Machinery International (A) Machinery International, an U.S. multinational corporation, sold advanced computer- controlled production equipment on a worldwide basis. The company had manufacturing facilities and sales offices in a number of foreign countries. Thomas Matthews, the corporate financial vice president, was reviewing the method used to translate into U.S. dollars the deutsche mark (DM) financial statements of the company's German subsidiary, A. B. Deutz GmbH (Deutz). In 2000, Deutz's statements were remeasured to U.S. dollars using Statement of Financial Accounting Standards No. 52, "Foreign Currency Translation" (FASB 52), and the U.S. dollar as the functional currency. This method had been considered appropriate in 1991 when Machinery International had acquired Deutz. Prior to its acquisition, Deutz's principal business had been to operate a small, underutilized manufacturing facility and act as Machinery International's German distribution agent for Machinery International products produced in the United States. During the years since its acquisition, Deutz had expanded its manufacturing facilities and direct sales operations. Given the changes in Deutz's activities, Matthews was now considering whether Deutz's functional currency ought to be changed from the U.S. dollar to the deutsche mark. To help resolve this issue, Matthews decided to ask his assistant, Jim Taylor, to restate Deutz's December 31, 2000 deutsche mark balance sheet to U.S. dollars using the deutsche mark as the functional currency and to prepare 2001 pro forma U.S. dollar denominated financial statements for the German subsidiary using U.S. dollars and the deutsche mark as the functional currency and to compare the results (see Exhibits 1, 2, and 3). Accordingly, Matthews instructed Taylor as follows: I am beginning to think our German subsidiary's functional currency for U.S. consolidated shareholder reports should be the deutsche mark. The subsidiary does a lot of business in Germany as well as the rest of Europe on its own account. In addition, it acts as a foreign sales branch for some of our U.S. divisions. It takes orders for them in local currency prices, bills, and collects directly from their European customers, and provides a local warehouse service to facilitate prompt delivery of the U.S. division's products. Also, it manufactures a critical subassembly that is shipped to our U.S. and Latin American plants. I have not pushed the numbers yet, but intuitively I know changing the functional currency will make a difference to the subsidiary's 2001 financial statements. Here is Deutz's actual deutsche mark December 31, 2000 balance sheet and its U.S. dollar equivalent using the U.S. dollar as the functional currency, (Exhibit 1), projected December 31, 2001 deutsche mark balance sheet (Exhibit 2), and projected 2001 deutsche mark income statement (Exhibit 3). I want you to translate Deutz's actual December 31, 2000 balance sheet into U.S. dollars assuming the deutsche mark is the financial currency. I also want you to restate Deutz's projected 2001 deutsche mark financial statements into their U.S. equivalent assuming first, Deutz's functional currency is the U.S. dollar, and, second, Deutz's functional currency is the deutsche mark. Our international accounting section can give you all the data you will need. Incidentally, Deutz plans to continue reporting in deutsche marks up to 2002, which is the end of the transition period to the euro. At that point Deutz will convert to the euro. This decision is motivated by the German requirement to maintain accounts in deutsche marks for tax purposes up to 2002.1 Following Matthews' instructions, Taylor met with the head of the international accounting section. Here are the notes Taylor took during that meeting: 1. 2. 3. 4. 5. The year-end exchange rates are: Actual 2000, DM1.96 = US$ 1 (or DM1 = US$.51); projected 2001, DM2.22 = US$1 (or DM1 = US$.45). The projected average 2001 exchange rate is DM2.19 = US$1 (DM1 = US$.457). The exchange rate at September 30, 1991, the date on which acquisition capital stock was recorded, long-term debt was issued, and the initial property and equipment were recorded was DM1.89 = US$1 (DM1= US$.529). The average exchange rate during the 2000 year-end inventory production period was DM1.87 = US$1 (DM1= US$.534). The company uses FIFO inventory accounting. The 2000 and 2001 certificate-of-deposit and due-to-parent items shown on Deutz's balance sheet are U.S.-dollar-dominated instruments with U.S. dollar values of $1 million and $1.5 million, respectively. The net impact of DM130, 719 exchange rate change loss on these items is recorded in the transaction gain (loss) account listed on the subsidiary's local currency 2001 income statement before restatement to U.S. dollars. 6. Assume the beginning retained earnings on the December 31, 2000 translated balance sheet is $203,291, assuming the functional currency is the deutsche mark. This assumption is to simplify the task. 7. The projected exchange rate at June 30, 2001, is DM2.41 = US$1 (DM1 = US$.415), the date on which prepaid expenses are projected to be incurred, additional depreciable property and equipment purchased, and dividends declared. These depreciable property expenditures are the only material ones since the subsidiary's acquisition. 1 Beginning on January 1, 1999, the euro became a currency in its own right. The conversion rates between the participating national currencies was irrevocable fixed. As a result, future exchange differences between the participating currencies was eliminated. 8. The German subsidiary's 2001 cost of goods sold in deutsche marks was calculated as follows: Inventories at January 1, 2001 DM1,600,000 Cost of 2001 production. 6,100,000 DM7,700,000 Less inventories at December 31, 2001 1,500,000 Cost of 2001 goods sold DM6,200,000 10. 11. 9. The 2001 production is scheduled to be spread evenly throughout the year. The estimated average exchange rate for the last quarter of 2001 is DM2.30 = US$1 (DM1 = US$.435). The 2001 DM150,000 depreciation expense includes DM10,000 related to depreciable assets purchased on June 30, 2001 (see note 7 above). Use "plug" numbers to balance the financial statements when preparing the U.S. dollar denominated 2001 financial statements and December 31, 2000 balance sheet. Questions 1. How did the DM130,719 transaction loss arise? Show how this loss was calculated (see Exhibit 3). 2. Complete Exhibits 1, 2, and 3. 3. Why does Deutz's have a remeasurement gain (or loss) and a translation gain (or loss) in 2001? (explain with words rather than numbers). 4. What differences do the choice of functional currency make in the German subsidiary's dollar statement results and its key financial ratios? Explain the reasons for these differences. 5. It is Machinery International's practice to evaluate its overseas operations' performance in terms of their U.S. dollar equivalent performance. The key performance measurements used by Machinery International are U.S. denominated return on sales, return on equity, return on assets and net income. If Machinery International changes Deutz's functional currency for financial reporting purposes, it intends to use the same approach for measuring the performance of the Deutz management. As a Deutz senior manager, how might you react to the new performance measurement approach, assuming the deutsche mark is the functional currency? Exhibit 1 Actual Statement of Financial Position, December 31, 2000 Assets Current assets Functional Currency: U.S. Dollars Exchange Rate Functional Currency: Deutsche Mark U.S. Exchange Dollar Rate Cash DM 575,000 .510 $ 293,250 .51 Certificate of deposit 1,960,784 .510 1,000,000 .51 Accounts receivable 1,685,000 .510 859,350 .51 Inventories Total current assets Property and equipment 1,600,000 .534 854,400 5,820,784 3,007,000 2,250,000 .529 1,190,250 .51 Less: Accumulated depreciation 260,000 .529 137,540 .51 Property and Equipment (net) 1,990,000 1,052,710 .51 Total assets DM7,810,784 $4,059,710 Liabilities and Stockholders' Equity Current liabilities Accounts payable DM1,745,625 .510 $ 890,269 .51 Due to parent 2,941,176 .510 1,500,000 .51 Total current liabilities 4,686,801 2,390,269 Long-term debt 2,000,000 .510 1,020,000 .51 Deferred income taxes 45,000 .510 22,950 .51 Stockholders' equity: Capital stock 600,000 .529 317,400 .529 Paid-in capital 200,000 .529 105,800 .529 Retained earnings 278,983 (Various) 203,291 Equity adjustment from translation Total stockholders' equity 1,078,983 Total liabilities and stockholders' equity DM7,810,784 626,491 $4,059,710 U.S. Dollar 203,291 Exhibit 2 Projected Statement of Finanical Position, December 31, 2001 Functional Currency: Functional Currency: Assets Current assets: Cash Certificate of deposit Accounts receivable Inventories Prepaid expenses Total current assets DM 530,000 2,222,222 1,400,000 1,500,000 75,000 5,727,222 Property and equipment 2,400,000 Less: Accumulated depreciation 410,000 Property and equipment (net) 1,990,000 Total Assets DM7,717,222 Liabilities and Stockholders' Equity Current liabilities: Accounts payable DM1,570,000 Due to parent 3,333,333 Total current liabilities 4,903,333 Long-term debt 1,600,000 Deferred income taxes 60,000 Stockholders' equity: Capital stock Paid-in capital Retained earnings 600,000 200,000 353,889 Equity adjustment from translation Total stockholders' equity 1,153,889 Total liabilities and stockholders' equity DM7,717,222 U.S. Dollars Deutsche Mark Exchange U.S. Exchange U.S. Rate Dollar Rate Dollar Exhibit 3 Projected Statement of Income, 2001 Functional Currency: U.S. Dollars Functional Currency: Deutsche Mark Exchange U.S. Exchange U.S. Rate Dollar Rate Dollar Sales DM7,800,000 Other income 31,250 7,831,250 Cost of goods sold 6,200,000 General and administration 650,000 Depreciation 150,000 Interest 220,000 7,220,000 611,250 Gross profit Remeasurement gain/(loss) Transaction gain (loss) (130,719) Income before income taxes 480,531 Income taxes-current 290,625 -deferred 15,000 305,625 Net income 174,906 Retained earnings at beginning of year 278,983 453,889 Less dividend paid 100,000 Retained earnings at end of year DM353,889