FLASH SALE! - "FINANCIAL MODELING COURSE BUNDLE AT 60% OFF" Enroll Now

# Temporal Method

Updated on June 17, 2024
Article byWallstreetmojo Team
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

## What is Temporal Method?

The 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. The temporal method is also utilized in the acquisition of assets and liabilities.

• The temporal method entails a majority of assets and liabilities to be evaluated by utilizing 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) exchange rate.
• The rate of exchange used is dependent upon the valuation technique employed. For assets and liabilities valued at current prices, the present exchange rate is used. On the contrary, the assets and liabilities valued at historical prices involve using historical exchange rates.
• Income-generating assets like property, inventory, plant, equipment, etc., are updated regularly to reflect their market values by utilizing this method of currency translation. The profits and losses resulting from 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 environment.

For eg:
Source: Temporal Method (wallstreetmojo.com)

### Temporal Method Example

Consider a company based in the U.K. 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 acquired 70 % of XYZ.

Now, ABC paid £ 2,600 for the acquisition of XYZ’s 70 % share capital. 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:

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

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:

###### Accounting for Financial Analyst (16+ Hours Video Series)

–>> p.s. – Want to take your financial analysis to the next level? Consider our “Accounting for Financial Analyst” course, featuring in-depth case studies of McDonald’s and Colgate, and over 16 hours of video tutorials. Sharpen your skills and gain valuable insights to make smarter investment decisions.

### Item wise treatment

The conversion of different balance sheet 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:

• Non-monetary items: Items reported at the historical price translated by utilizing historical exchange rates that existed when the assets were purchased. Such items are inventories, fastened assets, intangible assets, etc.
• Monetary items: Translated by currency exchange rates; They include money, receivable accounts, payable accounts, long-term debt, and alternative assets or liabilities that measure in currency outside of the general rate of exchange changes.
• Issued capital stock: Translated by using the rate that existed on the date of the issuance of stock;
• Retained earnings: Retained Earnings is not required to be translated. However, it could be used to balance the assets with liabilities & owner’s equity on the balance sheet.
• Balance sheet items: Expenses, coupled with specific non-financial balance sheet items, are translated with the associated rate on the balance sheet item. Expenses translated in this way include COGS, depreciation, and amortization.
• Non-balance sheet items:  Sales and a few expenses are translated by using the weighted average rate of exchange at the time of accounting.

### Exchange rates used for the Temporal method

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

• Current exchange rate: the rate of exchange which exists of the date of financial reporting
• Historical exchange rate: the rate of exchange that prevailed on the date when a specific transaction took place.
• Weighted average exchange rate: a rate that captures the change in rates of an exchange over a long accounting period;

### Applications

The temporal method applies the present rate of exchange to all the financial assets and liabilities (short-term as well as long-term).

The physical (non-financial) assets evaluated at past rates are translated at past rates. The different assets of an overseas subsidiary will, in all cases, be acquired over 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.

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