Question about Practice problem 2 - Multinational Operations

CFA Level II
#1

Practice problem 2 on page 282:

[question and answer removed by admin]

I understand that the answer would be FIFO, but why is it not FIFO and temporal method? With current method the owner the parent has a net asset position, and usually this should be negative when the subsidiary’s currency weakens? From the book “When the foreign currency decreases in value (weakens), the current rate method results in a negative translation adjustment in stockholders’ equity.”

So why is not FIFO and temporal method the correct choice… I thought this would give a positive currency translation in the P&L?

#2

You have already answered: "the current rate method results in a negative translation adjustment in stockholders’ equity.”.

Hence, by temporal report FX losses would appear in P/L and will impact the GPM which is not case by CRM.

EDIT: I see that GPM is the case, not NPM.

#3

But the translation adjustment is a balance sheet item (equity) it doesn’t affect gross profit. The question is about the different methods of translation for COGS: under trmporal - historical rates are used, under current - average rates.

Given the circumstances, which method results in lowest COGS (higher gross profit)?

#4

There is not universal rule. Depend of inflation/deflation rate, FX changes rate etc.

#5

In this query I will chose CRM and FIFO by intuition and such I usually answer on most FRA questions.

#6

There may be a coincidence that translation adjustment supports your intuition, but you would agree it has nothing to do with gross profit. So why is the COGS less under current method in inflationary/devaluationary circumstances?

#7

OK, let’s break this step by step:

The funds were converted into hryvnia (UAH) on 31 December 20X1 at an exchange rate of EUR1.00 = UAH6.70 and used to purchase UAH1,500 million in fixed assets and UAH300 of inventories.

Temporal method + FIFO

300 UAH Inventory / 6,7 = 44, 8 Eur by historical rate , let’s say that is 100 pieces of Inventory, thus 3 UAH each.

Sales : example 80 pieces of inventory by 6 UAH each for 480 UAH.

COGS: 80 x 3 = 240 UAH

GP = 480 - 240 UAH = 240 UAH

If LIFO had been applied instead of FIFO, inflation would impact COGS thus, COGS will be 3 (1+ Inflation rate) so GP will be lower (assuming inflation expense is already contained in margin of 3 UAH (3+3=6 selling price). This is straightforward.

Let’ say that on balance date f.ex 1 EUR is 7,4 UAH and average periodical rate was 7,0 UAH for 1 EUR.

Under temporal method, COGS will be remeasured by historical rate, thus

240 UAH / 6,70 = 35,82 EUR

Sales will be remeasured by average rate 480 /7,0 = 68, 57 EUR

GP under temporal method is 68,57 - 35,82 = 32,75 EUR

under current rate method

COGS and Sales will be translated by average rate.

COGS: 240 UAH / 7,00 = 34,29 EUR

Sales: 480 /7,0 = 68, 57 EUR

GP under current rate method is 68,57 - 34,29 = 34,28 EUR

Since COGS are lower under local currency depreciation, thus combination of target currency appreciation(local depreciation) and accelerating inflation would favorize FIFO + CRM in translation process.

#8

Thanks Flashback. I overlooked that it was gross profit margin, and I agree with you that it will be higher when you translate with a current and more weak currency. However, does this still hold:

With current method the owner the parent has a net asset position, and usually this should be negative when the subsidiary’s currency weakens? From the book “When the foreign currency decreases in value (weakens), the current rate method results in a negative translation adjustment in stockholders’ equity.”

#9

Watch out if it is net asset or net liability position.

Consider it as:

Situation 1:

You borrow money in EUR and your currency is anotehr currency.

I f your currency appreaciates against EUR, you reached the gain because your liability is lower (payments outflows).

Situation 2:

You bought an asset in EUR.

If EUR depreciates against your currency, you have losses in value.

Similar with production costs…

Eg. Your COGS are denominated in Chinese Renminbi Yuan and you are selling products (output) in EUR.

If Yuan depreciates, your production costs become more cheaper and you would realize extra profit.

Opposite if your production is in Switz and CHF has strongly appreciated against all other currencies, your production costs would be highly unprofitable.

In your example, company product and sell products in Ukrayine then earnings were translated into EUR.

Currency depreciation and inflation impacts have been offset by choosing FIFO method in combination of current rate method by translation.

#10

I agree, but with current method the owner still has a new asset position right? So would not this be negative when the subsidiary’s currency has weakened?

#11

Here we are talking onyl about selling process, finally whole parent net asset position in Ukrayine depends of other A/L positions in that subsidiary. It can be offset by borrowings in UAH or/and hedged 100 % thus must be not negative outcome for parent BS, but this is probably out of scope calculation required in this question.