Fronttalk Company is a U.S. multinational firm with operations in several foreign countries. It has a 100% stake in a German subsidiary. The foreign subsidiary’s local currency has depreciated against the U.S. dollar over the latest financial statement reporting period. In addition, the German firm 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) equal to the same ratio computed under the current rate method. B) lower than the same ratio computed under the current rate method. C) higher than the same ratio computed under the current rate method.
COGS temporal - historical COGS current - average historical < average because purchases were near end of the year and LIFO so higher Gross profit margin with historical(temporal) C?
That’s an easy one - C
all purchases at end of year. temporal method. So ending Inventory would be latest COGS will also be the latest - so with Historic the Current rate would be used for COGS. Since the local currency has depreciated - amount in US Dollar has appreciated -> US Dollar COGS would be higher. In the Current Rate method - Average rate used for COGs will be lower than the Temporal COGS. So Gross profit will be lower in the Temporal method. Choice B. have I gone cuckoo on this one??? rhetorical question… possibly yes…
B as LIFO needs to be calculated
Your answer: B was incorrect. The correct answer was C) higher than the same ratio computed under the current rate method. The basis for using the all current method is when Functional Currency is NOT the same as Parent’s Presentation (reporting) Currency. The basis for using the temporal method is when Functional Currency = Parent’s Presentation Currency. 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. ------ This one caught me off guard. I guess it really is simple, I tried to over analyze.
so did I – thought USD would appreciate. After I had committed the answer – thought again and realized… that’s when I added the cuckoo comment.
Should be C, no? Temporal method uses historic rate for COGS, but COGS contains most recent inventory due to use of LIFO and so the conversion into DC occurs at a depreciated rate, whereas the sales is converted at the average rate still (under both methods). Hence sales should be identical under both methods, and if the currency has depreciated we have something like: average rate 2FC/1DC historic rate for COGS 3FC/1DC So lets just say our COGS is 300FC under the temporal method this yields DC COGS of 100, whereas the current rate yields a COGS of 150. Because the question asks for gross profit margin comparison we can see that the temporal method yields a higher GP because the converted COGS figure coming out of converted sales is smaller (100 DC) than is the converted COGS under the current method (150 DC). Please correct me if my answer and/or reasoning is incorrect.
I still don’t understand this one… If foreign currency is depreciating versus the $ and the temporal method was being used, wouldn’t that equate to a higher COGS resulting in a lower gross profit? I also thought the answer was B Thanks for the help, TheChad
Here’s my thinking: Under the temporal method you use the historic rate to translate COGS. The exchange rate has depreciated against the dollar over the period, meaning it translates into MORE dollars at its CURRENT level. Thus, the exchange rate used (Historic) would be stronger (in LC terms), meaning the COGS translate into less dollars. Less dollars mean higher GP. – Hope that helps.
I think I got it…I think my problem was that I was translating COGS from the local currency into the functional currency… When in fact the translation method should be based on when the INVENTORY was purchased, which, in a LIFO environment means that it was purchased earlier in the year causing it to be worth more… I have to remember that COGS and Depreciation translation in the temporal method are based on when the assets that are on the balance sheet were purchased… Please let me know if I am thinking about this wrong. Thanks, TheChad
@jdane 10:54: What do you mean by “The exchange rate has depreciated against the dollar over the period, meaning it translates into MORE dollars at its CURRENT level.” If a FC depreciates against a DC, this means that the DC can now buy more FC, for instance going from 2FC/DC to 3FC/DC is a depreciation of the FC. If this occurs when you convert any number lets of FC, lets say 300FC, into DC, you will get less than at the pre-depreciated exchange rate (because you divide 300 by 2 or 3 in order to get the FC into the DC), because we want to max GP = max Sales-COGS; since sales are fixed this problem comes down to min COGS, COGS is clearly smaller when we divide by the depreciated rate (3FC/DC yields a COGS of 100) as opposed to the pre-depreciated rate (2FC/DC yields a COGS of 150). Hence, GP is highest when we convert COGS at the historic rate (i.e. using temporal method, which in this unique instance means using a more recent rate since the foreign sub utilizes LIFO inventory accounting; which by the way is a questionable statement in itself since the US is pretty much the only developed nation to allow LIFO accounting) as opposed to the average rate (as would be used under the current method) which doesn’t fully capture the depreciation of the FC relative to the DC.
TheChad Wrote: ------------------------------------------------------- > I think I got it…I think my problem was that I > was translating COGS from the local currency into > the functional currency… > > When in fact the translation method should be > based on when the INVENTORY was purchased, which, > in a LIFO environment means that it was purchased > earlier in the year causing it to be worth > more… > > I have to remember that COGS and Depreciation > translation in the temporal method are based on > when the assets that are on the balance sheet were > purchased… > > Please let me know if I am thinking about this > wrong. > > Thanks, > TheChad Scratch that…I just realized that my logic made no sense…I was assuming that the current method transalted COGS at the CURRENT exchange rate as opposed to the average… Makes 100% sense to me now. Thank adadydov, your explanation helped me realize where I was going wrong. Best, TheChad
Sorry, sometimes when I’m attempting to type my thoughts they don’t come out right. The sentence, “The exchange rate has depreciated against the dollar over the period, meaning it translates into MORE dollars at its CURRENT level.” should read: “The local currency has depreciated against the dollar over the period, meaning it translates into MORE dollars when translated using the current rate”
@jdane: I assume when you say local you mean FC (since we make the dollar the assumed DC). If this is the case and the “local” (i.e. FC) currency has depreciated you get fewer units of the DC (i.e. US$) when you convert at the newly depreciated rate not more as you say (this occurs because you will be dividing the same FC amount by a larger number to convert it into the DC as the FC has depreciated, or conversely the DC has appreciated.). Hope that helps.