what's I/S flow effect(exchange rate/operational effect)?

CFA Level II
#1

HI. Could someone explain flow effect on income statement? what’s exchange rate effect for? and operational effect? any application in exam? THANKS!

#2

Was this one of the exam questions? I think I bombed this one

#3

just read through FSA and got blanked… it’s in LOS 26

#4

Consider a company that had sales in 2007 of $1,000,000 and sales in 2008 of $2,000,000. Now pretend you need to convert those to Vietnamese dong for each year. The average exchange rate in 2007 was $1/dong and in 2008 was $1.5/dong. So if you converted them at the respective exchange rates you would get 1,000,000 dong in 2007 and 1,333,333 dong in 2008. The problem is that some of the change from 1,000,000 dong to 1,333,333 dong was due to the operational effect ($1,000,000 increase in sales) and some of that change was due to the exchange rate changing from $1 to $1.5.

#5

so you are trying to tell me that dong is quite crucial???

#6

Exchange Rate Effect = (Income Statement Item FC)*(Change in Avge Rate DC/FC) Operational Effect = (Change in Inc. Stmt Item FC)*(Avg Rate DC/FC t-1)

#7

for wonderingcfa’s example: exchange rate effect: incomestatement item FC*change in AVG DC/FC=1,000,000*(1-1/1.5)=333,333.33 and operational effect: chang in I/S FC*AVG DC/FC t-1=1,000,000*1=1,000,000 and total flow effect on I/S is 1.333.333.33 thanks

#8

Actually it would be exchange rate effect: incomestatement item FC*change in AVG DC/FC=1,000,000*(1/1.5 -1)= -666,666 and operational effect: chang in I/S FC*AVG DC/FC t-1=1,000,000*1=1,000,000 Since in my example the USD depreciated, the exchange rate effect was negative. So total effect is -666,666 + 1,000,000 = 333,334 increase in sales.

#9

In the BSAS exam, there is a question like this: Sales 2007 - E20,444 2006 - E18,756 Weighted Avg (E/USD) - 2007 - 1.20 2006 - 0.94 Question goes like this: The effect of exchange rate changes (the “flow effect” on Eurex’s translated 2007 sales in US Dollars is closest to: A) -4,712 B) -4,323 C) -2,917 D) 5,315 Answer given goes like this: The flow effect from the translated sales is calculated from multiplying the current sales by the change in average rates: 20,444*(1/1.20 - 1/0.94) = $-4,712. But from what I interpreted from the formulas you guys showed, isn’t this just the exchange rate effect and not the flow effect? Now according to what I interpreted from the formula above : Flow effect = Total effect.

#10

The I/S is always translated through average costs. Therefore, to get the balance sheet straight you need to add a flow effect to the Income statement to make up the difference from Average - EOY currency exchange rate. The holding effect applies to the B/S. Same idea just different rates.

#11

So for income statement, there’s only one exchange rate translation adjustement? The I.S. item times diff. in average rates?

#12

with wonderingcfa’s example, we use 1,000,000(previous year sales) to get exchange rate effect. but with sparty419’s example we are using 20,444(current year sales) to get exchange rate effect Which one?

#13

Exchange Rate Effect : Ending I/S Amt * (New Avg Rate - Old Avg Rate) Operationg Effect : (Ending I/S Amt - Beginning I/S Amt) * Old Avg Rate so in wanderingcfa’s example you’d take $2 mn * (1/1.5-1) = Exchange Rate Effect ($2mn - $1mn) * 1 = Operational Effect

#14

thanks everyone for clearing this bomb