If local currency is appreciating, will temporal or current method report higher net income (in parent’s domestic currency) when there is a net monetary liability.
The problem here is that there are two conflicting results:
Current method will report NI based on higher average rate. Temporal method will report Sales and SG&A based on average rate but lower depreciation costs and COGs resulting in higher NI.
Temporal method’s net monetary liability is exposed to rising exchange rates resulting in a foreign currency loss recorded in income statement causing lower NI.
So what will the end result be? Is it inconclusive or will one factor always dominate the other.
I do believe that the thought process you’ve described is sound, and I think we’d need numbers to calculate, i.e. inconclusive.
I think the important thing in the exam is that, like you have done correctly, discussed the type of exposure, the rates to be used under the two methods, and where does the translation adjustment go (income statement / balance sheet)
Good luck at the Singapore Expo this weekend! (I think they still hold it there isn’t it?!) =)
Temporal G/L in Net Inc. Since a net liability and curr appreciation, will be negative.
Check pages 275-276
“Under both IAS 21 and SFAS 52, when the temporal method is used, the translation adjustment needed to keep the translated balance sheet in balance is reported as a gain or loss in net income. SFAS 52 refers to these as remeasurement gains and losses. The basic assumption supporting the recognition of a translation gain or loss in income when the temporal method is used is that if the foreign entity primarily uses the parent’s currency in its day-to-day operations, then the foreign entity’s monetary items that are denominated in a foreign currency generate translation gains and losses that will be realized in the near future and thus should be reflected in current net income.”
Sorry, you’re right, I meant to say “Current” and not “Temporal” in my post.
Foreign currency gains and losses will flow to the balance sheet through OCI and and not Net Income under the CURRENT method. Temporal gains/losses will hit the income statement and Net Income.
f55 and andy have it right. This is not asking about sales, COGS, etc. It’s only limiting the comparison to the case when the loval currency is appreciating while the sub has a net monetary liability. This means monetary CL > monetary CA, for example Y1000 > Y400, for a net liability of Y600. Because of that, when you calculate retained earnings as a PLUG in the B/S, it will be lower than if CA was > CL. Here retained earnings will have to be lowered by Y600 to make A=L+E. That mean NI will be lower if you use temporal with a net liability and currency appreciating. It seems right anyway.
Isn’t net monetary liability same under both methods? Monetary items are translated using current rate in both methods, so no difference there. They are asking about the impact of the net monetary liability only (holding all else constant). Opinions?
I do not know why this is being debated. It is not inconclusive. There is a very clear chart on page 295 that tells you NI falls when foreign currency appreciates and there is a net liability.
The difference in COGS is really not relevant in this mattter since with temoporal you will have this huge translation loss. With currency method you have all gains.
The question gives you the clues as to how they want you to answer: “net liability” + “appreciating fx” + “temporal”.
They want you to see if you remember the translation loss.
In a period of rising prices, all else being equal, NI will be higher under the temporal method. (Historical COGS, Depr, Amort. Cost). I’m assuming the net liability is for the subsidiary (otherwise there would be no point for the remeasurement gain/loss) and if there is a net liability with local currency appreciating (fx depreciating), this will result in added gains under the temporal method. I therefore think it will be higher under the temporal method.
Local currency usually means the foreign currency (what is local in that foreign nation) since these questions usually are referring to a foreign subsidiary from parent company perspective.
So when the foreign currency is rising (appreciating) relative to parent’s presentation currency AND there is a net liability, there is a translation loss which lowers NI
Agree with the temporal is lower ppl. The translation lost could be super big. The translation lost for current is baked into BS, so doesn’t affect NI.
For temporal it’s part of the net income. If the increase in currency translation lost due to increase foreign is balanced out by the decrease in COGS and Depreciation then it’s going to be equal to current. Since long term debt and notes payable are probably a lot larger than COGS and depreciation, the NI will most likely fall.
Without actually numbers and if I had to choose, then it’s gonna be temporal because of large debt.
If there is an answer for inconclusive, I would choose that, since that’s the most correct answer.