CFA Level II ExamFinancial Statement AnalysisMedium
A U.S. company (reporting currency USD) owns 100% of a subsidiary located in a country whose local currency is the Euro (EUR). The subsidiary's operations are self-contained and independent of the parent company. Which of the following statements regarding the translation of the subsidiary's financial statements into USD is MOST accurate?
- AInventory will be translated at the historical exchange rate.
- BDepreciation expense will be translated using the historical exchange rate.
- CMonetary assets and liabilities will be translated at the historical exchange rate.
- DTranslation gains and losses will be reported as a component of other comprehensive income (OCI).
Show answer & explanationAnswer & explanation
Correct answer: D. Translation gains and losses will be reported as a component of other comprehensive income (OCI).
Given that the subsidiary's operations are self-contained and independent, its functional currency is the local currency (EUR). Therefore, the current rate method is used for translation. Under the current rate method, translation gains and losses are reported in other comprehensive income (OCI).
Why the other options are wrong
- A. Under the current rate method, inventory is translated at the current exchange rate, not the historical rate.
- B. Under the current rate method, depreciation expense is translated at the average exchange rate for the period, not the historical rate.
- C. Under the current rate method, all assets and liabilities (monetary and non-monetary) are translated at the current exchange rate.
Current Rate Method Translation Effects
The current rate method is used when a foreign subsidiary's functional currency is its local currency. Translation adjustments arising from this method are reported in Other Comprehensive Income (OCI).
- Functional currency is the local currency.
- All assets and liabilities translated at current rate.
- Equity accounts (except retained earnings) translated at historical rates.
- Income statement items translated at average rate.
- Translation adjustments go to OCI.
Memory trick: FUNctional currency determines the METHOD, OCI is a CURRENT event.