SPEC Co. is a Canadian investment company. It acquires real estate properties in foreign countries for speculative purposes. On January 1, Year 5, SPEC incorporated a wholly owned subsidiary, CHIN Limited. CHIN immediately purchased a property in Shanghai, China, for 70 million Chinese yuan (Y). At that time, the land and building were valued at Y30 million and Y40 million, respectively. The previous owner had purchased the property in Year 1 for Y36 million when the exchange rate was $1 = Y5.13. The building had an estimated useful life of 20 years with no residual value on January 1, Year 5.
The draft financial statements for CHIN as at and for the year ended December 31, Year 5, follow:
CHIN LIMITED
STATEMENT OF FINANCIAL POSITION
at December 31, Year 5
Land ............ Y30,000,000
Building ........ 40,000,000
Accumulated amortization .. (2,000,000)
Y68,000,000
Common shares ...... Y20,000,000
Retained earnings (deficit) .. (2,000,000)
Mortgage payable ..... 50,000,000
Y68,000,000
CHIN LIMITED
INCOME STATEMENT
for the Year Ended December 31, Year 5
Rent revenue ...... Y 6,000,000
Interest expense ... (5,000,000)
Amortization expense ... (2,000,000)
Other expenses ...... (1,000,000)
Profit (loss) ...... Y (2,000,000)
Additional Information
• The purchase of the property was financed with Y20 million of equity provided by SPEC and a Y50 million mortgage from a Chinese investor. The mortgage payable has a term of 10 years and requires interest-only payments of Y5 million on December 31 each year, and a final payment of Y50 million on December 31, Year 14. The market rate of interest on the mortgage was equal to the stated rate throughout Year 5.
• The property is rented for Y0.5 million per month, which is consistent with rent being charged by other property owners in the area. The rent is due on the last day of each month. CHIN hires local workers and buys all of its materials and supplies from local suppliers. CHIN incurred the other expenses evenly throughout the year.
• The exchange rates were as follows:
Jan. 1, Year 5 ...................... $1 = Y6.92
Average for Year 5 .................... $1 = Y7.20
Average for 12 days when rent payments were received ....... $1 = Y7.25
Dec. 31, Year 5 .................. $1 = Y7.50
Required:
(a) Should CHIN be classified as a self-sustaining or an integrated subsidiary? Explain.
(b) Ignore your answer to Part (a). Calculate the foreign exchange adjustment for Year 5, assuming that CHIN’s functional currency is the Chinese yuan, and indicate how this adjustment will be reported in CHIN’s Canadian-dollar financial statements. Show supporting calculations.
(c) Ignore your answers to Parts (a) and (b). Translate CHIN’s Year 5 income statement into Canadian dollars, assuming that CHIN’s functional currency is the Canadian dollar. Ignore foreign exchange gains and losses.
(d) Assume that SPEC does not own any shares of CHIN. Instead, SPEC acquired the property in Shanghai directly. SPEC financed the acquisition with Y20 million of its own funds and a Y50 million mortgage. If SPEC argued that the mortgage payable is a hedge of the anticipated sale of the land, what difference would it make for reporting purposes whether or not the mortgage payable is deemed to be an effective hedge of the anticipated sale of the land? Briefly explain.