according to the Practice Problems for Reading 24 (Book 2 page 313) Problem No. 2, the answer is C.
"Given Ruiz’s believe about the direction of exchange rates ( foreign currency is depreciating), Eurexim’s (parent company) gross proft margin would be HIGHEST if it accounts for the subsidiary’s inventory using:
a) FIFO & Temporal Method
b) wheighted av. cost and Temporal Method
c) FIFO and Current Rate Method
The way I thought of this problem:
foreign currency is depreciating so FIFO COGS is lower using historical cost (TEMP METHOD) than average cost (CURRENT METHOD)
gross profit margin = (Revenue - COGS) / Revenue
TEMP Method: (Average Rate - Historical Rate) / Average Rate
CURRENT Method: (AV Rate - AV Rate) / AV Rate
Since Historical Rate < Average Rate, the gross profit margin should be higher using the Temp Method!
However CFAI states: “For either inventory choice, the CURRENT RATE METHOD will give higher gross profit to the parent company if the subsidiary’s currency is depreciating -> Thus using FIFO, CURRENT RATE METHOD will generate a higher gross profit for the parent company”
so I attacked the problem the wrong way. I should assume using the Current Rate Method because of the 2 different currencies. Then this makes sense!
So assuming that we have 2 different currencies, the Temporal Method doesn’t even need to be considered?
It’s just a little confusing because under the Temp method we use the lower historical cost for COGS instead of av cost which would result in a higher profit margin also…
Foreign currency depreciating it means that current rate is less than the historic. IT means that the Cost of sales would be less and higher the GP like CPK stated.
The question is designed to test what exchange rate you use to translate COGS under the current rate and temporal rate methods.
Current rate --> average exchange rate assuming inventory is sold throughout the period
Temportal --> historical exchange rate since inventory is kept on balance sheet at historical cost
Since the foreign currency is depreciating a newer exchange rate (i.e. the average rate in this example) would translate into less of the domestic currency resulting in lower COGS --> higher profit. Look at cpk123’s example.
’‘Temportal –> historical exchange rate since inventory is kept on balance sheet at historical cost’’
How is this evident in the problem? According to the curriculum, Inventory is translated @current rate or @historical rate depending on whether it is measured at market or cost under the lower-of-cost-of-market-rule
If Foreign (Subsidiary) Currency is Depreciating and you are using FIFO, COGS would be higher as you sell relatively expensive inventory first.
In Temporal method, we are using the historical (actual COGS) value which is higher, Profit Lower, Profit Margin Lower.
In Current Rate method, as we use average COGS, which is relatively higher compared to current rate, the COGS would be relatively lower, Profit Higher, Profit Margin Higher.