Case Study : Foreign Exchange

Goodluck Corporation, a US company, manufacturing and markets office operating systems. Based on predictions of rapid economic growth in South America during the next decade, Goodluck plans to establish a wholly owned subsidiary in Colombia as of January 1, year 8, to manufacture and market office operating systems in that country. It will import from Goodluck a portion of the electronic software needed for the systems. Assembly will take place in Colombia.

Goodluck plans to contribute $100,000 to establish the subsidiary on January 1, Year 8. The exchange rate between the Colombian and the U.S dollar is expected to be $0.02:P1 on this date. Exhibit 1 presents pro forma financial statements for Year 8 for the Colombian subsidiary during its first year of operation. Exhibit 2 presents a partial pro forma consolidation balance sheet worksheet for Goodluck and its Colombian subsidiary for Year 8. The Colombian subsidiary expects to sell all office operating system by the end of Year 8 in Colombian pesos.

REQUIRED:

a: Discuss whether Goodluck should use the U.S. dollar or the Colombian Peso as the functional currency for its Colombian subsidiary, and why? (3 Marks)

b: Goodluck expects the exchange rate between the U.S. dollar and the Colombian peso to change as follow during Year 8:

Jan 1, Year8	$0.02: P1
Average, Year 8	$0.018: P1
December 31, Year 8	$0.015: P1

Complete Exhibit 1, showing the translation of the subsidiarys accounts into U.S. dollars based on the current method, and assuming that the Colombian peso is the functional currency. Using the translated amounts, complete the consolidation worksheet in Exhibit 2.

(5 Marks)

c: Repeat Part b, based on the temporal method this time. (5 Marks)

d: Compute the net income to revenues ratio based on (1) amounts originally measured in Colombian pesos; (2) amounts measured in U.S. dollars from part b; (3) amounts measured in U.S. dollars from part c. why is the net income to revenues percentage the same under (1) and (2), but different under (3)? (3 Marks)

e: Outline the potential foreign exchange rate risk management strategy for Goodluck.

(4 Marks)

Exhibit 1: Translation of Financial Statements of Colombian Subsidiary-Year 1 Colombian Pesos Exchange Rate U.S. Dollars Balance Sheet: Assets Cash.... Accounts Receivable. Inventories.... Fixed Assets (net) P 700,000 2,000,000 3,500,000 5,700,000 P 11,900,000 Liabilities and Equity Accounts Payable. Bonds Payable. Common Stock.. P 2,400,000 4,000,000 5,000,000 Retained Earnings. 500,000 P 11,900,000 Income Statement: Revenues. Cost of Goods Sold Depreciation Expense Other Expenses Net Income... P 15,000,000 (10,000,000) (300,000) (2,500,000) P 2.200,000 P Retained Earnings Statement: Balance, January 1, Year 1. Plus Net Income Less Dividends Balance, December 31, Year 1 2,200,000 (1,700,000) P 500,000 Please remember: Translation Adjustment account should be added into the Balance sheet or Income statement based on different methods. Exhibit 2: Consolidation Work Sheet for Loucks Corporation and Colombian Subsidiary in US dollars GoodLuck Colombian Corp. Subsidiary Adjustments and Eliminations Consolidated $ 48,000 125,000 260,000 Balance Sheet Cash..... Accounts Receivable. Inventories.... Investment in Colom- bian Subsidiary.... Fixed Assets (net). Total Assets... Accounts Payable ...... Bonds Payable........... Common Stock. Retained Earnings ..... Total Equities ..... 120,000 2 $ 280,000 50,000 100,000 $ Please make your own decision on whether you need to add the Translation Adjustment account into the consolidated Balance sheet based on different methods. Exhibit 1: Translation of Financial Statements of Colombian Subsidiary-Year 1 Colombian Pesos Exchange Rate U.S. Dollars Balance Sheet: Assets Cash.... Accounts Receivable. Inventories.... Fixed Assets (net) P 700,000 2,000,000 3,500,000 5,700,000 P 11,900,000 Liabilities and Equity Accounts Payable. Bonds Payable. Common Stock.. P 2,400,000 4,000,000 5,000,000 Retained Earnings. 500,000 P 11,900,000 Income Statement: Revenues. Cost of Goods Sold Depreciation Expense Other Expenses Net Income... P 15,000,000 (10,000,000) (300,000) (2,500,000) P 2.200,000 P Retained Earnings Statement: Balance, January 1, Year 1. Plus Net Income Less Dividends Balance, December 31, Year 1 2,200,000 (1,700,000) P 500,000 Please remember: Translation Adjustment account should be added into the Balance sheet or Income statement based on different methods. Exhibit 2: Consolidation Work Sheet for Loucks Corporation and Colombian Subsidiary in US dollars GoodLuck Colombian Corp. Subsidiary Adjustments and Eliminations Consolidated $ 48,000 125,000 260,000 Balance Sheet Cash..... Accounts Receivable. Inventories.... Investment in Colom- bian Subsidiary.... Fixed Assets (net). Total Assets... Accounts Payable ...... Bonds Payable........... Common Stock. Retained Earnings ..... Total Equities ..... 120,000 2 $ 280,000 50,000 100,000 $ Please make your own decision on whether you need to add the Translation Adjustment account into the consolidated Balance sheet based on different methods