Harvard Business School 9-100-012

Rev. March 13, 2001

Machinery International (A)

Machinery International, an U.S. multinational corporation, sold advanced computer-
controlled production equipment on a worldwide basis. The company had manufacturing facilities
and sales offices in a number of foreign countries. Thomas Matthews, the corporate financial vice
president, was reviewing the method used to translate into U.S. dollars the deutsche mark (DM)
financial statements of the company’s German subsidiary, A. B. Deutz GmbH (Deutz).

In 2000, Deutz’s statements were remeasured to U.S. dollars using Statement of Financial
Accounting Standards No. 52, “Foreign Currency Translation” (FASB 52), and the U.S. dollar as the
functional currency. This method had been considered appropriate in 1991 when Machinery
International had acquired Deutz. Prior to its acquisition, Deutz’s principal business had been to
operate a small, underutilized manufacturing facility and act as Machinery International’s German
distribution agent for Machinery International products produced in the United States. During the
years since its acquisition, Deutz had expanded its manufacturing facilities and direct sales
operations.

Given the changes in Deutz’s activities, Matthews was now considering whether Deutz’s
functional currency ought to be changed from the U.S. dollar to the deutsche mark. To help resolve
this issue, Matthews decided to ask his assistant, Jim Taylor, to restate Deutz’s December 31, 2000
deutsche mark balance sheet to U.S. dollars using the deutsche mark as the functional currency and
to prepare 2001 pro forma U.S. dollar denominated financial statements for the German subsidiary
using U.S. dollars and the deutsche mark as the functional currency and to compare the results (see
Exhibits 1, 2, and 3). Accordingly, Matthews instructed Taylor as follows:

I am beginning to think our German subsidiary’s functional currency for U.S.

consolidated shareholder reports should be the deutsche mark. The subsidiary does
a lot of business in Germany as well as the rest of Europe on its own account. In
addition, it acts as a foreign sales branch for some of our U.S. divisions. It takes
orders for them in local currency prices, bills, and collects directly from their
European customers, and provides a local warehouse service to facilitate prompt
delivery of the U.S. division’s products. Also, it manufactures a critical subassembly
that is shipped to our U.S. and Latin American plants.

I have not pushed the numbers yet, but intuitively I know changing the
functional currency will make a difference to the subsidiary’s 2001 financial
statements.

Professor David F. Hawkins prepared this case as the basis for class discussion and it is a rewritten version of an earlier
case.
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100-012 Machinery International (A)

Here is Deutz’s actual deutsche mark December 31, 2000 balance sheet and
its U.S. dollar equivalent using the U.S. dollar as the functional currency, (Exhibit 1),
projected December 31, 2001 deutsche mark balance sheet (Exhibit 2), and projected
2001 deutsche mark income statement (Exhibit 3). I want you to translate Deutz’s
actual December 31, 2000 balance sheet into U.S. dollars assuming the deutsche mark
is the financial currency. I also want you to restate Deutz’s projected 2001 deutsche
mark financial statements into their U.S. equivalent assuming first, Deutz’s
functional currency is the U.S. dollar, and, second, Deutz’s functional currency is the
deutsche mark. Our international accounting section can give you all the data you
will need.

Incidentally, Deutz plans to continue reporting in deutsche marks up to 2002,

which is the end of the transition period to the euro. At that point Deutz will convert
to the euro. This decision is motivated by the German requirement to maintain
accounts in deutsche marks for tax purposes up to 2002.1

Following Matthews’ instructions, Taylor met with the head of the international accounting
section. Here are the notes Taylor took during that meeting:

1. The year-end exchange rates are: Actual 2000, DM1.96 = US$ 1 (or DM1 =
US$.51); projected 2001, DM2.22 = US$1 (or DM1 = US$.45).

2. The projected average 2001 exchange rate is DM2.19 = US$1 (DM1 = US$.457).

3. The exchange rate at September 30, 1991, the date on which acquisition capital
stock was recorded, long-term debt was issued, and the initial property and
equipment were recorded was DM1.89 = US$1 (DM1= US$.529).

4. The average exchange rate during the 2000 year-end inventory production
period was DM1.87 = US$1 (DM1= US$.534). The company uses FIFO
inventory accounting.

5. The 2000 and 2001 certificate-of-deposit and due-to-parent items shown on

Deutz’s balance sheet are U.S.-dollar-dominated instruments with U.S. dollar
values of $1 million and $1.5 million, respectively. The net impact of DM130,
719 exchange rate change loss on these items is recorded in the transaction gain
(loss) account listed on the subsidiary’s local currency 2001 income statement
before restatement to U.S. dollars.

6. Assume the beginning retained earnings on the December 31, 2000 translated
balance sheet is $203,291, assuming the functional currency is the deutsche
mark. This assumption is to simplify the task.

7. The projected exchange rate at June 30, 2001, is DM2.41 = US$1 (DM1 =
US$.415), the date on which prepaid expenses are projected to be incurred,
additional depreciable property and equipment purchased, and dividends
declared. These depreciable property expenditures are the only material ones
since the subsidiary’s acquisition.

1 Beginning on January 1, 1999, the euro became a currency in its own right. The conversion rates between the
participating national currencies was irrevocable fixed. As a result, future exchange differences between the
participating currencies was eliminated.
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 Machinery International (A) 100-012

8. The German subsidiary’s 2001 cost of goods sold in deutsche marks was
calculated as follows:

Inventories at January 1, 2001 DM1,600,000

Cost of 2001 production. 6,100,000
DM7,700,000
Less inventories at December 31, 2001 1,500,000
Cost of 2001 goods sold DM6,200,000

9. The 2001 production is scheduled to be spread evenly throughout the year.

The estimated average exchange rate for the last quarter of 2001 is DM2.30 =
US$1 (DM1 = US$.435).

10. The 2001 DM150,000 depreciation expense includes DM10,000 related to

depreciable assets purchased on June 30, 2001 (see note 7 above).

11. Use “plug” numbers to balance the financial statements when preparing the U.S.
dollar denominated 2001 financial statements and December 31, 2000 balance
sheet.

Questions

1. How did the DM130,719 transaction loss arise? Show how this loss was
calculated (see Exhibit 3).

2. Complete Exhibits 1, 2, and 3.

3. Why does Deutz’s have a remeasurement gain (or loss) and a translation gain (or
loss) in 2001? (explain with words rather than numbers).

4. What differences do the choice of functional currency make in the German

subsidiary’s dollar statement results and its key financial ratios? Explain the
reasons for these differences.

5. It is Machinery International’s practice to evaluate its overseas operations’

performance in terms of their U.S. dollar equivalent performance. The key
performance measurements used by Machinery International are U.S.
denominated return on sales, return on equity, return on assets and net income.
If Machinery International changes Deutz’s functional currency for financial
reporting purposes, it intends to use the same approach for measuring the
performance of the Deutz management. As a Deutz senior manager, how might
you react to the new performance measurement approach, assuming the
deutsche mark is the functional currency?

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100-012 Machinery International (A)

Exhibit 1 xxx Actual Statement of Financial Position, December 31, 2000

Functional Currency: Functional Currency:
U.S. Dollars Deutsche Mark
Exchange U.S. Exchange U.S.
Rate Dollar Rate Dollar

Assets

Current assets

Cash DM 575,000 .510 $ 293,250 .51

Certificate of deposit 1,960,784 .510 1,000,000 .51

Accounts receivable 1,685,000 .510 859,350 .51

Inventories 1,600,000 .534 854,400

Total current assets 5,820,784 3,007,000

Property and equipment 2,250,000 .529 1,190,250 .51

Less: Accumulated depreciation 260,000 .529 137,540 .51

Property and Equipment (net) 1,990,000 1,052,710 .51

Total assets DM7,810,784 $4,059,710

Liabilities and Stockholders’ Equity

Current liabilities

Accounts payable DM1,745,625 .510 $ 890,269 .51

Due to parent 2,941,176 .510 1,500,000 .51

Total current liabilities 4,686,801 2,390,269

Long-term debt 2,000,000 .510 1,020,000 .51

Deferred income taxes 45,000 .510 22,950 .51

Stockholders’ equity:

Capital stock 600,000 .529 317,400 .529

Paid-in capital 200,000 .529 105,800 .529

Retained earnings 278,983 (Various) 203,291 203,291

Equity adjustment from translation

Total stockholders’ equity 1,078,983 626,491

Total liabilities and stockholders’ equity DM7,810,784 $4,059,710

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 Machinery International (A) 100-012

Exhibit 2 xxx Projected Statement of Finanical Position, December 31, 2001

Functional Currency: Functional Currency:
U.S. Dollars Deutsche Mark
Exchange U.S. Exchange U.S.
Rate Dollar Rate Dollar

Assets

Current assets:

Cash DM 530,000

Certificate of deposit 2,222,222

Accounts receivable 1,400,000

Inventories 1,500,000

Prepaid expenses 75,000

Total current assets 5,727,222

Property and equipment 2,400,000

Less: Accumulated depreciation 410,000

Property and equipment (net) 1,990,000

Total Assets DM7,717,222

Liabilities and Stockholders’ Equity

Current liabilities:

Accounts payable DM1,570,000

Due to parent 3,333,333

Total current liabilities 4,903,333

Long-term debt 1,600,000

Deferred income taxes 60,000

Stockholders’ equity:

Capital stock 600,000

Paid-in capital 200,000

Retained earnings 353,889

Equity adjustment from translation

Total stockholders’ equity 1,153,889

Total liabilities and stockholders’ equity DM7,717,222

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100-012 Machinery International (A)

Exhibit 3 xxx Projected Statement of Income, 2001

Functional Currency: Functional Currency:

U.S. Dollars Deutsche Mark

Exchange U.S. Exchange U.S.

Rate Dollar Rate Dollar

Sales DM7,800,000

Other income 31,250

7,831,250

Cost of goods sold 6,200,000

General and administration 650,000

Depreciation 150,000

Interest 220,000

7,220,000

Gross profit 611,250

Remeasurement gain/(loss)

Transaction gain (loss) (130,719)

Income before income taxes 480,531

Income taxes—current 290,625

—deferred 15,000

305,625

Net income 174,906

Retained earnings at beginning of year 278,983

453,889

Less dividend paid 100,000

Retained earnings at end of year DM353,889

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