exchange rate for the period. 9. In most instances, the functional currency is the currency in which most of the subsidiary’s transactions are denominated. 10. With translation, all balance sheet items other than stockholders’ equity are converted at the current exchange rate at the date of the financial statements. Income statement items are converted at the average rate during the period. Dividends are converted using the exchange rate prevailing on the date the dividends were declared. Paid-in capital is converted at the historical rate, that is, the rate prevailing on the date the subsidiary was acquired or the stock was issued. Retained earnings is translated in the first year using historical rates, but in subsequent years, it is computed by taking the balance in retained earnings from the prior period’s translated financial statements, adding translated net income, and subtracting translated dividends. Any resulting translation gains and losses are accumulated in a special stockholders’ equity account. 11. When translating foreign currency financial statements, the exchange rate as of the balance sheet date is used to convert assets and liabilities and the average rate for the year is used to convert revenues and expenses. The historical rate prevailing on the day the subsidiary was purchased or the stock was issued is always used in converting common stock from the foreign currency to the parent company’s currency. 12. When the foreign currency financial statements are translated, the debits of the trial balance will, in most instances, not equal the credits. This difference results from the effects of the differing exchange rates. This difference between debits and credits is called a translation adjustment and is included in the stockholders’ equity section of the balance sheet. 13. No, these firms are under no U. S. obligation to prepare special reports for their non-U. S. stockholders. Non-U. S. stockholders have special needs with regard to the financial information provided by these multinational companies. These needs may include: (a) reports prepared in the language of the user, (b) figures given in the denominated currency of the particular user, (c) accounting policies and principles reflecting the country of the user. Many companies do nothing special to respond to the needs of international users. That is, international users are forced to use the financial statements prepared for the domestic audience. However, a growing number of multinational firms are responding to the needs of the international investment community by preparing specialized financial statements and annual reports designed for nondomestic stockholders. 14. If a firm decides to prepare special reports for its nondomestic stockholders, the reports might have the following characteristics: a. Statements translated into the local language b. Statements denominated in the local currency c. Statements partially or fully restated to reflect the accounting principles of the users’ country d. Statements prepared according to international standards 15. Some of the advantages and disadvantages of each type of special-purpose report are listed below: a. The reports may have been translated into the local language without any other changes having been made in the financial statements. Thus, the user might be able to read the financial statements, but to fully understand their significance, the user would have to be familiar with the accounting principles used in preparing the statements. b. Reports denominated in the currency of the local user may be somewhat better than those discussed in part (a) above, but the problem of unfamiliarity with the underlying accounting standards persists. c. Reports restated to reflect the accounting principles of the user’s country would be an improvement; however, the degree of restatement will determine the degree of usefulness of the restated statement. Not many companies provide a full restatement. d. International accounting standards (IAS) are gaining increasing acceptance among the international community, especially outside the United States. The problem with one global standard is that local economies, cultures, and business practices differ, and accounting standards should be flexible enough to reflect those differences. 16. Mutual recognition involves country A accepting the financial statements of country B and country B accepting the financial statements of country A for all regulatory purposes. Although mutual recognition may be an inexpensive solution, the users of the financial statements bear the cost required to understand GAAP in various countries. 17. The International Accounting Standards Board (IASB) was created in 2001 to succeed the IASC (established in 1973). Like the FASB, the IASB develops proposals, circulates these among interested organizations, receives feedback, and then issues a final pronouncement. By working closely with national standard setting bodies, the IASB hopes to accelerate the convergence of high-quality accounting standards around the world. 8. The IASC was a creation of the national accountants’ associations around the world. For example, in the United States it was the American Institute of Certified Public Accountants (AICPA) that was involved in the formation of the IASC. This is an important point to recognize because it means that the IASC was operated by accountants, not by the worldwide business community. The IASB has broader business support; its members represent a broader cross-section of financial statement preparers, users, auditors, and analysts. In addition, most of the IASB members are independent full-time individuals who have severed their relationships with their previous employers. Finally, the IASB includes formal representatives from seven different national standard setting groups. 19. The U. S. capital market is the largest in the world. IAS will never gain wide acceptance in the United States until the SEC allows the use of the international standards in financial statements filed with the Commission. If and when the SEC allows the use of IAS, the credibility of the standards will increase dramatically worldwide. 20. If the SEC allows foreign companies to use IAS in their financial reports to U. S. investors, U. S. companies are sure to cry foul over a two-tiered system in which foreign companies are permitted to list their securities by following IAS and yet domestic U. S. companies must continue to follow the more extensive accounting requirements under U. S. GAAP. EXERCISES E 15-1 Foreign Currency Transactions 1. The equipment would be recorded in the books of Saginaw Power Company at $240,000 (750,000 ( $0. 32). This is the amount of U. S. dollars that could have been used to make the purchase on the purchase date. . On April 15 when payment is made, $262,500 (750,000 ( $0. 35) would be paid. 3. On April 15, Saginaw would record an exchange loss of $22,500, equal to the difference between the original obligation of $240,000 and the amount actually paid of $262,500. 4. The exchange loss of $22,500 due to the increase in value of the Swiss franc is recorded as another expense item in current pe riod’s income. E 15-2 Foreign Currency Transactions 1. The inventory would be recorded in the books of the GAAT Company at $36,800 (4,600,000 ( $0. 008). This is the amount of U. S. ollars that could have been used to make the purchase on the purchase date. 2. An exchange loss would be recorded as of June 30 to reflect the increased U. S. dollar obligation as a result of the increased value of the yen. The amount of the loss is $4,600 (4,600,000 ( [$0. 009 – $0. 008]). 3. When payment is made on July 6, GAAT would record an additional exchange loss to reflect the fact the U. S. dollar obligation has again increased as a result of the increased value of the yen. The amount of the loss is $4,600 (4,600,000 ( [$0. 010 – $0. 009]). E 15-3 Foreign Currency Purchase 1. On the day of the purchase, an obligation of $20,000 (10,000 units ( $2 per unit) would be recorded. This is also the amount of cash that would be required to be paid in 30 days because the transaction is denominated in U. S. dollars. 2. On the day of the purchase, an obligation of $20,000 (10,000 units ( DM 4 per unit ( $0. 50) would be recorded. The amount of cash that would be required to be paid in 30 days is $24,000 (10,000 units ( DM 4 per unit ( $0. 60) because the transaction is denominated in Deutsche marks. An exchange loss of $4,000 would be recognized to reflect the increased U. S. ollar obligation stemming from the increase in the value of the mark. E 15-4 Foreign Currency Purchase 1. The value at which the obligation would be recorded on December 15, 2002 is $3,846 (5,000,000 won/1,300). 2. The value to which the obligation should be adjusted on December 31, 2002 is $4,545 (5,000,000 won/1,100). An exchange loss of $699 ($4,545 – $3,846) has occurred reflecting t he increased U. S. dollar obligation stemming from the increase in the value of the won. 3. The number of U. S dollars that will be required to pay the obligation on January 30, 2003 is $5,000 (5,000,000 won/1,000). An additional exchange loss of $455 ($5,000 – $4,545) has occurred since the start of the year reflecting the increased U. S. dollar obligation stemming from the continuing increase in the value of the won. E 15-5 Translation or Remeasurement? 1. In determining the functional currency, one attempts to determine the primary economic environment in which the subsidiary operates. If the subsidiary generates and expends most of its cash in its local currency, then translation is appropriate as the functional currency would be considered the subsidiary’s local currency. Other factors to consider in determining the subsidiary’s functional currency include the forces that determine the firm’s sales price, the location of the subsidiary’s sales market, and the country in which financing is obtained and where production costs are incurred. If it is determined, after the above factors are considered, that the parent company’s currency is the subsidiary’s primary currency, then remeasurement is appropriate. 2. Management makes the final determination in selecting the firm’s functional currency. 3. A major difference between translation and remeasurement lies in the use of different exchange rates—for example, assets are translated at the exchange rate in effect on the balance sheet date whereas they are remeasured at the historical rate in effect when they were acquired. Another difference relates to the disclosure of the effect of changing exchange rates. With translation, the difference is reported as an equity adjustment on the balance sheet. With remeasurement, the difference is recognized as a gain or loss and recorded on the income statement. E 15-6 Translating Financial Statements AccountTranslation Amount Cash$100,000current rate Inventory700,000current rate Plant and equipment900,000current rate Sales3,500,000average rate Common stock450,000historical rate E 15-7 Foreign Currency Transactions and Translation 1. If, at the balance sheet date, a foreign currency transaction has not been completed and there has been a change in the exchange rate since the origination of the transaction, an exchange gain or loss is recorded. Then, upon settlement of the sales or purchase contract, any remaining exchange gain or loss is recognized. Thus, foreign currency transaction gains or losses are recorded in the period in which the exchange rate changes. Because UAL is an international carrier, it has transactions in foreign currencies. Due to changes in the exchange rates, there will be gains and losses on foreign currencies. 2. An account for a cumulative foreign currency translation adjustment would exist only if UAL had subsidiary companies located outside of the United States and then translated the financial statements of the companies into U. S. dollars. We can assume that UAL does not have such subsidiaries located outside of the United States. E 15-8 Translating Foreign Currency Financial Statements International Metals Translated Balance Sheet January 3, 2003 (in CanadianExchange(in U. S. dollars) Ratedollars) Assets Cash$58,000$0. 79$45,820 Accounts receivable112,5000. 7988,875 Inventory91,8000. 7972,522 Plant assets135,4000. 79106,966 Total assets$397,700$314,183 Liabilities and Equity Accounts payable$165,600$0. 79$130,824 Long-term debt88,0000. 7969,520 Paid-in capital65,1000. 7951,429 Retained earnings79,0000. 7962,410 Total liabilities and equity$397,700$314,183 Note that there is no translation adjustment. This is because the translated balance sheet is prepared on the acquisition date. A translation adjustment arises from exchange rate changes after the acquisition date. E 15-9 Translating Foreign Currency Financial Statements 1. International Data Products Trial Balance Trial BalanceExchangeTrial Balance (in Japanese yen)Rate(in American dollars) Cash6,000,000$0. 007$42,000 Accounts receivable18,500,0000. 007129,500 Inventory21,250,0000. 007148,750 Equipment27,700,0000. 007193,900 Cost of goods sold36,000,0000. 0065234,000 Expenses15,500,0000. 0065100,750 Dividends5,000,0000. 006733,500 Total debits129,950,000$882,400 Accounts payable24,000,000$0. 007$168,000 Long-term debt12,000,0000. 00784,000 Capital stock20,000,0000. 0055110,000 Retained earnings15,950,000computed105,000 Sales58,000,0000. 0065377,000 Translation adjustment38,400 Total credits129,950,000$882,400 2. International Data Products Income Statement Sales$377,000 Cost of goods sold234,000 Gross margin$143,000 Other expenses100,750 Net income$42,250 International Data Products Balance Sheet Assets Cash$42,000 Accounts receivable129,500 lnventory148,750 Equipment193,900 Total assets$514,150 Liabilities and Equity Accounts payable$168,000 Long-term debt84,000 Capital stock110,000 Retained earnings113,750 Translation adjustment38,400 Total liabilities and equity$514,150 Computation of Retained Earnings: Beginning retained earnings$105,000 Net income42,250 $147,250 Less: Dividends33,500 Ending retained earnings$113,750 E 15-10 Meeting the Needs of Foreign Investors For such a special report to be useful for non-U. S. stockholders, Lyle should do the following things: a. Prepare the report in the language of the non-U. S. stockholders. b. Prepare the report in the local currency of the non-U. S. stockholders. . Restate the financial statements using the accounting standards of the users’ country, or at least restate those parts of the statements that are relevant for a decision maker. E 15-11 Understanding Special-Purpose Annual Reports 1. Since Eurotech is a multinational company, it is trying to provide its nondomestic investors (such as U. S. stockholders) with information they can unde rstand. This includes translating statements into the language and currency of the users. By providing such a report, Eurotech is responding to the needs of its nondomestic users. 2. Such a report is quite useful. To assist my decision making as much as possible, I would want Eurotech to provide me with a report that is restated according to U. S. GAAP or makes use of some of the international accounting standards set forth by the IASB. If such restated statements are not prepared, it would be useful to have a schedule reconciling Belgian GAAP with U. S. GAAP. E 15-12 Differing Accounting Standards The probable cause of this difference in rankings is differences in generally accepted accounting principles (GAAP). The accounting standards in some countries, such as Germany and Japan, are more conservative than are the standards in the United States. This means that these standards result in systematically lower reported earnings than would be computed using U. S. GAAP. For example, the chapter included a discussion of â€Å"hidden reserves† in Germany. By establishing hidden reserves, companies can reduce profits in a given year. In later years, when these reserves are released or reduced, profits increase. In a sense, reserves smooth earnings and allow buildup of unreported profits that can be used in down years. E 15-13 Are International Ratios Comparable? If the only difference between U. S. nd foreign firms was a difference in accounting methods, it would not be a major problem to perform the necessary adjustments to be able to make financial ratios internationally comparable. Financial analysts are experienced in doing this very thing to improve the comparability of the financial statements of U. S. companies. However, U. S. and foreign firms differ in more than just accounting method choice; they operate in differen t business environments. For example, financing for most German firms comes not from stockholders but from large banks. Japanese firms are legendary for emphasizing growth in market share over short-term profits. Because U. S. and foreign firms do business in different ways, their financial ratios are not directly comparable, just as the financial ratios of two firms operating in different industries are not comparable. A major challenge facing international financial analysts is how to make appropriate adjustments for differing operating environments in order to make proper international ratio comparisons. E 15-14 Composition of the IASB Board 1. Of the seven national standard setters formally represented on the initial IASB, four are from Anglo-Saxon countries: Australia, New Zealand, Canada, United Kingdom, and United States. . In its initial composition, the IASB included no representatives from national standard setters in South America or from Central or Northern Africa. In addition, there are no representatives from the Middle East. In large part this stems from the fact that many countries with developing economies have not been very active in the expensive luxury of developing accoun ting standards. E 15-15 Preparation of a Form 20F Reconciliation 1. MEBA Company Reconciliation of Stockholders’ Equity to U. S. GAAP Stockholders’ equity computed according to home country GAAP100,000 Adjustments required to conform with U. S. GAAP: Goodwill, adjusted for amortization (80,000 – [80,000 ( 5/40]) 70,000 Unrealized gain on available-for-sale securities (4,700 – 3,000)1,700 Stockholders’ equity in accordance with U. S. GAAP171,700 With the adoption of FASB Statement No. 142, goodwill is no longer amortized (beginning in 2002) in the United States. There would still be a necessary adjustment to equity because goodwill is recorded as an asset in the United States. However, the adjustment would be for the entire 80,000. 2. MEBA Company Reconciliation of Net Income to U. S. GAAP Net income computed according to home country GAAP12,000 Adjustments required to conform with U. S. GAAP: Goodwill amortization (80,000/40 years)(2,000) Net income in accordance with U. S. GAAP10,000 With the adoption of FASB Statement No. 142, goodwill is no longer amortized (beginning in 2002) in the United States. Thus, there would be no need for the 2,000 reconciling item to subtract goodwill amortization. Thus, in this exercise, home country GAAP net income and U. S. GAAP net income would be the same. E 15-16 Preparation of a Form 20F Reconciliation 1. Gwang Ju Company Reconciliation of Stockholders’ Equity to U. S. GAAP Stockholders’ equity computed according to home country GAAP4,700,000 Adjustments required to conform with U. S. GAAP: Brand names (2,000,000) Postretirement obligation(1,500,000) Development costs (400,000) Stockholders’ equity in accordance with U. S. GAAP 800,000 Note: The adjustments for the postretirement obligation and development costs both reflect the fact that these amounts would have been expensed (reducing the retained earnings portion of stockholders’ equity) under U. S. GAAP. 2. Gwang Ju Company Reconciliation of Net Income to U. S. GAAP Net income computed according to home country GAAP500,000 Adjustments required to conform with U. S. GAAP: Development costs(400,000) Postretirement medical care expense(230,000) Net income in accordance with U. S. GAAP(130,000) PROBLEMS P 15-17 Foreign Currency Transactions 1. A purchase/sale resulting in a payable/receivable is considered separately from the subsequent payment/collection. The purchase/sale transaction is assumed to correctly measure the operating cost/revenue. Any exchange gains or losses on the payment/collection are the result of a decision not to settle immediately and not to hedge the open payable/receivable, but to speculate in exchange rate fluctuations. Accordingly, any exchange gains or losses are disclosed separately on the income statement as a financial item. Furthermore, adjustments are required at financial statement dates to recognize exchange gains or losses on outstanding payables/receivables. 2. The process of translating a foreign subsidiary’s financial statements is as follows: †¢ Assets and liabilities are translated using the current exchange rate prevailing as of the balance sheet date. †¢ Income statement items are translated at the average exchange rate for the year. †¢ Dividends are translated using the exchange rate prevailing on the date the dividends were declared. Paid-in capital is translated at the historical rate, that is, the rate prevailing on the date the subsidiary was acquired or the stock was issued. †¢ Retained earnings is translated in the first year using historical rates, but in subsequent years, it is computed by taking the balance in retained earnings from the prior per iod’s translated financial statements, adding translated net income, and subtracting translated dividends. †¢ A translation adjustment, either increasing or decreasing equity, is then recorded in order to balance the translated accounts. 3. A translation adjustment is recognized as accumulated other comprehensive income in the U. S. parent company’s stockholders’ equity. 4. ANALYSIS: The translation adjustment is recognized as a deferred gain (or loss) rather than as an income statement gain or loss because the only way the foreign currency gain can be realized is through liquidation of all the assets and liabilities of the foreign subsidiary. If the foreign subsidiary is a self-contained going concern, as it is assumed to be when the functional currency is the local currency and translation is used, it makes ense to defer the translation gain (or loss) because actual liquidation and conversion of the foreign subsidiary’s net assets into U. S. dollars is not expected any time soon. P 15-18 Foreign Currency Transactions 1. U. S. dollar amounts of receivables and (payables): Date of SaleBalance SheetDate of Payment or PurchaseDateor Receipt Goldstar (Korea)($515,000)($560,000)($575,000) Lockner (Switz erland)270,000270,000270,000 Geopacific (Canada)323,232332,112321,456 Printco (Japan)(337,500)(310,500)(328,500) 2. Exchange gains and (losses). An increase in a payable results in a loss; a decrease in a payable results in a gain. An increase in a receivable results in a gain; a decrease in a receivable results in a loss. Balance SheetDate of Payment Dateor Receipt Goldstar (Korea) ($45,000)($15,000) Lockner (Switzerland)nonenone Geopacific (Canada)8,880(10,656) Printco (Japan)27,000(18,000) Total ($9,120) ($43,656) Total exchange loss in 2002 is $9,120. Total exchange loss in 2003 is $43,656. 3. ANALYSIS: A company can partially hedge its exposure to foreign currency exchange risk by denominating transactions in a variety of different currencies. This is analogous to controlling investment risk by buying a diversified portfolio of stocks. As seen in this problem, some currencies strengthen at the same time that others weaken, and there is some canceling out of exchange gains and losses. However, this strategy does not eliminate all foreign currency exchange risk—in any given period, there is still exposure to exchange gains and losses. P 15-19 Translating Foreign Currency Financial Statements 1. Jane Company Ltd. Balance Sheet CanadianExchangeU. S. AccountDollarsRate*Dollars Cash$160,0000. 75$120,000 Accounts receivable, net180,0000. 75135,000 Inventory250,0000. 75187,500 Building, net800,0000. 75600,000 Land510,0000. 75382,500 Total assets$1,900,000$1,425,000 Accounts payable$170,0000. 75$127,500 Notes payable365,0000. 75273,750 Common stock700,0000. 85595,000 Retained earnings665,000 691,0001 Cumulative translation Adjustment(262,250)2 Total equities$1,900,000$1,425,000 Income Statement Sales$1,400,0000. 70$980,000 Cost of goods sold800,0000. 70560,000 Selling expenses320,0000. 70224,000 General and administrative expenses150,0000. 70105,000 Total expenses$1,270,000$889,000 Net income$130,000$91,000 *For the balance sheet, in all cases but common stock and retained earnings, the current exchange rate is used to translate the items. For common stock, the historical rate is used. For the income statement, the average rate is used. 1$600,000 retained earnings at the beginning of the period plus net income of $91,000 2Needed to make liabilities and stockholders’ equity equal to assets 2. ANALYSIS: U. S. Oils can reduce its foreign currency exposure in a variety of ways. One way is to replace some of its equity investment in Jane Company with debt. In the extreme, if total assets and total liabilities are the same amount, foreign currency exposure is zero because gains and losses on the assets and liabilities will perfectly offset one another. U. S. Oils can also enter into a long-term derivative agreement, such as a forward contract, that will hedge its exposure to Canadian dollar risk. P 15-20 Translating Foreign Currency Financial Statements 1. Doghead Technology Trial Balance December 31, 2003 Trial BalanceTrial Balance Dec. 31, 2003ExchangeDec. 31, 2003 (in French francs)Rate (in U. S. dollars) Cash925,000$0. 228$210,900 Accounts receivable1,875,0000. 228427,500 Inventory2,115,0000. 228482,220 Equipment1,025,0000. 228233,700 Cost of goods sold7,985,0000. 2101,676,850 Expenses4,234,0000. 210889,140 Dividends900,0000. 205184,500 Total debits19,059,000$4,104,810 Accounts payable2,100,0000. 228$478,800 Long-term debt1,000,0000. 228228,000 Paid-in capital1,200,0000. 175210,000 Retained Earnings (balance at beginning of year)640,000computed108,017* Sales14,119,0000. 2102,964,990 Translation adjustment115,003 Total credits19,059,000$4,104,810 *Retained earnings, 1/1/02 (301,000 francs ($0. 175)$52,675 Plus net income for 2002 (839,000 francs ($0. 178)149,342 $202,017 Less dividends for 2002 (500,000 francs ($0. 188)94,000 Retained earnings, 12/31/02$108,017 Doghead Technology Income Statement For the Year Ended December 31, 2003 Sales$2,964,990 Cost of goods sold1,676,850 Gross profit$1,288,140 Less: Expenses889,140 Net income$399,000 Doghead Technology Balance Sheet December 31, 2003 Assets Cash$210,900 Accounts receivable427,500 Inventory482,220 Equipment233,700 Total assets$1,354,320 Liabilities and Equity Accounts payable$478,800 Long-term debt228,000 Paid-in capital210,000 Retained earnings322,517 Translation adjustment115,003 Total liabilities and equity$1,354,320 Computation of retained earnings, December 31, 2003: Beginning retained earnings$108,017 Net income399,000 $507,017 Less: Dividends184,500 Ending retained earnings$322,517 2. ANALYSIS: Crab Beach invested 1,501,000 francs (total equity on January 1, 2002; 1,200,000 + 301,000) in Doghead Technology when one franc was worth $0. 175. By the end of 2003, each franc was worth $0. 228, suggesting that Crab Beach had experienced a gain of approximately $79,553 [1,501,000 francs ? ($0. 228 – $0. 175)]. The reason the deferred gain is not equal to $79,553 is that the investment just didn’t sit there during the two-year period—transactions occurred (sales, expenses, and dividends) that impacted the amount of Crab Beach’s net franc investment. P 15-21 Translating Foreign Currency Financial Statements 1. In the examples given in the text, the objective was to translate the financial statement items and determine the amount of translation adjustment required to balance the trial balance. In this case, the translation adjustment is given and the amount of retained earnings must be solved. Renecko Corp. Trial Balance Trial BalanceExchangeTrial Balance (in British pounds)Rate(in U. S. dollars) Cash55,000$1. 94$106,700 Accounts receivable113,0001. 94219,220 Inventory89,0001. 94172,660 Plant and equipment121,0001. 94234,740 Cost of goods sold218,0001. 98431,640 Other expenses74,0001. 98146,520 Dividends40,0001. 9778,800 Translation adjustment55,000 Total debits710,000$1,445,280 Current liabilities167,0001. 94$323,980 Long-term debt48,0001. 9493,120 Common stock100,0002. 15215,000 Retained earnings45,000*computed120,180** Revenues350,0001. 98693,000 Total credits710,000$1,445,280 *Total debits of 710,000 less credits (excluding retained earnings) of 665,000 = retained earnings of 45,000 as of the beginning of the year **Total debits of $1,445,280 less credits (excluding retained earnings) of $1,325,100 = retained earnings of $120,180 as of the beginning of the year Although not asked for in the problem, the retained earnings balance at the end of the year: Beginning retained earnings$120,180 Plus net income114,840 $235,020 Less dividends78,800 Ending retained earnings$156,220 2. ANALYSIS: This simple conversion process is misleading because it does not reflect the impact of changing exchange rates on the U. S. dollar value of South Kaibab’s investment in Renecko. | | |(In U. S. Dollars; | | |(In Pounds) |? 1 = $1. 4) | |Revenues |350,000 |679,000 | |Cost of goods sold |218,000 |422,920 | |Gross margin |132,000 |256,080 | |Other expenses | 74,000 |143,560 | |Net income | 58,000 |112,520 | | | | | |Cash | 55,000 |106,700 | |Accounts receivable |113,000 |219,220 | |Inventory | 89,000 |172,660 | |Plant and equipment | 121,000 | 234,740 | |Total assets | 378,000 | 733,320 | | | | | |Current liabilities | 167,000 | 323,980 | |Long-term debt | 48,000 | 93,120 | |Common stock | 100,000 | 194,000 | |Retained earnings | 63,000 | 122,220 | |Total liabilities and equity | 378,000 | 733,320 | P 15-22 Mutual Recognition 1. Of course, individual responses will differ on this question. One common opinion is that it is difficult to agree with this statement. It may hold for some countries, but certainly not all. As seen in the text of the chapter, significant adjustments must sometimes be made to convert the reported numbers under one country’s GAAP into U. S. GAAP. 2. Mutual recognition means that the financial statements of one country are recognized for all regulatory purposes by another country. For example, the SEC would recognize financial statements prepared under German GAAP as sufficient for meeting its regulations. For mutual recognition to be feasible, it would require that regulatory bodies believe that accounting practices of different countries are indeed equivalent. 3. ANALYSIS: The SEC could require complete restatement of financial statements, or a reconciliation to U. S. GAAP at a minimum. P 15-23 Preparation of a Form 20F Reconciliation 1. HKUST Company Reconciliation of Stockholders’ Equity to U. S. GAAP Stockholders’ equity computed according to home country GAAP146,000 Adjustments required to conform with U. S. GAAP: Minority interest included in stockholders’ equity (25,000) Unrealized gain on trading securities (4,700 – 3,000)1,700 Interest on the financing of self-constructed assets5,000 Stockholders’ equity in accordance with U. S. GAAP127,700 Note: The adjustments for the interest on the financing of self-constructed assets reflects the fact that this amount would NOT have been expensed (NOT reducing the retained earnings portion of stockholders’ equity) under U. S. GAAP. Similarly, the unrealized gain on trading securities would have increased net income, also increasing retained earnings. 2. HKUST Company Reconciliation of Net Income to U. S. GAAP Net income computed according to home country GAAP33,000 Adjustments required to conform with U. S. GAAP: Minority interest income(4,100) Unrealized gain on trading securities (4,700 – 3,000)1,700 Interest on the financing of self-constructed assets5,000 Net income in accordance with U. S. GAAP35,600 3. ANALYSIS: Home Country GAAPU. S. GAAP Net income33,00035,600 Stockholders’ equity146,000127,700 Return on equity22. 6%27. 9% In this case, return on equity is higher for HKUST using U. S. GAAP. Similarly, in many cases the reconciliation to U. S. GAAP will result in lower reported return on equity. A company might not wish to reconcile its reported numbers to U. S. GAAP, even when doing so would result in higher return on equity, because the reconciliation might require disclosure of information that the company would rather not disclose. In addition, the reconciliation process requires some effort by the accounting staff and so is not costless. P 15-24 Preparation of a Form 20F Reconciliation 1. Delpie Company Reconciliation of Stockholders’ Equity to U. S. GAAP Stockholders’ equity computed according to home country GAAP4,000,000 Adjustments required to conform with U. S. GAAP: Goodwill, adjusted for amortization (1,600,000 – [1,600,000 ( 3/40])1,480,000 Possible obligation for severance benefits1,500,000 Stockholders’ equity in accordance with U. S. GAAP6,980,000 With the adoption of FASB Statement No. 142, goodwill is no longer amortized (beginning in 2002) in the United States. There would still be a necessary adjustment to equity because goodwill is recorded as an asset in the United States. However, the adjustment would be for the entire 1,600,000. Note: The adjustment for the possible obligation for severance benefits reflects the fact that this amount would not have been expensed under U. S. GAAP, resulting in higher net income and an increase to the retained earnings portion of stockholders’ equity. 2. Delpie Company Reconciliation of Net Income to U. S. GAAP Net income computed according to home country GAAP400,000 Adjustments required to conform with U. S. GAAP: Possible obligation for severance benefits1,500,000 Goodwill amortization (1,600,000/40 years)(40,000) Net income in accordance with U. S. GAAP1,860,000 With the adoption of FASB Statement No. 142, goodwill is no longer amortized (beginning in 2002) in the United States. Thus, there would be no need for the 40,000 reconciling item to subtract goodwill amortization. 3. ANALYSIS: It appears that Delpie chose to recognize the obligation for possible future severance benefits this year rather than waiting to recognize the obligation in a future year in order to smooth its reported income. If Delpie had waited until next year to recognize the obligation for severance benefits, a large increase in income this year (from the unusual gain) would have been followed by a large decrease next year. Investors prefer a steadily increasing earnings stream, not one that wildly fluctuates from one year to the next. APPLICATIONS AND EXTENSIONS Deciphering Actual Financial Statements Deciphering 15-1 McDonald’s 1. McDonald’s reports that the functional currency of its operations that are located outside the United States is the local currency, with the exception of hyperinflationary countries. For those countries, the U. S. dollar is the functional currency. 2. McDonald’s purchases foreign currency options to serve as hedges of anticipated foreign currency royalty and other payments received from affiliates and subsidiaries. Short-term forward foreign exchange contracts are also used to mitigate exposure on foreign currency royalty and other payments received from affiliates and subsidiaries. Non-U. S. dollar financing transactions are used as hedges of long-term investments in foreign subsidiaries. 3. McDonald’s enters into agreements to exchange various foreign currencies in order to hedge the royalty payments that it expects to receive that are denominated in foreign currencies. Deciphering 15-2 Microsoft 1. In U. S. Dollars In Australian (AUD) dollars; AUD$1 = US $0. 6250. Net Income – U. S. GAAP15,054$9,409 In Canadian (C) dollars; C$1 = US $0. 6786. Net Income – U. S. GAAP13,8839,421 In British (BP) pounds; BP1 = US $1. 5908. Net income per published U. S. financial statements5,9229,421 In terms of U. S. dollars, the U. S. GAAP net incomes are the same for each of the three countries illustrated, except for rounding differences. 2. In U. S. In MarksDollars Jahresuberschu? nach deutschen Rechnungslegungs- vorschriften (HGB), nach Vorzugsdividenden22,775$11,629 Abschreibung auf erworbene Software19399 Rechnungslegungsvorschriften11860 Steuerminderung aufgrund der Ausubung von Aktienkaufoptionen durch Mitarbeiter(4,636)(2,367) Jahresuberschu? nach U. S. GAAP18,452$9,421 A similar table can be constructed using the Canadian GAAP disclosures: In CanadianIn U. S. DollarsDollars Net income – Canadian GAAP17,136$11,628 Acquired in-process technology 14598 Visio Pooling8960 Tax benefit of stock options(3,487)(2,366) Net Income – U. S. GAAP13,883$9,420 It is easy to match up the two reconciling items. In addition, from this comparison we see that, according to Microsoft, German GAAP and Canadian GAAP are almost identical in this case. Deciphering 15-3 Reed Elsevier 1. 2000Netherlands GAAPU. S. GAAP Net income3360 Stockholders’ equity3,0413,707 Return on equity1. 1%1. 6% 1999Netherlands GAAPU. S. GAAP Net income(63)(73) Stockholders’ equity1,8552,423 Return on equity(3. 4)%(3. 0)% 2. For both years, return on equity for Reed Elsevier computed using U. S. GAAP is higher than return on equity computed using Netherlands GAAP. This suggests that if a financial analyst is comparing Reed Elsevier’s financial ratios to those of a U. S. company, it is very important that the analyst do everything possible to make adjustments for the differing accounting standards used. International Financial Statements: BMW 1. Balance Sheet of BMW AG At December 31, 2000 in millions of Euro Current assets: Liquid funds2,879 Marketable securities and notes751 Trade receivables1,449 Receivables from sales finanacing10,372 Leased products7,206 Other receivables and other assets2,804 Inventories2,809 Prepaid expenses842 Total current assets29,112 Financial assets950 Tangible assets5,710 Intangible assets103 Total Assets35,875 Current liabilities: Trade payables1,831 Liabilities to banks105 Total current liabilities1,936 Long-term liabilities: Liabilities from sales financing15,508 Deferred income61 Deferred income from leasing financing662 Bonds2,211 Other liabilities2,391 Pension provisions1,666 Other provisions6,507 Registered profit-sharing certificates37 Total Liabilities30,979 Shareholders’ equity: Subscribed capital672 Capital reserve1,914 Revenue reserves2,000 Unappropriated profit available for distribution310 Total shareholders’ equity4,896 Total Liabilities and Shareholders’ Equity35,875 The prepaid expenses have been included with current assets; BMW lists them in a separate category. The trade payables (accounts payable) are obviously current liabilities; the small amount of â€Å"liabilities to banks† has also been somewhat arbitrarily classified as current. The item â€Å"registered profit-share certificates† is somewhat of a mystery; however, it must be either a liability or an equity and BMW excludes it from shareholders’ equity so it is reported as a liability here. BMW’s equity section contains a number of unfamiliar labels. Subscribed capital and capital reserve correspond very roughly with common stock at par and paid-in capital in excess of par. Revenue reserves corresponds approximately with retained earnings. The unappropriated profit is the amount of retained earnings that has been authorized (in accordance with the law and by vote of the board of directors) to be paid as dividends in the future. 2. Income Statement of BMW AG for the financial year ended December 31, 2000 in millions of Euros Net sales35,356 Cost of sales28,974 Gross profit6,382 Selling and marketing costs4,194 General administration costs520 Other operating expenses2,0256,739 (357) Other operating income1,935 Total operating income1,578 Net income from investments148 Net interest income388 Interest expenses from leasing financing(45185 Income before income taxes1,663 Taxes on income637 Net income1,026 Note: The exact arrangement given above is just one of many possible groupings. The category â€Å"Other operating income† includes gains on the disposal of fixed assets, gains from currency transactions and income from the release of provisions and liabilities. It is interesting to note that whether BMW generates profit from its operations depends on how one classifies these â€Å"other operating income† items. Business Memo: Choosing the Functional Currency To:The Board of Directors of Jeff Pong Company From:Member of the Accounting Staff Subj:Conversion of Mak Hung financial statements into U. S. dollars Once the financial statements of Mak Hung Enterprises have been restated to be in conformity with U. S. GAAP, they will be converted into U. S. dollars using the following process: †¢ Assets and liabilities are translated using the current exchange rate prevailing as of the balance sheet date. †¢ Income statement items are translated at the average exchange rate for the year. †¢ Capital stock is translated at the historical rate, i. e. , the rate prevailing on the date Mak Hung was acquired. This process is called translation and is used for all foreign subsidiaries that are considered to be self-contained. A self-contained foreign subsidiary is one that denominates most of its transactions in the local currency (Chinese yuan in this case). The local currency is called the functional currency of the subsidiary. This case contrasts with a subsidiary that primarily serves as a cash conduit for the parent; with this type of subsidiary, many transactions are denominated in U. S. dollars and cash transactions between the parent and subsidiary are frequent. For this type of parent-dependent subsidiary, the functional currency is said to be the U. S. dollar and the exchange rate conversion process, called remeasurement, differs significantly from the translation process outlined above. The accounting implications of the translation process are that any gains or losses arising from changes in the U. S. dollar/Chinese yuan exchange rate are not recognized as part of income but are instead reported as a separate category under consolidated equity. Research: The Movement of Exchange Rate U. S. dollar value of one currency unit January 1, 1999June 27, 2001 U. S. dollar1. 00001. 0000 British pound1. 66271. 4151 Chinese yuan (renminbi)0. 12080. 1208 Russian ruble0. 04790. 0343 euro1. 18740. 8633 euro value of one currency unit January 1, 1999June 27, 2001 U. S. dollar0. 84221. 1584 British pound1. 40031. 6392 Chinese yuan (renminbi)0. 10170. 1400 Russian ruble0. 04030. 0397 euro1. 00001. 0000 1. Relative to the euro, the U. S. dollar, the British pound, and the Chinese yuan strengthened between January 1, 1999 and June 27, 2001. The Russian ruble weakened slightly relative to the euro during that period. 2. The predominant trend during the two-and-a-half-year period examined was a weakening of the euro as financial markets expressed concern about whether the member countries would have the financial discipline to maintain the value of the euro. The Russian ruble continued to slide during this period in response to continued uncertainty over the solvency of the Russian government. 3. At this point, it is hard to say whether the euro will continue to weaken. One sure-fire piece of investment advice is to never try to outguess the foreign currency exchange market. Ethics Dilemma: Fear of Reporting Under U. S. GAAP This scenario is very close to what actually happened inside Daimler-Benz in 1993. The chief financial officer, Gerhard Liener, pushed hard to get Daimler-Benz to list its shares in the United States. Mr. Liener’s motivation was not so much gaining access to the U. S. securities markets but instead was exposing Daimler-Benz to the regulatory and disclosure requirements in the United States. Mr. Liener believed that, without these requirements, Daimler-Benz would continue to hide operating losses through the reversal of â€Å"hidden reserves. In doing so, the management of the company would delay making the tough decisions needed to fix the company. Mr. Liener’s story is a sad one. He was later ousted from the management of Daimler-Benz after portions of his diary, critical of the former chairman of the company, we re printed. Mr. Liener committed suicide in 1995. Nathaniel C. Nath, â€Å"Ex-Executive of Daimler is Called Suicide,† The New York Times, December 15, 1995: p. D2. The Debate: The FASB or the IASB Supporters of the FASB †¢ The United States has the largest capital market in the world. †¢ The FASB has long experience working with businesspeople in a sophisticated capital market. †¢ The FASB is well funded and has an experienced technical staff. Most of the advances in accounting standards in the past 20 years have originated with the FASB. †¢ The FASB enjoys broad business support. Supporters of the IASB †¢ There are many people and companies around the world who would never follow FASB standards just for the fact that they originate in the United States. †¢ The IASB enjoys broad-based support from many different countries. †¢ The IASB has particularly strong support among developing countries. †¢ The IASB has a head start in gaining in ternational credibility for its body of standards. Cumulative Spreadsheet Project 1. NOTE: BECAUSE OF SPREADSHEET ROUNDING, NOT ALL OF THE DISPLAYED TOTALS RECONCILE EXACTLY. HandymanHistorical rate0. 40 Chapter 15, Part 1Ending rate0. 62 Average rate0. 51 | | Year | Translated | | | | | 2003 | 2003 | | | |Balance Sheet | | | | | |Assets | | | | | |Cash |10 |6. 0 | | | |Receivables |27 |16. 74 | | | |Inventory |153 | 94. 86 | | | |Total current assets |190 |117. 80 | | | | | | | | | |Property, plant, equipment |199 |123. 8 | | | |Accumulated depreciation | 9 | 5. 58 | | | |Total Assets |380 |235. 60 | | | | | | | | | |Liabilities | | | | | |Accounts payable |74 |45. 8 | | | |Short-term loans payable | 10 | 6. 20 | | | |Total current liabilities |84 |52. 08 | | | | | | | | | |Long-term debt |207 |128. 34 | | | |Total Liabilities |291 |180. 2 | | | | | | |Translation | | |Stockholders’ Equity | | |Adjustment |$18. 70 | |Paid-in capital |50 |20. 00 | | | |Retained Earnings (as of 12/31) | 39 | 16. 48 | | | |Total Liab. and Equities |380 |216. 0 | | | | | | | | | |Retained Earnings (as of 1/1) |31 |12. 40 | | | |+ Net income |8 |4. 08 | | | |– Dividends | 0 | 0. 0 0 | | | |Retained Earnings (as of 12/31) | 39 | 16. 8 | | | | | | | | | |Income Statement | | | | | |Sales |700 |357. 00 | | | |Cost of goods sold |519 |264. 69 | | | |Gross profit |181 |92. 31 | | | |Depreciation expense |5 |2. 55 | | | |Other operating expenses |155 | 79. 5 | | | |Operating income |21 |10. 71 | | | |Interest expense | 9 | 4. 59 | | | |Income before taxes |12 |6. 12 | | | |Income tax expense | 4 | 2. 04 | | | |Net Income | 8 | 4. 08 | | | 2. HandymanHistorical rate0. 40 Chapter 15, Part 2Ending rate0. 28 Average rate0. 34 | | Year | Translated | | | | | 2003 | 2003 | | | |Balance Sheet | | | | | |Assets | | | | | |Cash |10 |2. 0 | | | |Receivables |27 |7. 56 | | | |Inventory |153 |42. 84 | | | |Total current assets |190 |53. 20 | | | | | | | | | |Property, plant, equipment |199 |55. 2 | | | |Accumulated depreciation | 9 | 2. 52 | | | |Total Assets |380 |106. 40 | | | | | | | | | |Liabilities | | | | | |Accounts payable |74 |20. 2 | | | |Short-term loans payable | 10 | 2. 80 | | | |Total current liabilities |84 |23. 52 | | | | | | | | | |Long-term debt |207 | 57. 96 | | | |Total Liabilities |291 |81. 8 | | | | | | |Translation | | |Stockholders’ Equity | | |Adjustment |($10. 20) | |Paid-in capital |50 |20. 00 | | | |Retained Earnings (as of 12/31) | 39 | 15. 12 | | | |Total Liab. and Equities |380 |116. 0 | | | | | | | | | | | | | | | |Retained Earnings (as of 1/1) |31 |12. 40 | | | |+ Net income |8 |2. 72 | | | |– Dividends | 0 | 0. 00 | | | |Retained Earnings (as of 12/31) | 39 | 15. 12 | | | | | | | | | | | | | | |Income Statement | | | | | |Sales |700 |238. 00 | | | |Cost of goods sold |519 |176. 46 | | | |Gross profit |181 |61. 54 | | | |Depreciation expense |5 |1. 70 | | | |Other operating expenses |155 | 52. 0 | | | |Operating income |21 |7. 14 | | | |Interest expense | 9 | 3. 06 | | | |Income before taxes |12 |4. 08 | | | |Income tax expense | 4 | 1. 36 | | | |Net Income | 8 | 2. 72 | | | 3. The translation adjustment in (1) is an increase in equity, reflecting the fact that the foreign currency has increased in value since the U. S. parent invested in Handyman. In contrast, the translation adjustment in (2) is a decrease in equity, reflecting the decline in the value of the foreign currency. Internet Search: www. daimlerchrysler. com This solution was prepared using information available on DaimlerChrysler’s Web site on June 12, 2001. 1. DaimlerChrysler reports that it’s NECAR 4 (New Electric Car) is now in operation and testing in California with a top speed of 145 km/h and an operating range of 450 kilometers. After testing they plan to begin production in 2003. 2. The 2000 income statement reveals that the combined company of DaimlerChrysler had net income of $7,411 million on revenues of $152,446 million. 3. The DaimlerChrysler financial statements are presented in both U. S. dollars and in euros. The balance sheet format is different from the standard U. S. format, with long-term assets being shown first and stockholders’ equity being listed before liabilities. 4. In its annual report, the company notes that â€Å"assets and liabilities of foreign subsidiaries . . . are generally translated using period-end exchange rates while the statements of income are translated using average exchange rates during the period. † This statement indicates that the company translates rather than remeasures. As of 12/31/00, DaimlerChrysler reported a cumulative translation adjustment of 3. 285 billion euros. Test Your Intuition Can U. S. companies create â€Å"hidden reserves†? Explain. Yes, U. S. companies can create â€Å"hidden reserves. † Recall that hidden reserves are simply overstatements of expenses that can be reversed in future years to bolster income. A prime example of a â€Å"hidden reserve† used by U. S. companies is a restructuring charge. Assume that France Company is a French company that happens to use U. S. GAAP. Will France Company recognize a $638 exchange gain on June 1, 2003? Explain your answer. No, France Company will not necessarily recognize a $638 exchange gain on June 1, 2003. If France Company maintains its accounting records in francs, then it will report no exchange gains or losses in association with this franc-denominated contract. If France Company were to maintain its records in U. S. dollars, then it would recognize a $638 gain. However, it is highly unlikely that a French company would maintain its records in U. S. dollars. These days, it is more likely for the company to maintain its records in euros. Using the information in Exhibit 15-5, identify the German words for â€Å"receivables† and â€Å"liabilities. † The word â€Å"receivables† appears three times in the current asset section. The corresponding German word appears to be â€Å"Forderungen. † The German word for liabilities, found several times in the bottom section