Temporal Method Definition
The temporal method, variously referred to as the temporal rate method, the historical method and the historical rate method, is a procedure of foreign currency translation that uses exchange rates based on the time of acquisition of assets and liabilities, to convert the values of the assets and liabilities from their local currency to the reporting or functional currency of the parent company, in instances where the functional currency and the local currency are not the same. The temporal method may also be employed to translate the financial statements of the parent company’s overseas subsidiaries from their local currencies to its functional currency. The temporal method classifies assets and liabilities into monetary assets and liabilities and non-monetary assets and liabilities, and employs different exchange rates based on the item being translated — while monetary assets and liabilities are converted using the exchange rate in effect on the date of creation of the balance sheet, non-monetary assets and liabilities are converted using the exchange rate in effect on the date of the actual transaction.
A Little More on the Temporal Method
The temporal method finds significance in scenarios where a company or its subsidiary operates in a country other than where the parent company is domiciled. In such scenarios, the temporal method allows the parent company to easily translate the financial statements of its foreign operations or subsidiaries back into its currency. Such a move enables the parent company to calculate its profits and losses accurately and generate financial statements accordingly.
Characteristics of the Temporal Method
The following are some of the general characteristics of the temporal method:
- The temporal method deems it mandatory to evaluate the bulk of the assets and liabilities by using the rate of exchange in effect at the time of creation of the particular asset or liability. The only exceptions to this rule are assets and liabilities that have a fixed foreign currency value — these are converted using the prevailing exchange rate.
- The exchange rate utilized depends on the valuation technique being employed. While the present rate of exchange is used for assets and liabilities that are valued at current prices, historical exchange rates are used as a norn for assets and liabilities that are valued at historical prices. Apart from the current and historical exchange rates, the weighted average exchange rate is often utilized to capture exchange rate movements occurring over the accounting period.
- The temporal method of currency translation makes it possible to reorganize and update income-generating assets such as property, inventory, and plant and machinery in such a way as to replicate their market values. The consolidated income statement reflects all profits or losses that result from such a translation. However such translations affect the consolidated earnings on a regular basis, thus making them fairly volatile.
- According to the temporal method, the balance sheet must be translated first, followed immediately by the income statement.
- The temporal method must ensure that there is consistency between the income statement and the retained earnings segment of equity on the balance sheet. In other words, it needs to make certain that the following equation balances:
Retained Earnings End = Retained Earnings Beginning + Net Income – Dividends
Steps in the Temporal Method of Currency Translation
There are two basic steps involved in the temporal method. They are:
- Translation of the items on the balance sheet: First, current exchange rates are used to translate monetary items such as cash, accounts receivable, accounts payable, and long-term debt. Moreover, assets or liabilities that are measured in currency outside of general price level changes are also translated using current exchange rates. Next, non-monetary items such as inventories, fixed assets, intangible assets, and all such company assets that are typically reported at historical cost are translated using historical exchange rates that existed when the assets were purchased. The next step is to translate the capital stock issued by utilizing the exchange rate in effect on the date of issuance of the stock. Lastly, retained earnings are not translated; however, they are used as plug values in order to balance assets with liabilities in addition to owner’s equity on the balance sheet.
- Translation of the items on the income statement: First, the weighted average exchange rate for the accounting period is used to translate non-balance sheet items such as sales and other similar expenses. Then, non-monetary balance sheet items such as cost of goods sold (COGS), depreciation, and amortization are translated with the corresponding rate for the balance sheet item.
Illustration of the Temporal Method
Let us assume that a company C1 that is domiciled in the U.S. purchases a 75% stake in a German company C2. The functional currency of C1 is the U.S. dollar ($), while the local currency of C2 is the Euro (€). As such, the parent company C1 uses the temporal method to translate C2‘s financial statements from the Euro to the USD.
First, current exchange rates (Euro to USD) are used to translate monetary items such as cash, accounts receivable, accounts payable, and long-term debt. This is followed by translating non-monetary items such as inventories, fixed assets, intangible assets, using historical exchange rates in effect at the time of purchase of the stake.