Financial Reporting and Analysis【 Reading 24】Sample

pacmandefense

eborah Ortiz, CFA®, is the director of Global Research for F.E. Horton & Co. Ortiz recently hired two junior analysts, Tina Hirauye and Dominique Wilkins to assist in the financial statement analysis of global conglomerates. Hirauye and Wilkins are both Level II candidates in the CFA® Program, so Ortiz thought they would be the ideal people to work on a project dealing with consolidating the results of foreign operating units in the financial statements of the global parent.
Before starting on the project, Ortiz has a meeting with Hirayue and Wilkins to discuss the use of different currencies in a company’s operations. At the meeting, Hirayue states that when analyzing multinational firms, there cannot be a difference between local and functional currencies. Wilkins disagrees with her and states that there can be a difference between local and functional currencies, but only if the parent of the subsidiary operates in a hyperinflationary environment. After another 30 minutes of discussion, Ortiz concludes the meeting by telling them to make sure they understand the different accounting rules for remeasurement and translation, under SFAS 52.
Hirauye and Wilkins are given projects involving three different firms:

• Molsan Industries is a Canadian multinational firm with a subsidiary in Japan. The subsidiary has operations in both Japan and Singapore.
• Tylo Corporation is a multinational firm based in France. Tylo does business on a global basis, but prepares and issues consolidated financial statements in U.S. dollars. Tylo has a subsidiary that does business in the United Kingdom. The majority of the cash that the subsidiary generates and expends is denominated in British Pounds (GBP).
• Neslarone is based in Switzerland and generates the majority of its cash in Swiss Francs (CHF). The firm issues and prepares its consolidated financial statements in U.S. dollars.

Hirauye and Wilkins spend the morning reviewing the details of their assignment and decide to take a break for lunch at a restaurant across the street from F.E. Horton & Co.’s headquarters. They agree that they have a challenging task and both are nervous about turning in their consolidated financial statements to Ortiz on the following day. At the restaurant, the two junior analysts run into two F.E. Horton senior analysts, Brad Windbigler and Elizabeth Alvarez, and the four of them decide to eat lunch together. Windbigler and Alvarez recently found out that they both passed Level III of the CFA® Exam, and, upon hearing about the task assigned by Ortiz, they are eager to help their two junior colleagues. Windbigler states that the current exchange rate is defined as the exchange rate between functional and reporting currencies at the balance sheet date, excluding all of a firm’s hedging activities. Alvarez also tries to offer assistance by stating that the correct exchange rate to use for monetary assets and liabilities when applying the temporal method is the average rate. When lunch is over, Hirauye and Wilkins thank their colleagues for their advice and go back to work to finish their assignment.Regarding the statements made at the meeting:

A) Hirauye’s statement is incorrect; Wilkins’ statement is correct.

B) Hirauye’s statement is incorrect; Wilkins’ statement is incorrect.

C) Hirauye’s statement is correct; Wilkins’ statement is correct.

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The basis for using the current rate method is when Functional Currency is NOT the same as Parent's Presentation (reporting) Currency. The basis for using the temporal method is when Functional Currency = Parent's Presentation Currency.

Hirauye and Wilkins both make incorrect statements regarding local and functional currencies. A foreign subsidiary may have a local currency but designate another currency as its functional currency. The functional currency is defined as the currency of the primary environment in which the subsidiary generates and expends cash, but the choice of the functional currency is ultimately a function of management’s judgment. Wilkins is also incorrect because the rate of inflation does not necessarily have an impact on designated currencies. (Study Session 6, LOS 24.a)

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Hirauye is working on consolidating the financial statements of Molsan Industries’ Japanese subsidiary. Under SFAS 52, regarding Foreign Currency Translation, if:

A) more than half of the subsidiary's revenue is from Japanese sources, then the results of the Singapore operation are translated into Japanese yen and then translated into Canadian dollars.

B) management determines that the subsidiary's functional currency is the Japanese yen, the results of the Singapore operation are first remeasured into Japanese yen and then translated into Canadian dollars.

C) management determines that the subsidiary's functional currency is the Singapore dollar, then the results of the Singapore operation are remeasured into Canadian dollars.

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The functional currency is determined by management. Financial data are remeasured into the functional currency chosen by management and then translated into the reporting currency. (Study Session 6, LOS 24.a)

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Wilkins has been tasked with analyzing Tylo Corporation, and is trying to distinguish between the various currencies employed in Tylo’s operations. Concerning the UK subsidiary's functional and reporting currencies the:

A) functional currency and reporting currency are the U.S. dollar.

B) functional currency is the British Pound; reporting currency is the U.S. dollar.

C) parent firm (Tylo) is headquartered in France, therefore the functional currency is the Euro, and the reporting currency is the U.S. dollar.

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The functional currency is defined as the currency of the primary economic environment in which the subsidiary generates and expends cash. Although the functional currency can be chosen by management, because we are told that Tylo's UK subsidiary generates and expends cash in British Pounds, the British Pound is the best choice for the functional currency. The reporting currency is the currency in which the parent firm prepares final consolidated statements, which in this case is the U.S. dollar. (Study Session 6, LOS 24.a)

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Ortiz had told the junior analysts to make sure they understand the different accounting rules under SFAS 52. When referring to foreign exchange rates, the difference between remeasurement and translation is that remeasurement:

A) and translation refer to the same process of translating the functional currency into the reporting currency.

B) is used to describe historical exchange rates while translation is used for current rates.

C) refers to the conversion of local currency into the functional currency; translation is the conversion of the functional currency into the reporting currency.

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Translation is between functional and reporting currency. Remeasurement occurs between local and functional currencies. (Study Session 6, LOS 24.a)

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Regarding the statements made at lunch:

A) Windbigler’s statement is correct; Alvarez’s statement is incorrect.

B) Windbigler’s statement is incorrect; Alvarez’s statement is incorrect.

C) Windbigler’s statement is correct; Alvarez’s statement is correct.

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Windbigler’s statement is correct. The current rate is defined as the market rate in effect at the balance sheet date. Hedging activities do not affect the rate, but affect the gain or loss from changes in exchange rates. Alvarez’s statement is incorrect. The correct exchange rate to use for monetary assets and liabilities when applying the temporal method is the current rate. (Study Session 6, LOS 24.b)

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Wilkins and Hirauye are working on constructing the consolidated statements for Neslarone. They know that after they convert from Swiss Francs (CHF) to U.S. dollars (USD), they will be left with a foreign currency adjustment that needs to be included on the financial statements. To convert from CHF to USD, the analysts should use the:

A) current rate method and they should record the foreign currency adjustment on the balance sheet.

B) temporal method and they should record the foreign currency adjustment on the income statement.

C) current rate method and they should record the foreign currency adjustment on the income statement.

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Neslarone is based in Switzerland and generates the majority of its cash in CHF, meaning the local and functional currencies are both CHF. The firm issues financial reports in USD, so the dollar is the reporting currency. The process of converting from the functional currency to the reporting currency is translation and the correct method to use is the current rate method. When using the current rate method, the foreign currency adjustment is recorded in the equity section of the balance sheet. (Study Session 6, LOS 24.c)

sabaruch

Which translation method should be used under a hyperinflationary economy when using U.S. GAAP?

A) All-current, because dividends are translated at the rate that applied when they were issued.

B) Temporal, because all non-monetary accounts are re-measured at the historical rate.

C) Monetary/non-monetary, because all monetary accounts are translated at the historical rate.

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The temporal method is more appropriate because all non-monetary accounts are remeasured at the historical rate. Under IFRS, the financials would be restated for inflation, and then translated under the current rate method.

sabaruch

Assume U.S. GAAP for this question.) For a subsidiary in a hyperinflationary economy, the functional currency should be the:

A) Local currency.

B) Subsidiary's operating currency.

C) Parent's currency.

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The functional currency should be the parent's currency. Under IFRS, the firm would restate the financials for inflation, and then translate under the current rate method.

sabaruch

A hyperinflationary economy is typically defined as one that has:

A) cumulative inflation that exceeds 100% over a three-year period.

B) an inflation rate that exceeds 10% per year for three consecutive years.

C) cumulative inflation that exceeds 100% over a twelve-year period.

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The typical definition is that cumulative inflation exceeds 100% over a three-year period.

sabaruch

In reality, what best describes the real value of non-monetary assets and liabilities in a hyperinflationary environment?

A) Typically not affected because their local currency-denominated values decrease to offset the impact of inflation.

B) Typically not affected because their local currency-denominated values increase to offset the impact of inflation.

C) All non-monetary accounts are re-measured at the current rate.

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Typically not affected because their local currency-denominated values increase to offset the impact of inflation (i.e., real estate values typically rise with inflation).

sabaruch

The nation of Deadoa is experiencing hyperinflation. A subsidiary of a multinational operating in Deadoa will notice changes in its purchasing power and in its financial results as reported on its parent company's financial statements. Which of the following best describes the situation for a subsidiary operating in Deadoa? Purchasing power will:

A) dramatically appreciate and the local currency will be rapidly appreciating against the presentation currency.

B) quickly deteriorate and the local currency will be rapidly appreciating against the presentation currency.

C) quickly deteriorate and the local currency will be rapidly depreciating against the presentation currency.

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Purchasing power and Deadoa currency will depreciate.

sabaruch

In a hyperinflationary economy, translation under the current rate method will most likely result in relatively:

A) high balance sheet values for long term assets.

B) low balance sheet values for long term liabilities.

C) high translation gains.

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In a hyperinflationary economy, translation under the current rate method will most likely result in relatively low balance sheet values for assets and liabilities. Translation losses will also occur.

sabaruch

Under U.S. GAAP, the temporal method is preferred to the current rate method in hyperinflationary economies because the temporal method:

A) is easier to perform under hyperinflation.

B) results in non-monetary asset values that are a better proxy for the economic values of those assets.

C) provides better conversions of subsidiary revenues.

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The temporal method results in non-monetary asset values that are a better proxy for the economic values of those assets than those obtained under the current rate method. Both methods convert revenues and SG&A at the average rate so there could be no clear preference when considering these measures.

sabaruch

Fronttalk Company is a U.S. multinational firm with a 100% stake in a foreign subsidiary. The foreign subsidiary's local currency has depreciated against the U.S. dollar over the latest financial statement reporting period. In addition, the subsidiary accounts for inventories using the last in, first out (LIFO) inventory cost-flow assumption and all purchases were made toward the end of the year. The gross profit margin as computed under the temporal method would most likely be:

A) higher than the same ratio computed under the current rate method.

B) equal to the same ratio computed under the current rate method.

C) lower than the same ratio computed under the current rate method.

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The foreign company uses LIFO so new purchases are flowing to cost of goods sold (COGS) and most purchases occurred toward the end of the year, so the current rate of exchange is our best guess for the COGS account. Since the local currency is depreciating, it is taking more foreign currency units to buy a dollar in the more recent periods and as a result, COGS as measured in U.S. dollars is lower and the gross profit margin is higher under the temporal method.

sabaruch

Which of the following ratios is unaffected by the choice between the current rate method and the temporal method?

A) Accounts receivable turnover.

B) Net profit margin.

C) Debt/Assets.

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Both accounts receivable and sales are converted at the same rate so the ratio is the same under each method.