CFA Level II ExamFinancial Statement AnalysisHard
A U.S. company (reporting currency USD) has a manufacturing subsidiary in a foreign country where the local currency is the Euro (EUR). The subsidiary's functional currency is determined to be the USD because its operations are highly integrated with the parent, and most of its raw materials are imported from the U.S. and sales are made back to the U.S. parent. The subsidiary purchased a piece of machinery for €1,000,000 when the exchange rate was 1 EUR = 1.15 USD. At year-end, the exchange rate is 1 EUR = 1.20 USD. What exchange rate should the parent company use to translate the machinery for consolidation purposes?
- AThe current (year-end) exchange rate.
- BThe exchange rate at the beginning of the year.
- CThe historical exchange rate at the time of purchase.
- DThe average exchange rate for the year.
Show answer & explanationAnswer & explanation
Correct answer: C. The historical exchange rate at the time of purchase.
Since the functional currency is the USD (the parent's reporting currency), the temporal method is used for translation. Under the temporal method, nonmonetary assets like property, plant, and equipment (machinery) are translated using the historical exchange rate that existed when the asset was acquired.
Why the other options are wrong
- A. Current rates are used for monetary assets and liabilities under the temporal method, or for all assets/liabilities under the current rate method.
- B. Beginning-of-year rates are not typically used for balance sheet translations.
- D. Average rates are typically used for income statement items under the temporal method, or for all income statement items under the current rate method.
Temporal Method - Nonmonetary Assets
Under the temporal method, when the parent's currency is the functional currency, nonmonetary assets (e.g., inventory, property, plant, and equipment, intangible assets) are translated using the historical exchange rate that prevailed when the asset was acquired.
- Used when parent's currency is functional currency.
- Monetary assets/liabilities translated at current rate.
- Nonmonetary assets/liabilities translated at historical rates.
- Equity (capital) also translated at historical rates.
- Translation adjustments (gains/losses) flow through net income.
Memory trick: Temporal Method: 'Time' matters for nonmonetary items, 'Current' for cash-like.