Temporal Method, Principles, Advantages, Challenges

Temporal Method, also known as the historical rate method, is an approach used in foreign currency translation to convert the financial statements of a foreign operation into the reporting currency of a parent company. This method is particularly used when the functional currency of the foreign operation differs from its local currency. The goal of the temporal method is to reflect the financial results and position of the foreign operation as if its transactions were conducted in the reporting currency.

Principles of the Temporal Method:

1. Currency Type and Rates:
   • Monetary items (e.g., cash, receivables, payables) are translated using the current exchange rate as of the balance sheet date.
   • Non-monetary items (e.g., inventory, fixed assets, goodwill) are translated at the historical exchange rate (the rate at the time the transaction occurred).
   • Revenues and expenses are generally translated at the average exchange rate for the period unless tied to specific non-monetary assets, in which case the historical rate is used.
2. Exchange Rate Impact on Accounts:
   • Items linked to historical costs (e.g., property, equipment, equity) retain their original exchange rate for translation.
   • Items subject to revaluation or changes over time (e.g., monetary liabilities) are updated with the current exchange rate.
3. Treatment of Gains and Losses:

Any translation adjustments or gains/losses arising from currency fluctuations are reported in the income statement. This differs from other methods, like the current rate method, where such adjustments might be recorded in equity.

When is the Temporal Method Used?

The temporal method is applied under the following scenarios:

1. The foreign subsidiary is tightly integrated with the parent company, and its transactions primarily serve the parent company’s operations.
2. The foreign entity’s functional currency is the same as the parent company’s reporting currency.
3. Required by accounting standards (e.g., US GAAP) in certain situations where monetary and non-monetary item classifications are crucial.

Advantages of the Temporal Method

• Reflects Economic Reality:

By translating non-monetary items at historical rates, the temporal method aligns the financial statements with the economic reality of costs and values at the time of acquisition.

• Simplifies Consolidation:

As it ties non-monetary values to their original exchange rates, there is less distortion in the parent company’s financial statements due to exchange rate volatility.

• Income Statement Integrity:

Since monetary gains or losses are recorded in the income statement, the impact of currency fluctuations is directly visible, aiding better financial analysis.

Challenges of the Temporal Method:

• Complex Calculations:

Translating non-monetary items at historical rates can be challenging when assets are acquired at various times and rates.

• Exchange Rate Volatility:

Gains or losses in monetary items due to currency fluctuations can create significant variances in the income statement, potentially distorting financial performance.

• Comparability Issues:

Differences in the treatment of monetary and non-monetary items might make it harder to compare results across subsidiaries operating in various currency environments.

Example of the Temporal Method

A US-based company owns a foreign subsidiary that reports in euros (€). The subsidiary has the following financial information for the year:

Translation:

1. Monetary Items:
   • Cash: 10,000 × 1.20 = $12,000
   • Accounts Receivable: 15,000 × 1.20 = $18,000
2. Non-Monetary Items:
   • Inventory: 20,000 × 1.10 = $22,000
   • Machinery: 50,000 × 1.15 = $57,500
3. Revenue:

Sales Revenue: 60,000×1.18=$70,800

The monetary and non-monetary items reflect the applicable rates, showing the economic reality of each category in USD.