Temporal Method (Meaning, Example, Advantages, Disadvantages)

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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 rate of exchange in effect at the time of creation of the particular asset or liability. Only those assets and liabilities that include a fixed foreign currency value are translated at the prevailing (current) rate of exchange.
The rate of exchange used is dependent upon the valuation technique being employed. For assets and liabilities that are 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 the temporal 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 rather volatile.

According to FASB Rule number 52, you also apply the temporal rate method if the operations at your firm are carried out in an exceedingly hyperinflationary environment.

Temporal Method Example

Let us take a detailed example of Temporal Method.

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 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:

Time	Rate
At Subsidiary Acquisition	TJS 7.0 = £ 1
When Acquiring Fixed Assets	TJS 6.1 = £ 1
On 31^st Dec of the previous year	TJS 5.6 = £ 1
Average rate through the year of acquisition	TJS 5.1 = £ 1
On 31^st Dec of the year of acquisition	TJS 4.6 = £ 1
On the date of Dividend payment	TJS 4.9 = £ 1

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

Sales	TJS 37,890
COGS	TJS 8,040
Depreciation	TJS 5,600
Gross Profit	TJS 24,250
Distribution costs	TJS 2,090
Admin. Expenses	TJS 7,200
Profit before tax (PBT)	TJS 14,960
Tax	TJS 6,880
Profit After Tax (PAT)	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 Rate	Calculation	Value in £
Sales	5.1	TJS 37,890/5.1	£ 7,429
COGS	5.1	TJS 8,040/5.1	£ 1,576
Depreciation	6.1	TJS 5,600/6.1	£ 918
Gross Profit (GP)	–	Sales–COGS-Dep.	£ 4,935
Distribution costs	5.1	TJS 2,090/5.1	£ 410
Admin. Expenses	5.1	TJS 7,200/5.1	£ 1,412
Profit before tax (PBT)	–	GP-Dist. Costs-Admin. Exp.	£ 3113
Tax	4.6	TJS 6,880/4.6	£ 1,496
Profit After Tax (PAT)	–	PBT-Tax	£ 1,617

Item wise treatment under Temporal Method

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 on the basis of various exchange rate rules for the particular items. Here are some of those items and the rules used for their conversion:

Non-monetary items: Items reported at the historical price are translated by utilizing historical exchange rates that existed at the time the assets were purchased. Such items are inventories, fastened assets, and intangible assets etc.
Monetary items: Translated by the use of currency exchange rates. They include money, receivable accounts, payable accounts, long-term debt, and alternative assets or liabilities that are measured in currency outside of general rate of exchange changes.
Issued capital stock: Translated by the 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

There are certain exchange rates 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 which prevailed on the date when a specific transaction took place.
Weighted average exchange rate: a rate which captures the change in rates of exchange over a long accounting period.

Applications of Temporal Method

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 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 of time. 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 temporal 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 of the temporal method:

Lines up with 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 of the temporal method:

The financial statements of the firm will have a lot of volatility
The mixing up of valuations makes a lot of confusions.

Conclusion

As a result of rapid globalization of markets and companies in almost on all nations around 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 why the foreign currency translation became something, which cannot be avoided. Thus, several methods are designed to ensure a consistent foreign currency translation; and 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 one. 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 the related 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.

Temporal Method