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 fi rst 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 fi rst-in, fi rst-out (FIFO) method is used to determine cost of goods sold. Additional exchange rates for the pound during Year 1 are as follows: January 131, Year 1 . . . . . . . . . . . . . . . . . . . . $1.00 Average Year 1 . . . . . . . . . . . . . . . . . . . . . . . . . 0.90 December 31, Year 1 . . . . . . . . . . . . . . . . . . . . 0.80

The foreign subsidiarys 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 profi t . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 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

Fixed assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 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 subsidiarys

functional currency.

Required

1. Use an electronic spreadsheet to translate the foreign subsidiarys fi nancial

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 fi gure in the translation worksheet.

2. Use an electronic spreadsheet to remeasure the foreign subsidiarys fi nancial statements

into U.S. dollars at December 31, Year 1, assuming that the U.S. dollar is the

subsidiarys 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 offi cer of Palmerstown Company summarizing

the differences that will be reported in the Year 1 consolidated fi nancial

statements because the pound, rather than the U.S. dollar, is the foreign

subsidiarys functional currency. In your report, discuss the relationship between

the current ratio, the debt-to-equity ratio, and the profi t margin calculated

from the foreign currency fi nancial statements and from the translated

U.S.-dollar fi nancial statements. Also, include a discussion of the meaning of

the translated U.S.-dollar amounts for inventory and for fi xed assets.

Arnold,