If you use the temporal method the Functional currency = the parents reporting currency. Does that mean that the subsidiary is using dollars to operate and the parent (a US firm) also uses dollars?
What does the local currency have to do in this scenario??? I know sales are at the average rate and total fixed assets at historical? So if the currency is appreciating, the Historical FA will be translated at historical USD to USD exchange rate so it will be lower and sales at the average USD to USD so?? but this doesn’t make sense because if I am operating in the foreign country using USD, I have no FX risk! I’m mixing something up here…please help!
The U.S. dollar has been appreciating relative to the local currency over the past year. The use of the temporal method to translate a foreign subsidiary’s financial statements to U.S. dollars will most likely have which of the following effects on the fixed-asset turnover ratio (S/FA) relative to what the ratio would have been without the effects of translation assuming no new fixed assets were purchased throughout the year?
A) There will be no effect on the ratio. B) The ratio will rise. C) The ratio will fall.
Your answer: B was incorrect. The correct answer was C) The ratio will fall.
Under the temporal method and U.S. appreciating, the items on the balance shee income statement that are measured at current or even average for the year rates (such as Sales in this example) will tend to DECREASE when translated into U.S. dollars. This is because you get less U.S. dollars now from each unit of foreign currency. However, FA are measured at historical cost under the temporal method. So, those assets will stay the same in terms of U.S. dollars year after year. So, Sales are decreasing and FA are staying the same. This means that the ratio will fall.
Vlad! Thanks! But I am still confused and here is why!
If the US (parents uses USD as the reporting currency) and the subsidiary’s functional currency is the USD… why would I care if the USD appreciates or depreciates since I am using USD ($US dollars) to operate the subsidiary? Exchange rates would not impact me.
In the questions they say Local currency which is not the USD.
How? If the functional currency is USD… why do they care what the foreign currency is doing? for example. the US Sub sales travel tickets in London. Brits will buy a ticket in pounds… the sub will exchange the tickets in GBP to USD at the time they receive the cash ( current spot rate). But technically they will used the average rate.
The functional currency does not change how the subsidiary reports financial statements. They will still be in the local currency. The functional currency is simply used to determine how to translate the subsidiary’s statements into parent’s statements. So, the Functional Currency is simply used to determine which translation method to use (current or temporal). The original financial statements of the subsidiary are still in the local currency.
If the subsidiary is more attached to or influenced by the local currency then changes (appreciate/depreciation) immediately affect ALL its assets when converting towards the parent currency. Current rate
If the subsidiary is more “attached” to the parent currency, only the more liquid (monetary) assets/liabilities are susceptible to changes in the local currency. Temporal.
The foreign sub will always being using the local currency for their own accounting… they are in the other country so chances are, if they are in Europe they are buying and selling things with euros… unless you get to the occasional country that uses USD as their country’s currency, but ignore that.
So from a Foreign Sub perspective, say EUR, your sales are in EUR, but let’s say you bought some equipment in CHF, you still translate that onto your balance sheet in EUR (but that’s a seperate translation the sub is doing, so ignore that). Then your parent in the US translates everything into USD. The method used to transalte depends on how “attached” you are. If the parent runs the show and the sub is just a sales outlet, use the temporal, if the sub is in charge of everything (purchasing, advertising, decisions), then use the current.
That makes sense! If the sub were using USD an operating in spain! Then we wouldn’t have any FX exposure. The FX exposure only comes into play when the sub is operating using EUR. At year end, we need to translate this sub to USD (this is were the FX exposure comes into play).
the Current and temporal method are techniques to translate(current) or remeasure (temporal).
that the wrong way of thinking! Don’t say if the sub is using USD/EUR and operating in spain.
When you are operating in a different country, you must deal with their currency. Exposure to it is inevitable.
But the amount of exposure in accounting terms becomes a managment decision. By determining whether the subsidiary company’s operations are more influenced by the parent company/country(current rate), or rather the country where it is operating in (temporal)… that determines the level of FX exposure.
if current rate they decide that all assets and liabilities are pretty much exposed. if temporal they are saying only liquid/monetary assets are more exposed.
I think a lot of people are making this more confusing than it has to be.
Starbucks is a company that would use the current method. The local currency is the functional currency, so if you’re in one country you buy and sell and deal with the local currency.
US Airways is a company that would use the temporal method. Sure, they make sales in other countries but they operate out of the US. In analyzing the balance sheet for their French arm they recongize passengers are buying tickets in Euros, but the functional currency is still the USD.
I don’t get the reason behind using the temporal method when the functional currency is the presentation (reporting) currency and using the current method when the functional currency is the local currency, can anyone elaborate on this?
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In a nutshell, you use the current rate method when the subsidiary acts essentially autonomously, and the temporal method when the parent directs all of the subsidiary’s actions. In the former case, the parent is little more than a reporting conduit, so they simply report everything as it is currently (using the current rate method), and the currency exchange rate gains/losses are the responsibility of the subsidiary, so they don’t appear on the parent’s income statement. In the latter case, the parent is responsible for everything from the time it occurs, so they report everything historically (using the temporal method), and the currency exchange rate gains/losses are the responsibility of the parent, so they appear on the parent’s income statement.
