Which of the following asset or liability values is likely to be the most understated in a hyperinflationary economy if translation occurs under the current rate method? A) A plant purchased several years ago. B) Accounts receivable. C) Dividends payable. The correct answer was A. The accounts receivable and dividends payable will each have book values that are closer to their market values than a plant purchased many years ago. — answer doesnt really explain why. i would appreciate some help, thanks.
known as the disappearing plant syndrome. you bought a plant long time ago. it got translated to the parent’s financial statements and over time has been – at the exchange rate. now inflation has gone up. Currency would depreciate a lot. the plant at its historic rate (in local currency) getting translated to the parents currency would be increasingly smaller. and ultimately would disappear…
this would be true under the temporal method, since the plant would be translated at a historical rate and would thus disappear. but the Q says that the current rate method is used–doesnt this change things since the plant would be translated at the current arate?
current rate would be the one that is way down isn’t it?
Yes exactly. But A/R would be translated at the (lower) current rate as well so why does the plant get understated more? Is it simply because it has been around longer?
every period your current assets keep getting reflected at the new rate. so that would not be something to be worried about. but plant and equipment - when the rate fluctuation is not too much - would be fine. But due to hyperinflation - it would suddenly assume a very small value. the historic rate is also going to be far away from the current value of the piece of plant or equipment. A/R, dividends payable are current expenses - so they would be at the market price… in addition to whatever translation effect is occurring due to the exchange rate. You could give up what you had on your balance sheet (sell it) and buy afresh - and still get the same or similar quantity. Not possible with plant or equipment.
got it, thanks. btw, dividends payable–would that be considered a monetary or nonmonetary liability?
There is something wrong with this question. The disappearing plant syndrome would occur were a straightforward current translation adopted, because everything would be translated at the year’s average or ending rate. This would indeed be misleading, because plant does not depreciate with cash during hyperinflation - in its own currency it actually rises (assuming its “value” is constant). The temporal method (prescribed by US GAAP) uses a variety of rates, incuding the historical for PPE, so no problem there. However, the straightforward current is not, in fact, to be used during hyperinflation (because of this obvious problem). Instead, a modified current translation is applied. First, items are restated to take account of inflation. So before translating everything at current rates plant and other assets are increased on the balance sheet by the amount of inflation between purchase and today (or if the assets have been revalued, rather than retained at original book value…the price rise between now and the revaluation date is used instead). The point is that the mismatch between historically recorded inflation-adjusting non-monetary assets and properly devalued cash equivalents that would occur under the usual current method, actually doesn’t occur under the modified current method. It seems like the question is referring to the disappearing plant syndrome, but IFRS (which prescribes the modified temporal) avoids this with the restatement for inflation. Out of the three, of course, an old plant is the most likely to be understated, because the other two are easy to value. However, the old plant is also the most likely to be overstated (consider 70s-style stagflation where the price index rose but property slumped - ok, less likely to be the case in hyperflation, but assume the fixed asset inflation lags slightly behind the general price index rise - in this case the modified temporal would also overstate). It is, simply, the most likely of the three to be incorrectly valued, because it’s value is crudely adjusted, and cash is easy to value. But if that’s the rationale behind the question it’s pretty weak stuff…
i see what youre saying but the reason its most likely to be understated is because over the years, inflation will have diminished its value substantially. the other 2 options are the other hand are being reset anually at market rates. therefore, the plant is the only one of the 3 to “never have received a market adjustment”
But prior to translating everything at the current exchange rate, under this modified current method the plant would be inflation-adjusted first - so whatever else might be responsible for holding back its stated value, inflation itself cannot be. Plant is often undervalued on the books, because it need not be revalued from purchase, but this is a general issue, not inflation- or currency-related. The prescribed current method takes the percentage increase in the price index from the date the assets were purchased or revalued (whichever’s more recent) and applies this to their book value. Therefore, inflation is not the culprit here. The answer remains A, because for other reasons, which have nothing to do with inflation of translation, the fixed asset is more likely to be understated on the books. If this is what’s going on with this question, then the whole context in which it’s set is irrelevant and distracting. In fact, a non-monetary asset translated at the current rate under hyperflation is likely to be valued higher in relation to its underlying value than if it had been translated at the current rate in a lower inflationary environment. Imagine a country with constant 3% annual inflation for 20 years - under the usual current method everything is translated without adjusting for inflation, so the asset will appear to be worth around half what it would be were inflation factored in. Under hyperinflation all movements in the price index are applied, so a higher relative value for the fixed asset would be the result.
I don’t really understand why folks are trying to answer a question that is not being asked. Original question asked “under current rate method”. No modified current rate method, no temporal method, nothing… they only mentioned Current rate method, hyperinflationary. So disappearing plant syndrome, does apply. The method to make sure the plant does not disappear from the parent’s b/s -> is US GAAP -> Temporal, report translation g/l on the i/s. IFRS-> first inflation adjust, then apply current rate method.
cpk123, that’s interesting, and if true makes it a pretty irresponsible question. I assumed from the question that if current were being used during hyperinflation that meant IFRS and the corresponding inflation adjustment (rather than US GAAP and the temporal, which doesn’t require it). You’re suggesting that the question is asking how it would be in some hypothetical universe if the current were applied without the adjustment? Of course the plant would disappear, but if the question is credible (since it isn’t at all qualified) we should surely assume that current method means IFRS in this case, etc. But perhaps you’re right - just a bad question.
I am concerned about Schweser’s questions sometimes.
Sometimes looks like they just gave the CFA book to a teenage asking him to reverse the sentences as to make questions.
Sometimes,like this one, they academically combine principles or methods without having an objective look on the overall, real implications. Very, very bad for real world appliance, even more in economics…
This said doesn’t take out the learning purpose, you just have to be carefull.
Made me think of an old sentence my father told me once, don’t know if it will translate in english:
“Who knows can Do, who doesn’t know can Teach.”