Foreign Currency Translation EOC R25 - Q2

following, currency, believes, into

Taken from CFAI EOC Q2 - R25.

Scenario indicates that a subsidiary's currency will depreciate vs. the parent currency. Analyst believes local currency/subsidiary environment to be inflationary. Which of the following will produce the highest gross margins for the parent co if inventory is accounted for using:

A. FIFO and temporal method
B. weighted average cost and temporal method
C. FIFO and the current rate method

This just isn't sinking into my brain. The correct answer is C. Inflationary environment means FIFO produces better profit margins than weighted average cost (I guess we are to assume that you cannot pass costs on, only that you eat the inflationary COGS increase???). What functionally is the explanation for how the translation occurs such that current rate is better in a depreciating subsidiary currency scenario. Is it that the COGS are translated based on the most recent exchange rate such that the remaining inventory booked on the balance sheet is therefore priced down in value? Any thoughts beyond the answer at the back of the book.

thx.

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ryanlb

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发表于 2011-7-11 19:29 | 只看该作者

Point 1 - FIFO provides higher profit margins than avg cost.

Think this way. First products in are cheaper in an inflationary environment than last products. FIFO is then clearly a lower COGS than LIFO. Average cost, well you are including costs that are not just from the beginning of the year, so it will be higher than FIFO and likely lower than LIFO. Don't complicate it with the currency yet.

Point 2 - In a subsidiary's depreciating currency Current Rate Method has higher profit margin

Temporal Method - My memory might be wrong but I believe that inventory is at historical exchange rates (someone please correct if wrong). So if we are using historical rates and the subsidiary currency is depreciating, it means that their historical rates were higher which means that COGS would be higher.

Current Method - You are using the average exchange rate for the year (again someone correct me if I am wrong because I am going from memory) which will like be more depreciated than temporal method because you had inventory from previous year that would be at the higher historical rate. Therefore, COGS is lower for current rate method.

In Summary FIFO has high profit margin and current rate has higher profit margin so your answer is C.

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SFoyil

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发表于 2011-7-11 19:29 | 只看该作者

Great explanation stingreye, you are correct. Just think COGS has to be lower under current method b/c the currency (hryvnia) has depreciated and COGS under current rt method is at the average rate, like all income statement items under current rt method. Lower COGS equals higher gross profit.

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