Temporal Method

What is Temporal Method?

Temporal rate method, or the historical rate method, is employed to convert the financial statements of a parent company’s foreign subsidiaries from its local currency to its “reporting” or “functional” currency when the functional currency and the local currency are not the same. Temporal Method is also utilized at the time of acquisition of assets and liabilities.

  • The temporal method entails a majority of assets and liabilities to be evaluated through the utilization of the rate of exchange in effect at the time of the creation of a particular asset or liability. Only those assets and liabilities that include a fixed foreign currency value translate at the prevailing (current) rate of exchange.
  • The rate of exchange used is dependent upon the valuation technique employed. For assets and liabilities valued at current prices, the present rate of exchange is used. On the contrary, the assets and liabilities valued at historical prices involve the utilization of historical exchange rates.
  • Income-generating assets like property, inventory, plant, and equipment, etc. are updated regularly to reflect their market values, through the utilization of this method of currency translation. The profits and losses as a result of translation directly go to the consolidated income statement. Due to this, it affects the consolidated earnings regularly, making them somewhat volatile.

According to FASB Rule number 52, you also apply the temporal rate method if the operations at your firm carry out in an exceedingly hyperinflationary environmentHyperinflationary EnvironmentHyperinflation is an accelerated level of inflation that tends to quickly destroy the actual value of the local currency since there is a rise in the cost of all products and services. It forces people to lower their holdings in that particular currency to participate in stable foreign currencies.read more.

Temporal Method

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Temporal Method Example

Consider that a company based in the UK that acquires 70 % of the share capital of another company based in Tajikistan (where the native currency is TJS). Let’s name the acquiring company as Company ABC and the acquired company as Company XYZ. So ABC acquires 70 % of XYZ.

Now, ABC paid £ 2,600 for the acquisition of XYZ’s 70 % share capitalShare CapitalShare capital refers to the funds raised by an organization by issuing the company's initial public offerings, common shares or preference stocks to the public. It appears as the owner's or shareholders' equity on the corporate balance sheet's liability side.read more. And for acquiring the reserves of XYZ, ABC had to pay down a sum equivalent to TJS 3,200 on the date of acquisition.

Now consider that the following rates apply:

TimeRate
At Subsidiary AcquisitionTJS 7.0 = £ 1
When Acquiring Hard AssetsTJS 6.1 = £ 1
On 31st Dec of the previous yearTJS 5.6 = £ 1
Average rate through the year of acquisitionTJS 5.1 = £ 1
On 31st Dec of the year of acquisitionTJS 4.6 = £ 1
On the date of Dividend paymentTJS 4.9 = £ 1

Now, the P/L statement of Company XYZ looks like the following:

SalesTJS 37,890
COGSTJS 8,040
DepreciationTJS 5,600
Gross ProfitTJS 24,250
Distribution costsDistribution CostsDistribution cost is the total of all expenses incurred by the producer to make possible the delivery of the product from its location to the location of the end customer.read moreTJS 2,090
Admin. ExpensesTJS 7,200
Profit before tax (PBT)TJS 14,960
TaxTJS 6,880
Profit After Tax (PATProfit After Tax is the revenue left after deducting the business expenses and tax liabilities. This profit is reflected in the Profit & Loss statement of the business.read moreProfit After Tax is the revenue left after deducting the business expenses and tax liabilities. This profit is reflected in the Profit & Loss statement of the business.read more)TJS 8,080

Now, the following table shows which rate will apply to each of the above items as per the temporal method example and what will be the £ values of these items after applying these rates:

Applicable RateCalculationValue in £
Sales5.1TJS 37,890/5.1£ 7,429
COGS5.1TJS 8,040/5.1£ 1,576
Depreciation6.1TJS 5,600/6.1£ 918
Gross ProfitGross ProfitGross Profit shows the earnings of the business entity from its core business activity i.e. the profit of the company that is arrived after deducting all the direct expenses like raw material cost, labor cost, etc. from the direct income generated from the sale of its goods and services.read more (GP)Sales–COGS-Dep.£ 4,935
Distribution costs5.1TJS 2,090/5.1£ 410
Admin. Expenses5.1TJS 7,200/5.1£ 1,412
Profit before tax (PBTPBTProfit before tax (PBT) is a line item in a company's income statement that measures profits earned after accounting for operating expenses like COGS, SG&A, depreciation & amortization, and non-operating expenses. It gives the overall profitability and performance of the company before making payments in corporate taxes.read more)GP-Dist. Costs-Admin. Exp.£ 3113
Tax4.6TJS 6,880/4.6£ 1,496
Profit After Tax (PAT)PBT-Tax£ 1,617

Item wise treatment

The conversion of different balance sheet items and non-balance sheet items under the temporal rate method for foreign currency translation includes some item wise nuances. The conversion is done based on various exchange rate rules for particular items. Here are some of those items and the standards used for their conversion:

Exchange rates used for the Temporal method

There are specific exchange rates included in the translation methodology used in the temporal rate method of currency translation. The exchange rates used are:

Applications

The temporal method applies the present rate of exchange to all the financial assetsFinancial AssetsFinancial assets are investment assets whose value derives from a contractual claim on what they represent. These are liquid assets because the economic resources or ownership can be converted into a valuable asset such as cash.read more and liabilities (short-term as well as long-term).

The physical (non-financial) assets that are evaluated at past rates are translated at past rates. The different assets of an overseas subsidiary will, in all cases, be acquired through a very long period. Now, the exchange rates do not remain stable for such long periods. Hence, many different exchange rates are applied for translating these foreign assets into the multinational’s home currency.

However, the utilization of this method will result in changes in different financial ratios when the balance sheet is converted into the presentation currency because the assets and liabilities are affected in several ways.

Advantages

  • Lines up with a valuation basis utilized in accounting; Therefore, the numbers have the most consistent internal meaning.
  • They will still be misspecified, however, just to the extent the underlying accounting numbers already are.

Disadvantages

Temporal Method Video

Conclusion

As a result of the rapid globalizationGlobalizationGlobalization is defined as the extension of trade, commerce and culture of an economy across different nations.read more of markets and the company’s presence across the globe, the businesses are not dealing in just their native currencies. They need to deal with a variety of currencies and on a very regular basis. This is the reason why foreign currency translation became something that cannot be avoided. Thus, several methods are designed to ensure a consistent foreign currency translationForeign Currency TranslationThe accounting method in which companies with international businesses translate the financials of their international subsidiaries into their domestic or functional currency in order to meet financial reporting requirements is known as foreign currency translation.read more; and the temporal method example is one among them.

The accounting standards incorporate foreign operations to use the temporal or historical rate method in cases where the native currency differs from the functional currency. Therefore, a subsidiary of a Canadian company with foreign operations in a small country where all business transpires in U.S. dollars, not the country’s native currency, would use the temporal rate method.

Once you apply the temporal rate method, you update income-generating assets on the balance sheet and profit-and-loss statement items, by using the historical exchange rates of transaction dates; or from the date that the organization last assessed the fair market price of the account. You acknowledge this adjustment as current earnings.

This article has been a guide to what is Temporal Method. Here we discuss temporal method examples along with its applications, advantages, and disadvantages. You can learn more about accounting from the following articles –