Assume that your company owns a subsidiary operating in Germany. The subsidiary
ID: 2802318 • Letter: A
Question
Assume that your company owns a subsidiary operating in Germany. The subsidiary conducts most of its business in the European Economic Union and maintains its books using the Euro as its functional currency. Following are the subsidiary’s financial statements (in €) for the most recent year:
Subsidiary (in €)
Income statement:
Cost of goods sold…………………………………………………………… (657,000)
Gross profit…………………………………………………………………… 438,000
Operating expenses…………………………………………………………… (284,700)
Net income…………………………………………………………………… €153,300
Statement of retained earnings:
Beginning of year retained earnings………………………………………….. €574,875
Net income……………………………………………………………………. 153,330
Dividends………………………………………………………………………. (15,330)
Ending retained earnings………………………………………………………. €712,845
Balance Sheet
Cash……………………………………………………………………………. €311,637
Accounts receivable……………………………………………………………. 254,040
Inventory……………………………………………………………………….. 326,310
PPE, net………………………………………………………………………… 603,564
Total assets……………………………………………………………………... €1,495,551
Liabilities and Stockholders’ equity
Current liabilities………………………………………………………………. €185,712
Long-term liabilities…………………………………………………………… 432,744
Common stock…………………………………………………………………. 73,000
APIC …………………………………………………………………………… 91,250
Retained earnings………………………………………………………………. 712,845
Cumulated translation adjustment……………………………………………....
Total liabilities & equity………………………………………………………... €1,495,551
Statement of cash flows:
Net income……………………………………………………………………… €153,330
Change in accounts receivable………………………………………………….. (42,340)
Change in inventories…………………………………………………………… (54,385)
Change in current liabilities……………………………………………………… 30,952
Net cash flows from operating activities………………………………………… 87,527
Purchase of PPE…..………………………………………………………………. (56,064)
Net cash flows from investing activities…………………………………………. (56,064)
Proceeds from long-term debt……………………………………………………. 72,174
Payment of Dividends……………………………………………………………. (15,330)
Net cash flows from financing activities…………………………………………. 56,794
Net Change in cash……………………………………………………………….. 88,257
Effect of exchange rate on cash……………………………………………………
Beginning cash……………………………………………………………………. 223,380
Ending cash……………………………………………………………………….. €311,637
The relevant exchange rate are as follows:
Beginning of year rate…………………………………………………………….. $0.95
Ending of year rate………………………………………………………………… $1.04
Average rate……………………………………………………………………….. $1.01
PPE purchase date rate…………………………………………………………….. $0.99
LTD borrowing date rate…………………………………………………………... $1.03
Dividend declaration date rate……………………………………………………… $1.02
Historical rate (common stock and APIC)…………………………………………. $0.63
Translate the subsidiary’s income statement, statement of retained earnings, balance sheet and statement of cash flow into the $US statements using the current rate method (assume that the beginning of year Retained Earnings is $437,543).
Explanation / Answer
Now when we want to convert functional currency in reporting currency using current rate method following point must be kept in mind.
The translation of financial statements begins with translating the income statement
All income transactions be translated at the rate that existed when the transaction occurred.
In most cases the use of an average rate is acceptable where transactions occur uniformly throughout the year. In our case, we will use an average rate based on the average annual rate, but businesses that are seasonal or transact business in currencies that fluctuate widely may want to translate using rates based on monthly weighted averages.
Then we will convert Balance sheet into reporting currency
the current rate method translates all assets and liabilities at the current spot rate at the date of translation.
But issued capital stock is translated at the exchange rate on the date of issuance and retained earning using following steps
beginning retained earning = already given
+Net income = take value from income statement
- Dividend = using rate at the time of declaring dividend
= End of retained earning
After doing all this work in the current rate method, the balance sheet must be balanced due to difference that will arise because of using different rate for some item in balance sheet.
Such difference is known as Cumulative Translation Adjustment
It is shown in other comprehensive income and separately in balance sheet under stock holder equity section.
And lastly cash flow using Average Rate.
Income statement: in Euro Avg. RATE in Dollars
Cost of goods sold…………………………………………………… (657,000) 1.01 (663570)
Gross profit…………………………………………………………… 438,000 1.01 442380
Operating expenses…………………………………………………… (284,700) 1.01 (287547)
Net income…………………………………………………………… 153,300 1.01 154833
Statement of retained earnings: in Euros Rate in Dollars
Beginning of year retained earnings………………………………….. 574,875 - 437543
Net income……………………………………………………………. 153,330 - 154833
Dividends………………………………………………………………. (15,330) 1.02 (15,637)
Ending retained earnings………………………………………………. 712,845 - 576739
Balance Sheet
Assets in Euros Rate in Dollars
Cash……………………………………………………………………. 311,637 1.04 324102
Accounts receivable………………………………………………… 254,040 1.04 264202
Inventory………………………………………………………………. 326,310 1.04 339362
PPE, net……………………………………………………………… 603,564 1.04 627707
Total assets……………………………………………………………..1,495,551 1555373
Liabilities and Stockholders’ equity
Current liabilities………………………………………………………. 185,712 1.04 193140
Long-term liabilities…………………………………………………… 432,744 1.04 450054
Common stock…………………………………………………………. 73,000 0.63 45990
APIC …………………………………………………………………… 91,250 0.63 57488
Retained earnings………………………………………………………. 712,845 - 576739
Cumulated translation adjustment…………………………………….... 231962
Total liabilities & equity……………………………………………... 1,495,551 1555373
Statement of cash flows: in Euros Rate In dollars
Net income……………………………………………………………… 153,330 1.01 154863
Change in accounts receivable…………………………………………..(42,340) 1.01 (42763)
Change in inventories…………………………………………………… (54,385) 1.01 (54929)
Change in current liabilities…………………………………………… 30,952 1.01 31262
Net cash flows from operating activities……………………………… 87,527 1.01 88402
Purchase of PPE…..……………………………………………………. (56,064) 1.01
Net cash flows from investing activities………… …………………. (56,064) 1.01
Proceeds from long-term debt…………………………………………. 72,174 1.01
Payment of Dividends…………………………………………………. (15,330) 1.01
Net cash flows from financing activities……………………………… 56,794 1.01
Net Change in cash…………………………………………………….. 88,257 1.01
Effect of exchange rate on cash……………………………………………
Beginning cash……………………………… …………………………. 223,380 1.01
Ending cash……………………………………………………… …….. 311,637 1.01