CFA Level II ExamFinancial Statement AnalysisMedium
A U.S. company (reporting currency USD) has a manufacturing subsidiary in a foreign country. The subsidiary's local currency is the Rupee (INR). The subsidiary primarily purchases raw materials and sells its finished goods locally, with limited intercompany transactions. Its operations are largely self-contained and independent of the U.S. parent's day-to-day cash flows. Which translation method should the U.S. parent company use to translate the subsidiary's financial statements?
- ATemporal method, with the INR as the functional currency.
- BCurrent rate method, with the INR as the functional currency.
- CCurrent rate method, with the USD as the functional currency.
- DTemporal method, with the USD as the functional currency.
Show answer & explanationAnswer & explanation
Correct answer: B. Current rate method, with the INR as the functional currency.
The description indicates that the subsidiary's operations are self-contained and independent, meaning its local currency (INR) is also its functional currency. When the local currency is the functional currency, the current rate method is used for translation.
Why the other options are wrong
- A. The temporal method is used when the parent's currency is the functional currency, or when the subsidiary operates in a highly inflationary economy (under U.S. GAAP).
- C. If USD were the functional currency, the temporal method would be used, not the current rate method.
- D. If USD were the functional currency, the temporal method would be used, but the facts suggest INR is functional.
Determining Functional Currency & Translation Method
The functional currency is the currency of the primary economic environment in which an entity operates. If the functional currency is the local currency, the current rate method is used. If the functional currency is the parent's currency (or for highly inflationary economies under U.S. GAAP), the temporal method is used.
- Functional currency is key to selecting translation method.
- Self-contained operations imply local currency is functional currency.
- Integrated operations imply parent's currency is functional currency.
- Highly inflationary economies (U.S. GAAP) always use parent's currency as functional and temporal method.
Memory trick: Functional Currency: Local for Current, Parent for Temporal.