What it means
A company with overseas subsidiaries must combine their results with its own, and that requires converting amounts from the foreign currency into one reporting currency. The temporal method is one of two main approaches, the other being the current rate method.
The choice of method follows from the economic facts of each subsidiary and cannot simply be chosen for convenience. The key idea is to preserve the measurement basis of each item.
Monetary items, such as cash, receivables and payables, are translated at the current exchange rate, because their value is fixed in foreign currency. Non-monetary items carried at historical cost, such as inventory, equipment and prepaid expenses, are translated at the rate in force when they were acquired.
Income statement items are generally translated at the rate on the date of the transaction, or at an average rate as a practical approximation. Expenses linked to historical cost assets, such as depreciation and cost of goods sold, use the historical rates of those assets.
Because some items use current rates and others historical, the balance sheet may not balance after translation. The difference is a translation gain or loss and is recognised in net income under this method, which can make reported profit more volatile than under the current rate method.
In practice the temporal method is linked to situations where the subsidiary acts as an extension of the parent, or where the foreign economy has very high inflation. In US reporting, an equivalent process called remeasurement applies when the functional currency of the subsidiary is the parent's currency.
Auditors will ask management to support the choice of functional currency with evidence. Finance teams often hedge the exposure that creates gains and losses, for example by using forward contracts to offset changes in the value of foreign monetary balances.
Hedging cannot remove the accounting effect entirely but it can narrow the swings that investors see.
In practice
Real-world examples.
Example
A US parent has a European subsidiary that sells goods supplied by the parent and invoices mainly in dollars. Because the subsidiary acts as an extension of the parent, the group uses the temporal method to translate its books. Gains and losses on its local-currency balances therefore flow straight into the group's income.
Example
A manufacturer operates a branch in a country with very high inflation. It translates the branch's inventory and equipment at the exchange rates in force when they were bought so that the figures are not distorted by the currency's fall. Using historical rates for those assets prevents the inflated local-currency values from distorting the group accounts.
Example
A treasury team sees large swings in profit caused by translation. It uses forward contracts to hedge the monetary balances so that income statement volatility is reduced. The hedge does not remove the accounting effect entirely, but it narrows the swings that investors see.
Formula
Calculation
Translated amount = Foreign currency amount x Applicable exchange rate (current for monetary items, historical for non-monetary items at cost)
A subsidiary holds cash of EUR 200,000 and payables of EUR 100,000, both translated at the current rate of $1.10 per euro. It also holds inventory of EUR 300,000 bought when the rate was $1.05. Cash becomes 200,000 x 1.10 = $220,000, payables 100,000 x 1.10 = $110,000 and inventory 300,000 x 1.05 = $315,000. Any difference needed to balance the translated statements is the remeasurement gain or loss, which goes to the income statement.Case study
Seen in the real world.
Atlas Components is an illustrative, fictional manufacturer with a subsidiary in Brazil that imports parts from the parent and sells in local currency. The group controller, Wei, had to decide how to translate its financial statements.
He chose the temporal method because the subsidiary depended on the parent for supply and financing. In a quarter when the local currency weakened sharply, the subsidiary's local-currency payables, translated at the lower current rate, produced a gain of $450,000.
In this fictional story, Wei explained to the board that the gain came from measurement and not from improved trading. He added a note to the report so that investors would not read the gain as lasting profit. Wei also asked the auditors to review the choice of functional currency, and they agreed with the reasoning after examining the subsidiary's pricing, financing and cash flows.
Watch out
Common mistakes.
- Translating everything at the current rate and calling it the temporal method. That is the current rate method, which produces different numbers.
- Treating translation gains and losses as operating performance, when they arise from exchange rate movements. Analysts often adjust for them when judging underlying performance.
- Using the same method for every subsidiary, when the choice depends on the functional currency and the economic facts.
Questions
People also ask.
How does the temporal method differ from the current rate method?
The temporal method uses historical rates for non-monetary items and puts gains and losses in income, while the current rate method uses the current rate for most items and puts gains and losses in equity.
When is the temporal method used?
It is typically used when the subsidiary's functional currency is the parent's currency or when the economy is highly inflationary.
Where do gains and losses go?
Under the temporal method they are recognised in the income statement, which can make earnings more volatile.
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