Reading 21 Multinational Operations Question 2

[crd012]

I get why the FIFO method gets a higher gross profit margin for the parent company if it subsidary is experiencing inflation, but I can not get my head around why the current rate method gives higher gross profit to the parent company if the subsidary currency is depreciating. If someone could explain that I would appreciate it.

 

[jbpens66]

If the subsidiary currency is depreciating, then the parent’s currency must be appreciating in value, hence the higher gross profit. Simple way to think about it.

 

[crd012]

That seems a little too simple to me. Just because your currency is appreciating doesn’t mean you have a better gross profit margin if you have a subsidary that has a currency that is depreciating. You may have a wider margin on the parent company side, but wouldn’t that be cancelled out by the shrinking margin for the subsidary? Or am I overthinking this?

 

[Cam2782]

Here you go. When the current method is used for this pure ratio the average exchange rate is used for COGS which will be less than the historical rate (which is used for the temporal method) when the currency is depreciating. Lower COGS gives you a higher gross profit leading to a higher margin. Hope this helps!

 

[crd012]

Yep, there we go that makes sense to me now, thanks cam

 

[jbpens66]

Cam - good way of explaining it - I know what I was saying was essentially at the most basic level, but sometimes that’s just as effective to think about it.
Obviously both currencies don’t move in the same exact direction, so when the current method is used, current rates apply to all assets and liabilities. Of course, this doesnt not impact the income statement since translation adjustments are realized in the S.E. component under the current method.
However, the intuition with exchange rates still holds true from a P&L perspective as the temporal method would require the historical (stronger rate) as opposed to the average rate from the current method (assuming that there are expenses related to COGS, dep/amort.), otherwise most expenses require translation through avg. rates regardless of which method is being used.
When it comes to FRA, I believe the CFAI explains it beautifully. I switched from Schweser notes for the mean time and found the CFAI readings to be easier on the mind since there aren’t any gaps to fill. Concepts seem to be beaten into your head several times throughout the reading. Just my 2 cents.