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Foreign Currency Risk

Report for Management-Foreign Currency Risk

Assignment 2: Report for Management-Foreign Currency Risk
XYZ, Inc. is a U.S.-based company in the process of acquiring a subsidiary in a country whose functional
currency is not the U.S. dollar. Use the report template, located in the online course shell, to create a
report for management that details the risks involved in operating a subsidiary in a functional currency
with the U.S. dollar as the reporting currency. Note: You may create and /or make all necessary
assumptions needed for the completion of this assignment.
Write a four to five (4-5) page report in which you:

  1. Specify the potential foreign subsidiary�s business operation, the functional currency used, and the
    type of intercompany transactions anticipated between the acquiring company and the potential
    subsidiary. Describe the two
    (2) Major financial statement translation methods currently used in US GAAP (i.e. the current rate method
    and the temporal method). Determine the major procedural differences inherent in applying each method.
    Analyze the fundamental manner in which balance sheet exposure differs under the two (2) methods in
    question. 2.

Report for Management-Foreign Currency Risk 2

The differences in foreign exchange occur when transactions are recorded on accrual basis and in
foreign currencies. The problems in foreign exchange and the differences in currency
fluctuations can be avoided by dealing in a single currency, fixing the rates of exchange to be
applied and converting the currencies into local currencies when required.

  1. Home park plc is a company that has its head office in New York, USA. Home Park plc is a
    multinational company that manufactures toys and dolls for children in the US and for its
    subsidiary in London, UK. All the transactions are converted into US dollars before being
    recorded in the company books of accounts. The subsidiary company sells the toys at ₤10 each
    while the manufacturing costs are estimated to cost ₤6 per unit. The conversion rate for the dollar
    to pounds is ₤1 = $1.6. (Ross, Westerfield & Jaffe, 2013)
    The subsidiary company has a manufacturing department that manufactures the toys for sale in
    for the local market under license from the parent company in the US. All the profits are
    repatriated back to their mother company in the US. (Ross, Westerfield & Jaffe, 2013)
    The financial year for the Home Park plc ends in November while the sales were made in
    October when the British pound was at the rate provided above. The current rate of the British
    pound to the dollar is ₤1 = $ 1.2, a difference of $4 dollars.
    The records in October, 2014 indicated that the sales of 100 units amounted to in $ 1600 while
    the costs were $600 hence a profit of $1000 was recorded in the books of the subsidiary. The
    accounting system being accrual, the debtors were entered as $1600 being the accounts

Report for Management-Foreign Currency Risk 3
receivable in the balance sheet. However, at the end of the year, the British sterling pound was
operating at the rates shown above i.e. ₤1 = $ 1.2. The debtor paid $1200 and the Home Park
sales revenue dropped by 25% i.e. the revenues dropped by $400.

  1. Under the Foreign Currency Translation of the Financial Accounting Statement No. 52 which
    sets forth and guides the right accounting treatment for the US GAAP.
    The temporal method uses the effective rate of translation at the time of the transaction and
    different rates are applied for different transaction. For example, the sales in October for the
    Home Park subsidiary in the UK will be recorded as follows:
    Home Park Subsidiary
    Income and Expenditure for the Month of Oct 2014

Oct-14 $
Sales 1600
Costs 960
Profits 640
Home Park Subsidiary
Balance Sheet Extract as at the end of Oct 2014

Oct-14 $
Current Assets  


At the end of December the following entries will be entered for the sales of 100 units:
Home Park Subsidiary
Income and Expenditure for the Month of Dec 2014

Dec-14 $
Sales 1200
Costs 720
Profits 480

Report for Management-Foreign Currency Risk 4
Home Park Subsidiary
Balance Sheet Extract as at the end of Oct 2014

Dec-14 $
Current Assets  


Under the functional currency method the current rate is applied and the assets and liabilities are
translated at the rates that are prevailing as at the time of the translation. All the equity accounts
are translated at the historical rates while the income and expenditure are translated at the
weighted-average rate for the financial period.

  1. The major strategy would be to check for adjustments for foreign exchanges in the income and
    expenditure accounts for the subsidiary company. The major steps would be first check the
    income and expenditure account and identify the contra entries that have been made to counter
    the effects of the fluctuations on foreign currencies. (Garrison, Noreen & Brewer, 2009)
  2. The best way according to me would be to use the fixed rate of translation for a particular
    financial period. For instance, Home Park plc may decide to use the initial exchange rates of
    ₤1 = $1.6. The fix rate method would avoid the confusions that may arise because of different
    rates of exchange and also would simplify the accounting work. (Khan, 1993)
    The similarities and differences of IFRS and US GAAP in international marketplace;
    The components of the financial statements two years of comparative data when filling reports
    and returns under the IFRS while the US GAAP requires three years of comparative data except
    the balance sheet, the other financial statements are income and expenditure, cash flow, changes
    in equity, accounting policies and notes. The IFRS does not insists on a particular format for

Report for Management-Foreign Currency Risk 5
financial statements however US GAAP insists that the balance sheet has to be classified or non
classified with a decreasing order of liquidity while the income and expenditure has to classify
all the expenditure by function in a single or multiple step format. The extraordinary items are
prohibited in IFRS while in US GAAP they are classified as rare and unusual items. Negative
goodwill is also recorded as extraordinary item under US GAAP. The IFRS cash flows may
include bank overdrafts while the US GAAP excludes all overdrafts. In IFRS, items like
correction of errors, changes in accounting policies and accounting estimates, presentation and
disclosures of associates, acquisitions and mergers are all similar to US GAAP.
The following are the accounting requirements that relate to translation and treatment of
financial statements for foreign subsidiaries or affiliates;
The policies that guide the accounting practice in the US and relating to the US GAAP are all
included in the Financial Accounting Board (FASB) Accounting Standard Codification (ASC)
on foreign currency issues topic 830 while the International Financial Reporting Standards
(IFRS) relating to foreign currency treatment and translation issues are contained in the IAS 21
and 29.
A number of differences and similarities between IFRS and US GAAP in respect to the
accounting treatment of foreign currency translation matters. For instance, both GAAP and IFRS
accounting standards require that all the income, expenses, assets and liabilities to be remeasured
using the entity’s currency i.e. the functional currency that’s applicable in the host country’s
economy before translating it to the reporting country. (Hilton, 2005)
The other differences between the US GAAP (ASC 830) and IFRS (IAS 21 and 29) is that in
cases of hyperinflation all the financial statements have to be remeasured using the reporting

Report for Management-Foreign Currency Risk 6
country’s currency i.e. as if the currency was the functional currency. The IFRS insists on using
only the functional currency even if there is hyperinflation.
To determine a country’s functional currency, the US GAAP considers several of indicators
which are basically not set up while the IFRS has a hierarchy of indicators that lists all the
secondary and primary indicators that are applied to determine the county’s functional currency.
To conclude, different countries have different approaches of dealing with foreign currencies
however the US GAAP and the IFRS guide the accounting policies in the US and internationally

Report for Management-Foreign Currency Risk 7
Garrison, R., Noreen, W. & Brewer, P. (2009) Managerial Accounting , New York, NY:
McGraw-Hill Irwin. 65 -70
Hilton, R.W., (2005) Managerial Accounting: Creating Value in a Dynamic Business
Environment. McGraw-Hill.
Khan, M. (1993) Theory & Problems in Financial Management, New York, NY: McGraw Hill
Ross, S. A., Westerfield, R. W., & Jaffe, J. (2013) Corporate finance (10th Ed.) New York, NY:
McGraw-Hill Irwin. 175.

Warren, C.S., Reeve, J.M. and Fess, P.E. (2005) Accounting, 21st ed. Thomson


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