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 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 investments and inventory. 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 Gua- los, 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.

How should Southwestern report each of these three assets on its current balance sheet? Does the company have a gain because the value of the vilsek has increased relative to the U. S. dollar? Could you be more specific about the three assets? How should the land be reported? The same as investments held for trading?

Answer 1

A foreign currency transaction is any transaction that is denominated in or needs to settle in any foreign currency. Such foreign currency transactions must be recorded, on initial recognition in reporting currency, by applying the exchange rate between the foreign currency and the reporting currency to the foreign currency amount at the date of the transaction. So at the time of transaction these three assets i.e. Land, Marketable Securities, and Inventory are to be recorded as follows:

Land                        $30,000(150,000vilsek *0.20)

Securities                $30,000(150,000vilsek *0.20)

Inventory                $30,000(150,000vilsek *0.20)

Exchange differences may result from translating income and expenses at the exchange rates at the dates of the transactions and assets and liabilities at the closing rate. Such exchange differences may arise both on income and expense items recognized in profit or loss and on those recognized directly in equity

At every balance sheet Date:

(a) All the foreign currency monetary items must be reported at the closing rate. Though, in specific circumstances, the closing rate might not exhibit with reasonable accuracy amount in the reporting currency which is expected to be realized from.

In such scenarios, the monetary items must be reported in reporting currency at the value which is expected to be realized from, or needed to disburse, such monetary item at the balance sheet date;

(b) Non-monetary items that are carried in terms of historical cost denominated in a foreign currency should be reported using the exchange rate at the date of the transaction; and

(c) Non-monetary items that are carried at the fair value or similar valuation denominated in the foreign currency must be reported at the exchange rates prevailing when such values were determined.

• Land being a non-current non-monetary item will be carried at its historical cost using the exchange rate at the date of Transaction i.e. $ 30,000.
• Short term marketable Securities is current investment. A current Investment is investments that by its nature is readily realizable and is intended to be held for less than a year from the date of acquisition and it is held for trading. They are always carried at lower of cost and fair value. So short term Marketable Securities should be reported at $30,000 . Therefore the securities will be carried at $30,000.
• Inventories are valued at cost or NRV (Net Realizable value) whichever is lower. It is a non-monetary item. Non-monetary item will be carried at its historical cost using the exchange rate at the date of Transaction. Accordingly the Inventory will be carried at its historical cost $30,000.
• Though there is Exchange rate gain of $4500 in the transactions but it will not be credited to profit and loss account (Income statement) because the value of the vilsek has increased relative to the U.S. dollar but 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. Therefore it will be carried at its historic cost.