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Subject 6. Impact on Financial Statements and Ratios PDF Download
The local subsidiary's financial ratios can be significantly affected by translation or remeasurement when compared to their computation under the local currency.
Translation under the current method utilizes average rates to translate the income statement and period-ending rates to translate the balance sheet. As a result, for ratios that use both income statement or balance sheet accounts in the numerator and denominator (e.g., net profit margin and debt-to-equity ratios), the current method will yield the same results as the computation in the local currency.
For ratios that combine both the income statement and the balance sheet (e.g., turnover and return ratios), however, ratios computed under translation and remeasurement will differ from those computed in the local currency. This is because the percentage change in the local currency is different from the percentage change in the dollar equivalent. As a result, the numerators and denominators will change at different rates, leading to different ratios.
The choice of these methods can have a significant effect on gross profit, especially when combined with FIFO inventory costing. Under the temporal method, COGS is computed at historical exchange rates while the current method uses current exchange rates. Use of these historical exchange rates delays recognition of the effects of changes in exchange rates.
Net income is also affected by the different treatment of depreciation expense, translated at current rates under the current method and remeasured at historical rates under the temporal method. If the local currency has appreciated vis-à-vis the $US, the temporal method will record lower depreciation than the current method, thus inflating profits.
The choice of these methods can also affect the balance sheet. Non-monetary assets are remeasured at historical exchange rates under the temporal method. As a result, if the local currency has appreciated vis-a-vis the $US, accounts such as inventories and PP&E will be reported at lower balances than they would be under the current rate method. In addition, equity accounts will also differ. Under the current rate method, the cumulative translation adjustment is a component of other comprehensive income. Under the temporal method, the remeasurement adjustment affects income directly and is, therefore, a component of retained earnings.
Finally, since both the balance sheet and the income statement are different under the current and temporal methods, so are all of the usual financial ratios: current, quick, leverage, margin, and turnover. The direction of the difference between the two method depends on whether the local currency has been appreciating or depreciating vis-a-vis the $US.
The following table summarizes the ratio effects under the assumption of an appreciating local currency:
One final note, in the consolidation process, changes in exchange rates can affect the consolidated ratios even if the underlying ratios of the individual companies have remained unchanged. This is because changes in exchange rates affect the weighting of each non-US subsidiary in the consolidated totals.
Learning Outcome Statementsanalyze how the current rate method and the temporal method affect financial statements and ratios;
CFA® 2023 Level II Curriculum, Volume 2, Module 13
User Contributed Comments 9
|danlan2||In a whole, All current method generates less good result than Temporal method for all except AR turnover and inventory turnover.|
|sjurrens||that's only because the local currency is appreciating. It would be opposite if the local currency was depreciating. So, be careful danlan2.|
|chris54321||@danian2, be careful!!!
|ghowell||why does it say that current method uses current exchange rate for COGS when it is an income statement item? (shouldnt it be average exchange rate?)|
|merc5559||be careful @danlan2!!!!!!|
|Allen88||sjurrens dont mess around|
|mattrowe26||be careful @danlan2!!!|
|kjw88||for heavens sake be careful @danlan2!|
|torakrubik||@danlan2 are you ok?|
I am happy to say that I passed! Your study notes certainly helped prepare me for what was the most difficult exam I had ever taken.
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