Finquiz - Item-set Answers, Study Session 5, Reading 18

Reading 18

Multinational Operations

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FinQuiz.com CFA Level II Item-set - Solution Study Session 5 June 2017

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Reading 18

Multinational Operations

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FinQuiz Level II 2017 – Item-sets Solution Reading 18: Multinational Operations 1. Question ID: 11628 Correct Answer: A In order to determine where foreign currency translation gains/losses are recorded, it is necessary to determine the method to be used to translate El-Co Fiesta’s financial statements into U.S. $. This method, in turn, is determined by the relationship of the functional currency of the subsidiary and the presentation currency of the parent (Bernstake Ltd.). The relevant functional currency is determined primarily by the currency in which the subsidiary generates and expends cash; the currency which influences the sales price of goods and services; and the currency of the country whose competitive forces and regulations mainly determine the sales price of its goods and services. In the case of the El-Co Fiesta, the relevant functional currency is the ARP. Since this currency differs from the parent company’s presentation currency, the relevant translation method to use is the current rate method. The current rate method records translation gains/losses as part of comprehensive income, a component of stockholder’s equity. 2. Question ID: 11629 Correct Answer: A The appropriate translation method is the current rate method (see the solution to part 1). Under this method all monetary and non-monetary assets are translated at the current rate (at December 31, 2009). Thus total assets, in U.S. $ terms, amount to $603,478.26 (ARP 3,470,000 ÷ ARP 5.75/U.S. $) or approximately $603,000. 3. Question ID: 11630 Correct Answer: B Under the temporal method, Bernstake Ltd. would incur a foreign currency translation loss if the subsidiary’s monetary assets were less than its monetary liabilities (or vice-versa) and foreign currency weakened (or strengthened). The parent company would incur a translation gain if the subsidiary’s monetary assets were greater than its monetary liabilities (or vice-versa) and foreign currency strengthened (or weakened). Based on the exchange rate trend, the ARP has weakened (over the year 2009) from being worth 4.45 to 5.75 for every US$. Additionally, translating El-Co Fiesta’s financial statements would result in a translation gain as it as has a net monetary liability exposure (the monetary assets, ARP 1,420,000, are less than the monetary liabilities, ARP 1,730,000) and the ARP has depreciated.

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Reading 18

Multinational Operations

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4. Question ID: 11631 Correct Answer: A The temporal method will produce an inventory turnover ratio that is identical to the pre-translation ratio. Pre-translation ratio is 0.85 (ARP 850,000/ARP 1,000,000) and ratio under the temporal method is 0.85 [(ARP 850,000 ÷ 4.85)/ (ARP 1,000,000 ÷ 4.85)]. The ratio produced under current rate method will be 0.96 [(ARP 850,000 ÷ 5.10)/(ARP 1,000,000 ÷ 5.75)]. This ratio is higher to the one calculated from the temporal method. This is because the ARP has depreciated relative to the dollar, resulting in a lower US$ value for the inventory figure (which is converted at the current rate) under the current method, hence a lower denominator for the ratio. On the other hand, inventory under the temporal method is translated by using the rate at which inventory was acquired. As the rate at which inventory was acquired is historical, the inventory translated under this method has a higher US$ value producing a higher denominator and decreasing the inventory turnover ratio. If El-Co Fiesta used the LIFO method for inventory valuation (instead of FIFO), all inventory units on the balance sheet would have comprised of older items and thus valued at relatively older exchange rates, resulting in higher translated inventory values. Thus LIFO method produces a higher denominator and hence a lower inventory turnover ratio also decreasing the ratio is the lower translated value of the cost of goods sold (translated at a newer, lower exchange rate). Current FIFO inventory valuation method would have resulted in lower translated inventory values (relative to the LIFO method), as the inventory would have relatively recent items with more recent rates being used. This produces a smaller denominator and hence a higher inventory turnover ratio. Also increasing the ratio is the higher translated value of the cost of goods sold (translated at a newer, lower exchange rate). 5. Question ID: 11632 Correct Answer: A Since long-term bonds are monetary liabilities, these are translated using current exchange rates under the temporal method. Thus the U.S. $ value of notes payable amounts to $222,608.70 (ARP 1,280,000 ÷ ARP5.75/U.S. $) or approximately $223,000. 6. Question ID: 11633 Correct Answer: A Under hyperinflationary periods, IFRS requires nonmonetary assets to be restated for the general purchasing power unit of the monetary unit. These restated assets will then be translated under the current rate method at the current exchange rate. Inflation-adjusted inventory = ARP 1,000,000 × 130/100 = ARP 1,300,000 Translated Inventory = ARP 1,300,000 ÷ ARP 8.00/U.S. $ = $162,500

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Reading 18

Multinational Operations

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7. Question ID: 15956 Correct Answer: C Since France Co has a net monetary liability exposure and the Euro has appreciated relative to the dollar (Exhibit 4), the best course of action for the subsidiary would be to finance the purchase of the plant using equity rather than debt (long-term notes payable) since capital stock is not exposed to foreign exchange risk under the temporal method. The subsidiary has a net monetary liability exposure of €6,740 million as its monetary assets (cash and accounts receivable), €3,825, are less than its monetary liabilities (total liabilities), €10,565 million. Eliminating capital stock is not a recommended course of action since the notes payable are exposed to foreign exchange risk under the temporal method (which is used as the translation method since the presentation and functional currencies are identical), whereas capital stock is not. France Co’s existing cash balance of €175 million can only partially reduce its liabilities of €10,565 million. If the parent were required to pay off France Co’s remaining liabilities of €10,390 million (€10,565 million – €175 million), it would need to send US$ 6,754 million (€10,390 million × US$ 0.65/€) on January 1, 2010. On December 31, 2010 Arioco-P would be required to send US$ 7,793 million (€10,390 million × US$ 0.75/€) to pay €10,390 million. This will result in a foreign exchange loss of US$ 1,038 million (US$ 7793 million – US$ 6,754 million), thereby failing to eliminate exposure. 8. Question ID: 15957 Correct Answer: B Given that the Euro has appreciated from 0.65 to 0.75 relative to the US dollar, France Co will report a translation loss under the temporal method as its monetary liabilities are greater than its monetary assets (see the previous solution) resulting in a reduction in net income and hence its total equity balance. On the other hand, since the current exchange rate used to translate total assets under the current method is greater relative to the historical exchange rates used to translate assets under the temporal method and since it has a net asset exposure of €4,566 million (€15,131 million − €10,565 million), there will be a positive translation adjustment. Since the positive translation adjustment will increase the total equity balance, this will result in a higher total balance being reported for the subsidiary under the current rate method. 9. Question ID: 15958 Correct Answer: A A higher gross profit margin will be reported under the temporal method. Under both methods, sales will be translated at the average rate. The rate at which cost of goods sold is to be translated will determine the method to produce the highest gross profit margin for the subsidiary. Under the current rate method, cost of goods sold is translated at the average rate, i.e. US$ 0.70 per €. The rate at which cost of goods sold is translated under the historical method will be an older and lower rate, given the increase in the value of Euro over the 2010 period. Thus, the cost of goods sold will be higher and gross profit lower under the current rate method, which produces a lower gross profit margin using this method.

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Reading 18

Multinational Operations

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10. Question ID: 15959 Correct Answer: A Given that France Co.’s functional currency is identical to Arioco-P’s presentation currency, US$, the temporal method is used to determine its translated retained earnings as follows: € (millions) Cash Accounts Receivable Inventory Total current assets Property, plant, and equipment Less: accumulated depreciation Total assets Total liabilities Capital stock Retained earnings Total

Exchange rate (US$ per €) 0.75 0.75 0.67

$ (millions)

15,136

0.65

9,838.40

(8,360) 15,131 10,565 2,000 2,566 15,131

0.65

(5,434.00) 10,308.25 7,923.75 1,300.00 1,084.50 10,308.25

175 3,650 4,530 8,355

0.75 0.65 to balance

131.25 2,737.50 3,035.10 5,903.85

Since France Co was established on January 1, 2010 it has no opening retained earnings. 11. Question ID: 15960 Correct Answer: C Implication 1 has been inaccurately identified. Implication 2 has been inaccurately identified. In scenarios of hyperinflation, U.S. GAAP simply requires the foreign currency financial statements of the concerned subsidiary to be translated using the temporal method. On the other hand, IAS 21 (IFRS) requires foreign currency financial statements to be restated for inflation and then translated using the current rate. Under the temporal method and U.S. GAAP, liabilities will be translated at an exchange rate of AD 125.53 per US$. Under IFRS, liabilities will not be restated for inflation as they are expressed in terms of the monetary unit current at the balance sheet date. Thus under the current rate method and IFRS, these liabilities will be translated at the same exchange rate as used under the temporal method, i.e. AD 125.53 per US$. Thus the translated liabilities under the two standards are identical. Inflation in Algeria increased by 300% or by 3 times over the 2010 period. At the same time, the AD lost about 26% [(125.53 – 100)/100] of its value. Since the decrease in currency value is not matched by the change in local inflation, IFRS and U.S. GAAP will produce different results. 12. Question ID: 15961 Correct Answer: A Using the temporal method (see the solution to part 4), France Co’s closing inventory account balance is approximately US$ 3,035 million (€4,530 million × US$ 0.67 per €).

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