if use the temporal method, COGS uses the historical rate and US$ appreciate , so historical rate has more /FC, compared to /FC now. so COGS should be higher under temporal method? Please add some comments. Thanks
Fronttalk Company is a U.S. multinational firm with a 100% stake in a foreign subsidiary. The foreign subsidiary’s local currency has depreciated against the U.S. dollar over the latest financial statement reporting period. In addition, the subsidiary accounts for inventories using the last in, first out (LIFO) inventory cost-flow assumption and all purchases were made toward the end of the year. The gross profit margin as computed under the temporal method would most likely be:
A) higher than the same ratio computed under the current rate method. B) equal to the same ratio computed under the current rate method. C) lower than the same ratio computed under the current rate method.
Your answer: C was incorrect. The correct answer was A) higher than the same ratio computed under the current rate method.
The foreign company uses LIFO so new purchases are flowing to cost of goods sold (COGS) and most purchases occurred toward the end of the year, so the current rate of exchange is our best guess for the COGS account. Since the local currency is depreciating, it is taking more foreign currency units to buy a dollar in the more recent periods and as a result, COGS as measured in U.S. dollars is lower and the gross profit margin is higher under the temporal method.
I;m guessing the key here is when the purchases were made. Since the purchases were made towards the end of the year,on a LIFO basis, COGS was lesser in $ terms as FC depreciated.
This question finds its roots in the Reading on inventory where it says LIFO method results in Higher COGS but since it is accompanied with a depreciating currency that Higher COGS is multiplied with a depreciating conversion metric & results in lower COGS in temporal method than in current rate method(coz current rate method will use Avg rate for conversion which will be higher than the “historical” rate in temporal method).
Hence the G/P Ratio in current rate method wud be [Revenue-COGS(using avg rate which is higher)]/Revenue
& G/P Ratio in temporal method wud be [Revenue-COGS(using “historical rate” which is lower)]/Revenue
Net result being a higher G/P Margin in Temporal method.
With currency, the trick will always be to think about it logically. As Harry said, In an extreme example, use $ and AUD. The dollar is appreciating (as in the example), so Beginning of year, in a direct quote to the US firm
$/AUD = 10 (1 AUD buys $10),
average $/AUD = 7 (1 AUD buys $7),
ending $AUD = 5. (etc)
Notice the AUD is buying less dollars as time goes on - so the translation will be worth less in $.
Inventory is bought at the end of the year, and accounted for using LIFO. So, the inventory purchased at the end of the year represents COGS. The trick is to figure out the inventory/cogs distinction first, then translate.
So, assume COGS in the local currency is 20 under LIFO, and LIFO assumes we sell the inventory we purchased at the end of the year. So, to translate at the average rate, we know 1 AUD = $7. So, If we use the current (avg) method, we will have 20 * 7 = 140 as COGS.
If we use temporal method (to match the purchases), the value of COGS is 20 * 5 = 100 as COGS. COGS is less under temportal => higher Profit Margin