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 in the amount of 10,000,000 pounds on January 8, Year 1. Plant and equipment is depreciated on a straight-line basis over a 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 first-in, first-out (FIFO) method is 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 for Year 1

0.90

December 31, Year 1

0.80

The foreign subsidiary’s income statement for Year 1 and balance sheet at December 31, Year 1, are as follows:

Income Statement

For the Year Ended December 31, Year 1

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 taxes

  600

Net income

1,400

Retained earnings, 1/1/Y1

   0

Retained earnings, 12/31/Y1

1,400

Balance Sheet

At December 31, Year 1

Pounds (in thousands)

Cash

2,400

Inventory

4,000

Property, plant, and equipment

10,000

Less: Accumulated depreciation

(1,000)

Total assets

15,400

Current liabilities

2,000

Long-term debt

4,000

Contributed capital

8,000

Retained earnings

 1,400

Total liabilities and stockholders’ equity

15,400

As the controller for Palmerstown Company, you have evaluated the characteristics of the foreign subsidiary to determine that the pound is the subsidiary’s functional currency.

Required:

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

Use an electronic spreadsheet to remeasure the foreign subsidiary’s financial statements into U.S. dollars at December 31, Year 1, assuming that the U.S. dollar is the subsidiary’s 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 the chief executive officer of Palmerstown Company summarizing the differences that will be reported in the Year 1 consolidated financial statements because the pound, rather than the U.S. dollar, is the foreign subsidiary’s functional currency. In your report, discuss the relationship between the current ratio, the debt-to-equity ratio, and the 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 amounts for inventory and for property, plant, and equipment.