Vulcan Manufacturing Limited (VML) is a Canadian-based multinational plastics firm, with subsidiaries in several foreign countries and worldwide consolidated total assets of $500 million. VML's shares are listed on a Canadian stock exchange.
VML is attracted to developing countries by their growing demand for its products. In recognition of trade barriers designed to encourage domestic production in those countries, and in order to service local demand, VML incorporated a foreign subsidiary in a South American country on September 1, Year 4. The subsidiary, South American Plastics Inc. (SAPI), manufactures patented sheet plastic and sells virtually all of its output locally. Also, almost all labor and raw materials are provided locally. SAPI finances its day-to-day activities from its own operations and local borrowing.
During Year 4 and Year 5, the South American country suffered an inflation rate of more than 100%, accompanied by substantial devaluation of the local currency and a drastic increase in interest rates. The government is expected to impose wage and price controls in Year 6. The inflation rate is expected to stabilize at more moderate levels sometime in Year 6 or Year 7.
The CFO of VML has recently received SAPI's draft balance sheet as at August 31, Year 5 ( Exhibit I ), together with some comments prepared by SAPI's controller ( Exhibit II ). He is somewhat surprised by the return on investment of nearly 12%. This figure is well above the target rate agreed upon for bonus purposes, which was set at 3% in recognition of start-up costs associated with the first year of operations. The apparently favorable performance will result in large bonuses for SAPI's management.
Increases in SAPI's domestic selling price have kept pace with the general rate of inflation and increases in input prices and borrowing costs in the South American country. The CFO is satisfied that the inflation and devaluation the country has experienced has not seriously affected SAPI's cash flows from operations.
In the annual report to Canadian shareholders for the year ended August 31, Year 5, the CFO wants to communicate to shareholders the economic impact that inflation and devaluation in the South American country have had on VML's investment in SAPI. He is concerned that gains or losses arising from translation of the statements in accordance with IAS 21 will mislead shareholders.
EXHIBIT I
SOUTH AMERICAN PLASTICS INC.
Extracts from Draft Balance Sheet as at August 31, Year 5 (in Thousands)
Assets
Cash ..................... FC* 10,020
Held-to-maturity investments ............. 3,120
Accounts receivable ................ 93,000
Inventory (at cost) ................ 67,200
Prepaid expenses .................. 8,040
181,380
Plant assets ................... 143,111
Less accumulated depreciation ........... 14,311
128,800
FC 310,180
Liabilities and Shareholders’ Equity
Current monetary liabilities ............ FC 65,140
Long-term debt .................. 157,200
222,340
Common shares ................. 51,000
Retained earnings ................ 36,840
87,840
FC 310,180
EXHIBIT II
SOUTH AMERICAN PLASTICS INC.
Controller's Comments on Financial Statements
1. Opening Balances:
SAPI's balance sheet on September 1, Year 4, consisted of cash of FC 208,200,000; long-term debt of FC 157,200,000; and common shares of FC51,000,000.
2. Held-to-maturity Investments:
The held-to-maturity investments were purchased when 1FC = $0.31. The aggregate market value for the investments at August 31, Year 5, was FC 3,000,000 due to an increase in interest rates in the market.
3. Inventories:
Inventories were purchased when 1FC = $0.30. VML values inventory at the lower of cost and net realizable value. The aggregate net realizable value of the inventory was FC 100,000,000 at August 31, Year 5.
4. Prepaid Expenses:
The amounts, representing prepaid rent and property taxes, were paid when 1FC = $0.26.
5. Plant Assets:
Plant assets were purchased shortly after the date of SAPI's formation at a time when 1FC = $0.40. The recoverable amount of the fixed assets (in their current condition) was FC 200,000,000 at August 31, Year 5.
6. Current Liabilities:
All current liabilities were incurred at a time when 1FC = $0.25.
7. Long-Term Debt:
The debt represents a floating interest rate loan, which will be repaid in foreign currency units on August 31, Year 8.
8. Retained Earnings:
No dividends were paid during the Year 5 fiscal year.
9. Exchange Rates:
Sep. 1, Year 4 ......... 1 FCU = $0.40
Aug. 31, Year 5 ....... 1 FCU = $0.20
Average rate for year ..... 1 FCU = $0.30
The CFO believes that the exchange gains and losses will obscure the true impact of foreign inflation and devaluation on SAPI's economic value in Canadian-dollar terms. He has called the audit partner and you, the Senior, into his office. The following conversation ensues:
CFO: We have to issue our financial statements soon, and we have to apply IAS 21 to our South American subsidiary. I must confess that I don't know IAS 21 as well as you two do. My staff tells me that we must use a special method this year, due to the local hyper-inflation, although I confess that I don't see why. Apparently we will have a choice between the temporal method and the current rate method once the inflation rate stabilizes, which I expect to happen in Year 6 or Year 7. I am very reluctant to use a special method on this year's statements. It forces me to include fictitious gains and losses in our consolidated income statement.
Partner: Your staff is correct in stating that IAS 21 requires the use of a special method for the year just ended. However, shareholders should not be misled by exchange gains or losses in comprehensive income provided that they are fully disclosed as such.
CFO: I guess I just do not understand IAS 21. For example, how might the adoption of the current rate method in Year 6 or Year 7 improve matters? It seems to me that an overall exchange loss will arise if the rate keeps on going down. What does the loss mean? As long as our subsidiary's cash flows keep pace with local inflation, it will be able to maintain its expected rate of profitability and therefore its ability to pay dividends to us. Yet shareholders will see an exchange loss!
Partner: I will have Senior prepare a report that explains to you how the exchange gains or losses under either translation method tie in with the notion of risk underlying IAS 21. We will also explain how this notion alleviates your concern about communicating the true economic risk to shareholders. Senior will recommend ways to tell the whole story to shareholders.
CFO: Sounds great. I would also like Senior to provide advice on any other important issues related to SAPI. For starters, I have some concerns about the way our bonus plan for SAPI's management is working. One possibility I am considering is to evaluate SAPI's performance in Canadian-dollar terms.
Required:
Prepare the report to the CFO.