CFA Level II ExamFinancial Statement AnalysisHard
A U.S. company (reporting currency USD) owns a 100% stake in a foreign subsidiary. The subsidiary operates in a highly inflationary economy according to U.S. GAAP criteria. The subsidiary's local currency is LC. For translation purposes, what is the functional currency of this subsidiary, and which translation method applies?
- AUSD as functional currency, Temporal Method.
- BLC as functional currency, Current Rate Method.
- CUSD as functional currency, Current Rate Method.
- DLC as functional currency, Temporal Method.
Show answer & explanationAnswer & explanation
Correct answer: A. USD as functional currency, Temporal Method.
Under U.S. GAAP, if a foreign subsidiary operates in a highly inflationary economy (cumulative inflation of 100% or more over three years), the parent company's reporting currency (USD) must be treated as the functional currency. Consequently, the temporal method is used for translation.
Why the other options are wrong
- B. Incorrect. In highly inflationary economies under U.S. GAAP, the parent's currency is the functional currency, and the temporal method applies.
- C. Incorrect. If USD is the functional currency, the temporal method, not the current rate method, is used.
- D. Incorrect. The functional currency is not the local currency in this specific scenario under U.S. GAAP.
Hyperinflationary Economy Translation (U.S. GAAP)
Under U.S. GAAP, if a foreign subsidiary operates in a highly inflationary economy (cumulative inflation >= 100% over 3 years), the parent's reporting currency is designated as the functional currency, and the temporal method is used for translation.
- Applies when cumulative 3-year inflation is >= 100%.
- Parent's reporting currency becomes the functional currency.
- Temporal method is used, not current rate method.
- Translation adjustments are recognized in net income, not OCI.
Memory trick: Hyperinflation (U.S. GAAP): 'USD' is the functional, 'Temporal' is the method.