Advanced Financial Accounting Question Need Help Today

Question

Gunther Co. established a subsidiary in Mexico on January 1, 2011. The subsidiary engaged in the following transactions during 2011:

January 1 : Sold common stock to Gunther for 5,000,000 pesos . Purchased inventory throughout the year, 8,000,000 pesos (1/4 remained at year end). Sales for year totaled 12,000,000 pesos.
Dec 31 : Purchased equipment for 1,000,000 pesos

Gunther concluded that the subsidiary's functional currency was the dollar. Exchange rates for 2011 were:
Jan 1 : 1 peso = $.20
Jan 31 : 1 peso = $.19
Dec 31 : 1 peso = $.16
Weighted Average For Year = 1 peso = $.18

Question :
What amount of foreign exchange gain or loss would have been recognized in Gunther's consolidated income statement for 2011?
A. $800,000 gain.
B. $760,000 gain.
C. $320,000 loss.
D. $280,000 loss.
E. $440,000 loss.

 

I need detailed help with steps on how to solve and get correct answer of D

Answer 1

Since the functional currency for the subsidiary in Mexico is also USD like its parent (Gunther) which we assume is the ultimate reporting entity also with USD as the functional currency, the only concern for the income statement would be foreign currency transactions of either entity.  Any account balance denominated in pesos must be revalued to USD, with the offset to the income statement.  All other sub accounts are translated to USD for consolidated reporting with the offset to the balance sheet - not income statement for consolidated reporting because the functional currency of the sub already matches its parent's functional currency.

 

The offset of these revaluations goes to the income statement of the sub or parent before consolidation (these are true accounting entries, not just consolidating worksheet entries) because the financials are incorrect before this step IF the fx rates have changed since the last publishing date.

 

The rule is to revalue ending balances resulting from the foreign currency transactions.  The income statement activity will be merely translated with the offset to AOCI.  

 

We need to look at the ending peso bank account, because based on the problem the combined entity is holding 9 million more pesos on 31st December versus the beginning of the year.  No other details are given so we must assume all sales and purchases were cash purchases, not on account.  The $5 million received by the sub from parent (apparently purchased with USD on the same date, 1st January) were worth $.04 less each on 31st December.  $.20 minus $.16 = $.04 loss  Multiplying $5M by this loss is ($200,000).  The sales receipts of $12 million less the $8 million paid out for inventory purchases leaves a net cash inflow of $4 million during 2011.  The average fx rate on the cash receipts/pay-out dates was $.18 which is $.02 higher than the ending fx rate $.16.  Since net cash flowed in during this reduction in value of the peso, we have a loss of ($80,000) = minus $.02 multiplied by $4 million.  Note that the $1 million paid out on 31st December suffered the loss already before disbursement.