Bhagyesh Ghagi Section B Roll no.

214
Translating foreign currency financial statements. Refer to the preceding illustration
for Domestic Company and its U.K. subsidiary for Year 1. The following information relates to the
U.K. subsidiary for Year 2. All transactions occur evenly during Year 2.
1. Acquires inventory on account totalling £850.
2. Sells inventory costing £800 on account for £1,200.
3. Pays selling and administrative expenses of £160, interest expense of £50, and income tax expense of
£45.
4. Collects £1,160 from customers for sales on account and pays £820 to suppliers for purchases of inventory
on account.
5. Pays dividends of £25 evenly during Year 2.
6. Recognizes £50 of depreciation expense.
The exchange rates were as follows:

When Subsidiary Issued Bonds and Common Stock $2.0:£1

When Subsidiary Acquired Property, Plant, and Equipment $2.0:£1
December 31, Year 1 $2.2:£1
Average during Year 2 $2.0:£1
When Subsidiary Acquired Inventory Available for Sale during Year 2 $2.015:£1
December 31, Year 2 $1.8:£1

a. Prepare a balance sheet for the U.K. subsidiary in U.K. pounds and in U.S. dollars on December 31, Year
2, using (1) the all-current translation method and (2) the monetary-nonmonetary translation method.
Follow U.S. accounting principles by including the foreign exchange adjustment in a separate shareholders’
equity account under the all-current method and in net income (and, therefore, retained earnings)
under the monetary-nonmonetary method.
b. Prepare a statement of net income and retained earnings for the U.K. subsidiary for Year 2 in U.K.
pounds and U.S. dollars using (1) the all-current translation method and (2) the monetary-nonmonetary
translation method. This statement should reconcile the change in retained earnings during Year 2 in both
U.K. pounds and U.S. dollars. Note that retained earnings on January 1, Year 2, is $168 under the all-current
method and $91 under the monetary-nonmonetary method (see Exhibit 1).

a)
Translation of Balance Sheet
December 31, Year 2
All-Current Method Monetary-Nonmonetary Method
Exchange Exchange
Pounds Rate Dollars Pounds Rate Dollars
ASSETS
Cash £140 $1.8:£1 $ 252 £140 $1.8:£1 $ 252
Accounts Receivable 160 $1.8:£1 288 160 $1.8:£1 288
Inventories 200 $1.8:£1 360 200 $2.015:£1 403
Property, Plant, and
Equipment (net) 400 $1.8:£1 720 400 $2.0:£1 800
Total Assets £900 $1,620 £900 $1,743
LIABILITIES AND
SHAREHOLDERS’ EQUITY
Accounts Payable £200 $1.8:£1 $ 360 £200 $1.8:£1 $ 360
Bonds Payable 450 $1.8:£1 810 450 $1.8:£1 810
Common Stock 100 $2.0:£1 200 100 $2.0:£1 200
Total Liabilities and
Shareholders’ Equity £900 $1,620 £900 $1,743

b)
Translation of Income Statement and Retained Earnings for Year 2

All-Current Method Monetary-Nonmonetary Method

Exchange Exchange
Pounds Rate Dollars Pounds Rate Dollars
Sales . . . . . . . . . . . . . . . . . . . . . . . . £1,200 $2.0:£1 $2,400 £1,200 $2.0:£1 $ 2,400
Cost of Goods Sold . . . . . . . . . . . . . . (800) $2.0:£1 (1,600) (800) $2.015:£1 (1,612)
Selling and Administrative . . . . . . . . . (160) $2.0:£1 (320) (160) $2.0:£1 (320)
Depreciation . . . . . . . . . . . . . . . . . . . (50) $2.0:£1 (100) (50) $2.0:£1 (100)
Interest. . . . . . . . . . . . . . . . . . . . . . . (50) $2.0:£1 (100) (50) $2.0:£1 (100)
Income Taxes . . . . . . . . . . . . . . . . . . (45) $2.0:£1 (90) (45) $2.0:£1 (90)
Net Income . . . . . . . . . . . . . . . . . . . . 95 $ 190 £ 95 $ 332
Less Dividends . . . . . . . . . . . . . . . . . (25) $2.0:£1 (50) (25) $2.0:£1 (50)
Increase in Retained Earnings . . . . . . £ 70 $ 140 £ 70 $ 282

December 31, Year 2 . . . . . . . . . . £ 150 $ 308 £ 150 $ 373

6- Insurance against exchange rate risk

On January 1, 2000 Xerox Corporation signs a contract with Japanese government to
supply office machinery. The contract stipulates that Xerox will receive 500,000 Yen on
January 1, 2001. Xerox wishes to insure itself against exchange rate risk.
The yield on a one year US Treasury bill on January 1, 2000 is 5.73% and the yield on a
one year
Japanese Treasury bond is 1.17%. The spot exchange rate on the same date is 110 Yen
per US dollar.

a. Suppose that Xerox uses the forward market to insure itself against exchange
rate risk. Compute the amount of dollars that Xerox will receive for sure.
Using Covered Interest rate parity, the implied forward exchange rate is
F = [(1+0.0117)/(1+0.0573)]* 110 = 105.26,
(Yen per dollar) hence the amount of dollars that Xerox will receive is
$500,000/105.26 = 4750.14.

b. Suppose that there were no forward markets and that Xerox does not want any
exposure to exchange rate risk. The company can still eliminate all exchange rate
risk by borrowing in Yen and investing in US Treasury bonds.

b1. Compute the magnitude of Yen borrowing that Xerox will have to conduct to
insure against exchange rate risk.
Xerox will borrow in yen the amount
500,000/(1+0.0117)=494217.65,
that is the present value of 500,000 yen. Then invest this amount, in dollars, in
U.S. t-bills. The amount of USD invested is 500,000/((1+0.0117)*110), and the
amount of dollars received at the end of the year is
[500,000/((1+0.0117)*110)]*(1+0.0573).
b2. Compute the amount of dollars that Xerox will receive.
As shown above the amount of dollars Xerox will receive is
[500,000/((1+0.0117)*110)]*(1+0.0573)=$4750.33