I struggle to understand why the “average rate” is the most appropriate for translating inventory? If you understood that one and could try explain I would be very appreciative. Thanks
We know that:
Consol-Can (the Canadian subsidiary) is using the US dollar as its functional currency, thus one uses the “temporal method” to translate the subsidiary account.
The reading mentions that:
Temporal Method for “nonmonetary assets and liabilities” (e.g Inventory)
- if nonmonetary assets/liabilities are measured at historical cost then
it is translated using “ historical exchange rate ”
- if nonmonetary assets/liabilities are measured at current value then
it is translated at the exchange rate at the date the current value was determined.
However, the solutions explain that the most appropriate exchange rate is the “average rate” because the beginning inventory was sold first and sales and purchase were evenly acquired.
Reference: CFAi Vol2 R21 Q7 (p271-272)
It’s not the average rate that is used, rather it is the the weighted average rate when inventory was acquired. The aim is to match the capitalized inventory costs with the historical rate that existed when the costs were capitalized. For example:
- Purchases of 100 @ 1/30/X1 - Exchange rate at the time = .8
- Purchases of 50 @ 6/30/X1 - Exhange rate at the time = .85
- Purchases of 50 @ 11/30/X1 - Exchange rate at the time = .9
Now for simplicity, assume that the company started with 0 balance inventory and didn’t sell anything during the year (as inpractical as that may sound). The ending inventory would be 200 and is translated at the historical exchange rate that existed at the time that each component was capitalized. Rather than ask you to break down ending inventory and translate each individual component at its historical exchange rate, the text gives you a weighted average exchange rate that can be applied to the ending inventory balance. Continuing with our example, the weighted average exchange rate would be:
[(100 x .8) + (50 x .85) + (50 x .9)] / 200 = .838
Therefore, the ending inventory of 200 would be translated at (200 x .838) = 167.5 ccy
What the text is explaining in the solution of Q7 is that the starting inventory balance was completely sold off during the period. This means that the historical exchange rates for inventory that existed at the beginning of the period are irrelevant, as the beginning balance does not factor into the ending balance (think FIFO method). As such, the inventory balance at the end of the period is purely a result of capitalized costs during the current period.
Somebody please correct me if I’m wrong, but I think the text falters in suggesting that as the result of sales and purchases being evenly acquired during the period the average rate should be used. Under the FIFO method, even if purchases are evenly capitalized into inventory throughout the year, the sales will take from beginning inventory first, skewing ending inventory towards end of period rates. As such, you should always use the weighted average rate for inventory purchases, if given. It just so happens that in this question the average rate and the weighted average rate for inventory were same, so the answer still holds, but this need not always be the case.
Thank you so much for your detailed explanation! Now, It does all make sense. I will need to remember that under the “Temporal Method”, I should make sure to use the weighted average rate of the inventory to translate the account.
Just to be sure, if this example was with a different functional currency, we would then apply the “current method”. In that case, do we simply take the current rate (end of the year rate) for the inventory? Or should we also consider the weighted average rate for that inventory?