A foreign subsidiary is operating in a country whereby the local currency is depreciating relative to the parent’s presentation currency. Assuming the subsidiary is a FIFO firm, which accounting method will result in the highest gross profit margin reported in the parent’s consolidated income statement?
A. Current rate method.
B. Temporal method.
C. The current rate method and the temporal method will result in the same GM.
You 3 minutes.
Considering that the local currency is depreciating, under the temporal method and FIFO the old items would cost more, thus making COGS = Beginning Inventory - Ending Inventory + Purchases under the temporal method higher. This will decrease the gross profit = Sales - COGS. The answer is A - Current rate method.
What would be your answer if LIFO was used?
Well it depends if you can reach the more expensive inventory. If your inventory decreased then you would reach them. If it didn’t then it should be the same or it would be hard to say (average * q or q*x1 +q*x2 + q*x3).
It depends on whether the currency depreciates faster or slower then the local inflation rate. If we assume that every new purchased item after translation to the parent’s currency costs less , then this would decrease the price of COGS, making gross profit higher.
Also, you need to consider any LIFO liquidations.
COGS under All-current uses average rate. COGS under temporal uses historical rate, which means average rate, if items were purchased/manufactured throughout the year, which is the typical case. So, I think if not told otherwise, I’d assume they are the same.
If that’s the case, then if present year inventory higher than previous year inventory, then Current would still be higher, since you sell the “more expensive” inventories. If inventory for this period is equal or greater than previous, then both will give you the same result.
GM is always higher under current method when currency depreciates. Temporal results in lower GM. This is because current method uses current exchange rate which (regardless of method) will be less in parent currency terms if it depreciating.
When currency appreciates, the opposite is true. Local currency COGS translate into more parent currency COGS and hence lower gross margin.
FIFO and LIFO matter with respect to the inventory balance (and turnover). Your inventory balance is likely higher under LIFO and temporal since when currency is depreciating, inventory will have older prices and be translated at historical rate. FIFO will still use average rate but consist of newer items at recent (lower prices). So it is somewhat indeterminate.
Someone please correct me if wrong. This is always tricky to get the directional stuff right and for GM I think CFAI throws in LIFO and FIFO as a red herring but for things like inventory balance it matters