CFA Level II ExamFinancial Statement AnalysisHard
A U.S. multinational corporation (functional currency USD) has a subsidiary operating in a country where the local currency has significantly depreciated against the USD throughout the year. The subsidiary's balance sheet includes inventory valued at historical cost. If the temporal method is used for translation, how will the translation of this inventory impact the consolidated financial statements compared to if the current rate method were used?
- AInventory will be translated at a lower value under the temporal method, leading to higher cost of goods sold.
- BInventory value will be the same under both methods as it's a non-monetary asset.
- CInventory will be translated at a higher value under the temporal method, leading to lower cost of goods sold.
- DInventory will be translated at a higher value under the current rate method, leading to lower cost of goods sold.
Show answer & explanationAnswer & explanation
Correct answer: C. Inventory will be translated at a higher value under the temporal method, leading to lower cost of goods sold.
Under the temporal method, inventory carried at historical cost is translated at the historical exchange rate. If the local currency depreciated, the historical rate (when the currency was stronger) would result in a higher USD equivalent value for inventory compared to the current rate (when the currency is weaker). A higher inventory value means a lower cost of goods sold.
Why the other options are wrong
- A. This is incorrect. A lower inventory value would lead to higher cost of goods sold, but the temporal method would result in a higher inventory value under these conditions.
- B. This is incorrect. The translation rates for non-monetary assets differ significantly between the two methods, especially when exchange rates change.
- D. Under the current rate method, inventory is translated at the current rate. If the local currency depreciated, the current rate would result in a lower USD value for inventory compared to the historical rate.
Temporal Method - Inventory Translation
Under the temporal method, inventory carried at historical cost is translated using the historical exchange rate that prevailed when the inventory was acquired.
- Monetary assets/liabilities are translated at the current rate.
- Non-monetary assets/liabilities (like historical cost inventory) are translated at historical rates.
- This preserves the historical cost principle in the parent's reporting currency.
- Translation gains/losses are recognized in net income.
Memory trick: Temporal's History, Current's Now, Currency's Dip, Value's How.