Question

HOW DO WE REPORT THIS?

Southwestern Corporation operates throughout Texas buying and selling widgets. To expand into more profitable markets, the company recently decided to open a small subsidiary in the nearby country of Gualos. The currency in Gualos is the vilsek. For some time, the government of that country held the exchange rate constant: 1 vilsek equaled $0.20 (or 5 vilseks equaled $1.00). Initially, Southwestern invested cash in this new operation; its $90,000 was converted into 450,000 vilseks ($90,000 × 5). Southwestern used one-third of this money (150,000 vilseks, or $30,000) to purchase land to hold for the possible construction of a plant, invested one-third in short-term marketable securities, and spent one-third in acquiring inventory for future resale.

Shortly thereafter, the Gualos government officially revalued the currency so that 1 vilsek was worth $0.23. Because of the strength of the local economy, the vilsek gained buying power in relation to the U.S. dollar. The vilsek then was considered more valuable than in the past. Southwestern’s accountants realized that a change had occurred; each of the assets (land, inventory, and marketable securities) was now worth more in U.S. dollars than the original $30,000 investment: 150,000 vilseks × $0.23 = $34,500. Two of the company’s top officers met to determine the appropriate method for reporting this change in currency values.

Controller: Nothing has changed. Our cost is still $30,000 for each item. That’s what we spent. Accounting uses historical cost wherever possible. Thus, we should do nothing.

Finance director: Yes, but the old rates are meaningless now. We would be foolish to report figures based on a rate that no longer exists. The cost is still 150,000 vilseks for each item. You are right, the cost has not changed. However, the vilsek is now worth $0.23, so our reported value must change.

Controller: The new rate affects us only if we take money out of the country. We don’t plan to do that for many years. The rate will probably change 20 more times before we remove money from Gualos. We’ve got to stick to our $30,000 historical cost. That’s our cost and that’s good, basic accounting.

Finance director: You mean that for the next 20 years we will be translating balances for external reporting purposes using an exchange rate that has not existed for years? That doesn’t make sense. I have a real problem using an antiquated rate for the inventory and marketable securities. They will be sold for cash when the new rate is in effect. These balances have no remaining relation to the original exchange rate.

Controller: You misunderstand the impact of an exchange rate fluctuation. Within Gualos, no impact occurs. One vilsek is still one vilsek. The effect is realized only when an actual conversion takes place into U.S. dollars at a new rate. At that point, we will properly measure and report the gain or loss. That is when realization takes place. Until then our cost has not changed.

Finance director: I simply see no value at all in producing financial information based entirely on an exchange rate that does not exist. I don’t care when realization takes place.

Controller: You’ve got to stick with historical cost, believe me. The exchange rate today isn’t important unless we actually convert vilseks to dollars.

a. How should Southwestern report each of these three assets on its current balance sheet?

b. Does the company have a gain because the value of the vilsek has increased relative to the U.S. dollar?

Answer 1

The solution goes as follows -

The current case presented in the problem is related to accounting for foreign currency transaction and it will not be an exaggeration to state that most significant perspective for accounting at international operations is the transaltion of financial statements.

What is Foreign currency transaction ?

A foreign currency transaction is any transaction that is denominated in or needs to settle in any foreign currency.Such foreign currency transaction must be recorded on initial recognition in reporting currency by applying the exchange rate between the foreign currency and the reporting currency amount at the date of the transaction.

REQUIREMENT:-

1) How should Southwestern report each of these three assets on its current balance sheet?

Answer- There are different approaches when it comes to accounting for foreign currency translation,and the treatment will vary according to different methods -

A. CURRENT RATE METHOD-  According to this method , all assets at current balance sheet are restated at their domestic currency equivalents on the basis of rate only i.e Current Rate / Closing Rate.

Example

• Acquistion of Land    = 150 Vilseks x $0.23 = $34,500
• Purchase of Market securities = 150 Vilseks x $0.23 = $34,500
• Purchase of Inventory    = 150 Vilseks x $0.23 = $34,500

B. TEMPORAL METHOD -  According to this method , all assets at current balance sheet are restated at their domestic currency equivalents on the basis of rate only i.e Current Rate / Closing Rate and fixed assets are stated at historical cost rate.

Example

• Acquistion of Land    = 150 Vilseks x $0.20 = $30,000
• Purchase of Market securities = 150 Vilseks x $0.23 = $34,500
• Purchase of Inventory    = 150 Vilseks x $0.23 = $34,500

2.  Does the company have a gain because the value of the vilsek has increased relative to the U.S. dollar?

Answer - The subsidiary has a gain on account of increase in the value of all the assets if we consider current rate method , that is

$34,500 - $30,000 = $4,500

THANK YOU !

AND HAVE A NICE DAY !!