Palmerstown Company case 8-2

Palmerstown Company established a subsidiary in a foreign country on January 1, Year 1, by investing 8,000,000 pounds when the exchange rate was $1.00/pound. Palmerstown negotiated a bank loan of 4,000,000 pounds on January 5, Year 1, and purchased plant and equipment on the amount of 10,000,000 pounds January 8, Year 1. Plant and equipment is depreciated on straight-line basis over 10 year useful life. The first purchase of inventory in the amount of 1,000,000 pounds was made on January 10, Year 1. Additional inventory of 12,000,000 pounds was acquired at three points in time during the year at an average exchange rate of $0.86/pound. Inventory on hand at year-end was acquired when the exchange rate was $0.83/pound. The FIFO method used to determine cost of goods sold. Additional exchange rates for the pound during Year 1 are as follows:

January 1-31, Year 1

$1.00

Average Year 1

0.90

December 31, Year 1

0.80

The foreign subsidiary%u2019s income statement for Year 1 and balance sheet at December 31, Year1, are as follows:

Income Statement

For the Year Ended December 31, Year Pounds (in thousands)

Sales

15,000

Cost of goods sold

9,000

Gross Profit

6,000

Selling and administrative expenses 3,000

Depreciation expense 1,000 Income before tax 2,000

Income tax 600

Net income

1,400

Retained earnings, 1/1/Y1

0

Retained earnings, 12/31/Y1 1,400

Balance Sheet

At December 31, Year1

Pounds (in thousands)

Cash 2,400

Inventory 4,000 Fixed assets 10,000 Less: Accumulated depreciation (1,000) Total taxes 15,400 Current liabilities 2,000 Long term debt 4,000 Contributed capital 8,000

Retained earnings 1,400 Total liabilities and stockholder%u2019s equity 15,400

As the controller forPalmerstown Company, you have evaluated the characteristics of the foreign subsidiary to determine that the pound is the subsidiary%u2019s functional currency.

Required:

A.Use an electronic spreadsheet to translate the foreign subsidiary%u2019s financial statements into U.S. dollars at December 31, Year 1, in accordance with U.S. GAAP. Insert a row in the spreadsheet after obtained earnings and before total liabilities and stockholders%u2019 equity for the cumulative translation adjustment. Calculate the translation adjustment separately to verify the amount obtained as a balancing figure in the translation worksheet.

B.Use an electronic spreadsheet to remeasure the foreign subsidiary%u2019s financial statements into U. S. dollars at December 31, Year1, assuming that the U. S. dollar is the subsidiary%u2019s functional currency. Insert a row in the spreadsheet after depreciation expense and before income before taxes for the remeasurement gain (loss).

Prepare a report for CEO of Palmerstown Company summarizing the differences that will be reported in the Year 1 consolidated financial statement because the pound, rather than the U. S. dollar, is the foreign subsidiary%u2019s functional currency. In your report, discuss the relationship between the current ratio, the debt to equity ratio, and profit margin calculated from the foreign currency financial statements and from the translated U. S. dollar financial statements. Also, include a discussion of the meaning of the translated U. S. dollar for inventory and fixed assets.

Explain why the translation adjustments/ remeasurementgain(loss) calculated in a and b are either positive or negative.

Provide supporting calculations for cost of goods sold where necessary