This is question 11 in the schweser FRA self-test on page 291 of book 2… ************************************************************************ …The company owns approximately 35% of the stock in a U.S. based subsidiary and accounts for that investment using the equity method. Patterson detemines that the consolidation method would more properly represent the true nature of the company’s financial position. Prior to making the adjustments, Patterson is asked by Susan Bynor, her supervisor, what Patterson believes the most likely effects will be on earnings per share, return on assets, return on equity, and operating profit margin as a result of consolidating the unconsolidated subsidiary versus using the equity method. Patterson replies that all four measures will decrease because consolidation is a more conservative accounting treatmenet than the equity method. ************************************************************************ Assuming Patterson’s analysis of the effect on gross profit and total asset turnover from applying th translation method the company did not use is correct, did the local currency likely appreciate or depreciate during the year, and what is the effect on the current ratio from applying the method Patterson used instead of the method the company used: A. The local currency appreciated and the current ratio is lower B. The local currency depreciated and the current ratio is lower C. The local currency depreciated and the current ratio is unchanged. I will post the answer shortly, which doesn’t make any sense to me. Best, TheChad
Is it C?
sales - cogs/sales we just looked at this one in the thing i f’d up, let’s see if i can do this w/o f’ing up again. cogs under temporal = historical cogs under AC = average the info in the problem says that gross profit margin and TA turnover will be higher if the “other” method is applied. “other” here is temporal, you know that b/c it has a CTA which is only AC. so when is temporal greater than AC here, appreciating or depreciating? let’s go back to my mess up beg us/euro 2 ave 1.5 end 1… that’d be depreciating local- says they use FIFO- so historical gets you a bigger cogs and therefore a lower gross profit turnover. so it has to be appreciating. sales/assets assets under temporal is a more historical #… so again to get the ratio to get bigger you’d want assets to be smaller, would be if it’s appreciating. let’s say US/euro beg 1, ave 1.5, end 2… if you have some fixed asset worth 100, 100 x 1 = 100 for temporal, 100 x 2 for AC = 200… since in denominator, appreciating currency makes the ratio bigger under temporal. CA/CL… all monetary assets/liabilities translated at current rate for both so no change. but CA includes inventory- temporal uses historical, AC uses current. so as long as the co has inventory, under the scenario here, you’re going to have a bigger CA/CL using all current vs temporal with an appreciating currency. i like A which is what they give… seems ok to me.
bannisja, where does it say: CTA? I find the question very confusing. Part A speaks about the equity method and B asks me about AC & temporal??? Not sure I get it.
that part about the CTA had me confused as well. CTA is something reported in the Balance Sheet on the Current Rate method and would not show up on the Temporal. Temporal would have gains / losses due to translation showing up on the Income statement…
i had to go to the actual schweser text- the stuff he gave above didn’t say enough. here- “the company has an ownership interest in only 1 foreign sub. the CTA increased from 8 mil at the end of 2007 to 11 mil at the end of 2008. patterson is interested in the effect on the company’s financial statements from using the other method of consolidating the results of the foreign subsidiary than the one the co actuallly used, and she correctly determines that gross profit margin and TA turnover would be higher if the other method were applied” gives that paragraph as part of the supporting stuff before the questions. CTA only for AC method, so “other” is temporal here.
since the CTA increased from 8 Million to 11 Million and in the Current Rate method - it is based on Net Asset position two possibilities: 1. Net Asset Position and currency appreciated. 2. Net Liability Position and Currency depreciated. Gross profit and Total Asset Turnover movement from the method not applied (which in this case is “Temporal” method) are correct and have increased. Gross Profit = (Sales - COGS)/Sales Sales = Average COGS = Average for Current Rate Sales = Average, COGS=Historic for Temporal Total Asset Turnover = Sales / Total Assets Sales=Average in both methods Total Assets = Current in the Current Rate method Monetary assets and liabilities are Current rate in both methods Non-Monetary assets (Inventory + Fixed assets) - Historic in the Temporal method. If currency had appreciated If Company used FIFO method - Current Value of FIFO Inventory would be Higher – so COGS and the Gross Profit would be lower. So this means Currency has depreciated. Now since the Fixed assets are held at the original historic cost - there would be no change, but the Inventory - at Historic price would be lower - so Fixed assets overall would be lower - hence Total Asset turnover would be higher. So we have it that the Currency has depreciated. We also have determined that the Inventory has become lower --> so Current Ratio would be lower. Definitely not a 3 minute problem that … So my choice is B… (corrected this - got the answer choice wrong).
cpk, I got b as well, however, the answer in the book is a. I don’t have my book with me at work but when I get home tonight I will post their explanation which doesn’t make a lot of sense to me. Thanks for everyone’s help. TheChad
I have looked at their solution since I have the books and since then sent them an erratum with my explanation. Will post back once I hear from them. CP
bannisja Wrote: ------------------------------------------------------- > the info in the problem says that gross profit > margin and TA turnover will be higher if the > “other” method is applied. I believe the question actually says that they would be lower, which is why I got a depreciating currency. Best, TheChad
pg 289 last para does say: Patterson is interested in the effect of using the other method of consolidating the results of the foreign sub than the one co. actually used. and correctly determines that Gross profit margin and total asset turnover would be HIGHER if the other method were applied.
You’ are right…I misunderstood banni…I shouldn’t have doubted 
Best, TheChad