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I just stumbled across a question regarding temporal v current rate and what happens to the following ratios when foreign currency is depreciating.
Payable turnover ratio = purchase / average payable
Quick ratio = (Cash + marketable securities + receivables) / CL
Inventory turnover ratio = COGS / average inventoryFrom my understanding quick ratio is a pure balance sheet ratio so no changes and inventory turnover ratio is definitely a mixed (cogs in I/S and inventory in B/S).
My question is where does purchases go? E.g. inventory would be under B/S and COGS would be under I/S. -
@vincentt, I think this is an excellent question, shows that you think deeply about the question!
Purchases is a figure you have to derive from starting and ending stock levels, as well as COGS.
Purchases = COGS + Ending inventory – Starting inventory
So it has I/S elements in it, and therefore you can proceed to interpret the effect on the ratios accordingly.
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@sophie thanks for the quick reply as always!
In the current method:
COGS -> average rate
Inventory -> current rateIn the temporal method:
COGS -> historical
Inventory -> HistoricalPayable – current rate for both
however, it seems like the answer is saying the inventory turnover is the only ratio that would change which is kinda confusing as if the purchase is using an average rate then it would not be pure as the payable is definitely a current rate.
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@vincentt, is the question multiple choice, asking which ratio would be differ between the 2 methods?
Because as it stands my assessment is similar to yours, even if payables ratio is in some case defined as COGS/avg payable, as COGS are treated differently in both methods, where the denominator (payables) as you said are both the same for payables.
I wonder if there is more info in the question? Can you share it with us?
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Based on my understanding of the question (which of the 3 ratios is affected in all current vs. temporal), the only thing I can justify the answer is that there is a sub-case for payables turnover (using the COGS/avg payables definition) where it’s the same for both methods.
It’s where you use LIFO method for inventory, then COGS uses average rate under temporal.
Ahhhh, you can see I’m getting frustrated too! ~X(
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@vincentt, is the question multiple choice, asking which ratio would be differ between the 2 methods?
Because as it stands my assessment is similar to yours, even if payables ratio is in some case defined as COGS/avg payable, as COGS are treated differently in both methods, where the denominator (payables) as you said are both the same for payables.
I wonder if there is more info in the question? Can you share it with us?
Sorry for the late reply, was busy diving into CFA materials over the weekend.
The question is from 7city’s portal and it’s an ‘image’, so would be a pain to type it out.
To summarise, (as far as I could see, you could pretty much ignore the entirely vignette) the question is asking if you were to change from current rate method to temporal method, which of the 3 ratios would change.
1. payable turnover ratio = (purchase / average payable)
Current method -> purchases = ? ; average payable = in b/S hence current rate
Temporal method -> purchases = ? ; average payable = in B/S hence historical
– i’m not sure what rate does “purchases” use, hence i’m not able to come to any conclusion.2. quick ratio = (CA – inventory) / CL
Current method -> CA & CL = uses current rate
Temporal method -> CA & CL = uses historical rate (if not mistaken?)
– both numerator and denominator are using the same rate for each of their own method hence it will produce the same ratio.3. inventory turnover = cogs / average inventory
Current method -> cogs = in I/S hence average rate; average inventory = in B/S hence current rate
Temporal method -> cogs = historical; average inventory = i believe historical– since both uses different type of rates the ratio will be different
right answer is 3 (inventory turnover), that’s the only ratio that will change when the company changes it’s method from current to temporal.
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@vincentt – I think we all agree that your assessment of quick ratio and inventory turnover is correct. Inventory turnover will be different here, hence the obvious answer.
On payables turnover ratio, average payables is a monetary liability, hence I believe they are both current rate under all current and temporal methods.
As mentioned previously, the only way I could justify the answer is that there is a sub-case for payables turnover (using the COGS/avg payables definition) where it’s the same for both methods.
It’s where you use LIFO method for inventory, then COGS uses average rate under temporal, same as COGS’ treatment under all current method.Regardless the LIFO or FIFO inventory method, the inventory turnover ratio is still different for both methods.
Anyone else care to share some light here, my brain may have gone rusty here. @Diya, @MattJuniper, @AjFinance?
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thanks @sophie
i hope I did not violate any rules by linking directly to the cfa prep..
The vignette:
Winstanley is a US based multinational which bought a Hong Kong subsidiary, Milton, on January 1, 2009. No new fixed assets were bought by Milton until July 1, 2011and the depreciation relating to these new assets was HKD 10 million in the year to December 31, 2011. Purchases are made evenly over the year and held in inventory for 3 months.
The functional currency of the Hong Kong subsidiary has been identified as the HKD but the board are now questioning the CFO, Henry More, about this.
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“Purchases are made evenly over the year and held in inventory for 3 months.”
@vincentt – therein lies the keyword. For payables turnover ratio, use the COGS/Avg Payables definition (it seems CFA uses this as an approximation vs. normal accounting methods).Explanation as follows:
Under temporal method, historical price is used for for non-monetary assets (i.e. use the exchange rate in effect when you bought those assets). If purchases are made evenly throughout the year, this is in effect an average rate, if you think about it.Therefore, in this particular case, it’s irrelevant whether LIFO or FIFO is used (ignore my earlier speculations), COGS will be determined using the period’s average rate under temporal method, and hence the same as all current method (COGS= avg rate, avg payables = current rate).
I hope this make sense. Meanwhile I can do some mini victory dance as I can sleep in peace now :))
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@sophie X_X !! I got owned by one sentence!!!
so back to the question:
1. payable turnover ratio = (purchase / average payable)
Current method -> purchases = ? ; average payable = in b/S hence current rate
Temporal method -> purchases = ? ; average payable = in B/S hence historicalI agreed with you regarding the use of average rate for purchases but wouldn’t that changes the ratio based on what you mentioned above
temporal = average rate / historical
current = average rate / current ratewouldn’t the ratio be different based on your assumptions on the rates?
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@vincentt – I think we all agree that your assessment of quick ratio and inventory turnover is correct. Inventory turnover will be different here, hence the obvious answer.
On payables turnover ratio, average payables is a monetary liability, hence I believe they are both current rate under all current and temporal methods.
@vincentt, I think average payables should be current rate for both methods.In fact, you’d mentioned this before in your earlier post far above:
Payable – current rate for both
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