Southwestern Corporation operates throughout Texas buying and selling widgets. To expand into more profitable markets, the company recently decided to open a small subsidiary in the nearby country of Gualos. The currency in Gualos is the vilsek. For some time, the government of that country held the exchange rate constant: 1 vilsek equaled $0.20 (or 5 vilseks equaled $1,00). Initially Southwestern invested cash in this new operation; its $90,000 was converted into 450,000 vilseks ($90,000 x 5). Southwestern used one-third of this money (150,000 vilseks, or $30,000) to purchase land to hold for the possible construction of a plant, invested one-third in short-term marketable securities, and spent one-third in acquiring inventory for future resale.
Shortly thereafter, the Gualos government officially revalued the currency so that 1 vilsek was worth $0.23. Because of the strength of the local economy, the viklsek gained buying power in relation to the U.S. dollar. The vilsek then was considered more valuable than in the past. Southwestern%u2019s accountants realized that a change had occurred; each of the assets was now worth more in U.S. dollars than the original $30,000 investment: 150,000 vilseks x $0.23 = $34,000. Two of the company%u2019s top officers met to determine the appropriate method for reporting this change in currency values.
Controller: Nothing has changed. Our cost is still $30,000 for each item. That%u2019s what we spent. Accounting uses historical cost wherever possible. Thus, we should do nothing.
Finance director: Yes, but the old rates are meaningless now. We would be foolish to report figures based on a rate that no longer exists. The cost is still 150,000 vilseks for each item. You are right, the cost has not changed. However, the vilsek is now worth $0.23, so our reported value must change.
Controller: The new rate affects us only if we take money out of the country. We don%u2019t plan to do that for many years. The rate will probably change 20 more times before we remove money from Gualos. We%u2019ve got to stick to our $30,000 historical cost. That%u2019s our cost and that%u2019s good, basic accounting.
Finance director: You mean that for the next 20 years we will be translating balances for external reporting purposes using an exchange rate that has not existed for years? That doesn%u2019t make sense. I have a real problem using an antiquated rate for the investments and inventory. They will be sold for cash when the new rate is in effect. These balances have no remaining relation to the original exchange rate.
Controller: You misunderstand the impact of an exchange rate fluctuation. Within Gualos, no impact occurs. One vilsek is still one vilsek. The effect is realized only when an actual conversion takes place into U.S. dollars at a new rate. At that point, we will properly measure and report the gain or loss. That is when realization takes place. Until then our cost has not changed.
Finance director: I simply see no value at all in producing financial information based entirely on an exchange rate that does not exist. I don%u2019t care when realization takes place.
Controller: You%u2019ve got to stick with historical cost, believe me. The exchange rate today isn%u2019t important unless we actually convert vilseks to dollars.
How should Southwestern report each of these three assets on its current balance sheet? Chose a position and defend it. Perhaps you are a banker, or a stockholder, or a member of management. In the role you choose, what figure would you consider the fairest representation of each of the three assets? What figure is the best conveyor of information to an outside party? There is no single best answer to these questions. Do not assume the current pronouncement is correct. Consider the objectives of financial reporting in formulating your answer.