Here’s the qn: Foxy Company is a U.S. multinational firm with has a 100% stake in a German subsidiary. The subsidiary’s local currency (euro) has appreciated against the U.S. dollar over the latest fiscal year. The German firm accounts for inventories using the LIFO basis. The net profit margin as computed under the current rate method would probably be: (a) Equal to the same ratio computed under the temporal method. (b) Lower than the same ratio computed under the temporal method. © Higher than the same ratio computed under the temporal method. (d) Higher or lower than the same ratio computed under the temporal method. I thought the answer would be ©. As under the current method profit margin (Sales-COGS/Sales), the ratio wouldn’t change as they all increase by the same amount. But under the Temporal method, COGS wouldn’t increase as it would be translated at historical cost. Therefore, if Sales goes up and COGS remains the same, this ratio would be lower than the current method… The answer is (d) though. Does anyone understand why?
Euro appreciated against the . Functional currency = US Local Currency = Euro Since LIFO assumption and appreciating Local Currency = Higher COGS. that part is fine. but it does not say if prices of inventory was rising or falling. If rising - and the inventory was valued on Historical level --> COGS would be lower. so Net Profit Margin would be showing up as increased. If falling prices - COGS would be higher - Net Profit margin would fall. So unless we are told the direction of movement of prices - we cannot truly tell. (Another question): are you using OLDER material for your preparation? My observation is based on your question having 4 answer choices – this year onwards we have only 3 answer choices.
Thanks for your answer. I still dont quite understand. If you had COGS -> LIFO and prices were rising, the untranslated local Currency COGS would be higher. (inventory would be lower). Using weighted average exchange rate for the current method. If you use the temporal method of historical exchange rates, the COGS contains items that will have the more current exchange rates attached to them (as last in first out), and exchange rates have appreciated, then the COGS would be more. If prices are rising - this means for temporal method you will apply a higher fx rate to a higher COGS. If prices are falling- this means for the temporal method you will apply a higher fx rate (as still LIFO) to a lower COGS. Either way the translated COGS will be higher under the temporal method then the current method due to the higher fx rate in either senario…?So profit margin will be lower…? Am I being completely stupid?
Forgot to add re: questions. It was from the 7 city online stuff, and all the qns still seem to be in the 4 answer format… even though it all relates to 2009 material.
The common thing for both current and temporal methods is that Sales are translated at the weighted average exchange rate. Sales will be the same under both methods. The difference is at COGS that in turn determines where the NI would be, and further the Net Profit=NI/Net sales. With the temporal method, the appreciation of EUR against $ could also indicate losses hitting the income statement (these are called remeasurement losses in SFAS no. 52), if the company had a net liability balance sheet exposure (that is, if the monetary assets netted against the monetary liabilities resulted in a negative balance). These adjustments are necessary to keep the translated balance sheet in balance. Under the temporal method, you are required to use weighted average exchange rates for translation of Sales and most expenses, with the exception of expenses/write downs of non-monetary assets, that is COGS (inventory, non-monetary asset, depreciation and amortization - say PP&E again non-monetary asset, or intangible assets), where you use the historical rate. Under the current method, you are required to use weighted average exchange rates for all income statement items (COGS included). This company uses LIFO, so the last one in is the first one out, you could use a more current rate for COGS, because that is when you “historically” acquired the inventory that you are now selling. Again, the question doesn’t say what happens throughout the year with the level of inventory, if it remained stable or not, because a weighted average exchange rate is more likely going to be used for COGS if the inventory is bought/sold evenly throughout the year. Say this is the case, then the COGS under both methods would be approximately the same, and the remeasurements become that more important. Bottom line, you know nothing about the initial net balance sheet exposure (asset - temporal method generates positive remeasurements/gains from the exchange rate, or liability - temporal method generates negative remeasurements/losses from the exchange rate), you know nothing about the level of inventory, you know nothing about the economic environment in Germany being (de)inflationary. Since we cannot tell with certainty if the ratio would be higher, lower or equal, (d) seems the most likely solution.