My question is: Book 2 Financial reporting and Analysis self-test question 11 In the explanation provided by Scheweser, it says: " Gross margin and total asset turn over will be higher under the temporal method if the local currency is appreciating. If the local currency is appreciating, current ratio will be lower under the temporal method assuming the subsidiary has invenroty on its balance sheet" But Gross margin should be pure income statement ratio and current ratio is pure balance sheet ratio, how come they can be lower? I think they should be same under different methods, right?
COGS is at historical cost under temporal method and average under all-current
For Gross Margin: As TheAliMan said, COGS is at historical under temporal and average under all-current. Since the local currency is appreciating, this appreciation will mean the COGS value will be higher under the all current method than the temporal method since when you bring the COGS value from the local currency to the presentation currency you are doing it at the higher average rate and not the lower historical rate. If COGS is higher, gross margin will be lower. Gross margin turnover = (sales - COGS) / sales, the ratio will be lower under current rate and higher under temporal. Sales is done at the average rate on both. For Current Ratio: Inventory is done at the current rate for the current rate method and the average rate for the temporal method. Since the local currency is appreciating, the current rate will be higher than the average. Therefore inventory will be higher under the current rate method and so will the current ratio
Is this gross margin change related to inventory method? I would think GM will increase if the firm use FIFO and the foreign currency is appreciating. If use LIFO, it would be opposite, GM goes down since COG would be higher if foreign currency is appreciating.
the fact that in temporal method the COGS is valuated at Historic interest rates - actually makes the difference. Historic for FIFO ==> Really old rates (Because old inventory is what goes into COGS) Historic for LIFO ==> Most current rate. (Latest inventory goes into COGS). Local currency appreciates. So FIFO COGS will be lower, LIFO COGS will be higher. LIFO COGS in Temporal case will be higher than the COGS in the Current Rate method - since Current Rate method uses Average Rate for COGS. Gross Margin in LIFO temporal will thus be lower than for Current Rate method. Appreciating Local Currency: COGS FIFO Temporal < COGS Current Rate < COGS LIFO Temporal. Have I got this right?
'LIFO COGS in Temporal case will be higher than the COGS in the Current Rate method - since Current Rate method uses Average Rate for COGS. ’ CPK, I think this statement is incorrect. If local currency is appreciating, then average rate used under All current method for COGS should be lower than historic rate used under temporal method. Therefore, COGS under all current should be higher than COGS under temporal method. For example: suppose COGS is Rs. 80 and the exchange rate is Rs. 60/ at the time of purchase (historic). Terefore, under temporal method, COGS is 1.333 . Suppose Rupee appreciates to Rs. 55/$ at year end. Now COGS is $1.45 (All current method). I am not usre if this example is correct. Please feel free to comment if you think my logic is not right.
nimz it all depends on whether COGS was LIFO or FIFO. If COGS were LIFO --> Temporal would be 1.45 as you have calculated. (Since the Current Rate would be the Historic Rate for the COGS --> This is the distinction you HAVE to make). Historic in Temporal For COGS and Inventory depends on the Inventory Flow assumption. All Current -> would use Average rate: something in between say Rs. 57.50/$. so Temporal LIFO > All Current > Temporal FIFO (which would be the 1.333 you have calculated).
Got your point. Thanks…
Here’s a bit of advice from my experience. First thing to do when you get to a question on consolidation of foreign entities is make sure your FX rates are stated correctly. If your FX rates are stated in pounds/US Dollar and you have a British company that you want to report in US Dollars, you’ll need to first calculate the inverse fx rates. Last year when i prepared for level 2, i made sure i did every question i could find in the CFAI books and Schweser books related to the Financial Statement analysis section of the exam, then i made sure i reviewed them to see how CFAI could throw a curve ball into the question and how to identify it, deal with it and move on. It paid big dividends for me on test day.