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.

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Source: Temporal Method (wallstreetmojo.com)

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:

Time	Rate
At Subsidiary Acquisition	TJS 7.0 = £ 1
When Acquiring Hard Assets	TJS 6.1 = £ 1
On 31st Dec of the previous year	TJS 5.6 = £ 1
Average rate through the year of acquisition	TJS 5.1 = £ 1
On 31st 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 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 more	TJS 2,090
Admin. Expenses	TJS 7,200
Profit before tax (PBT)	TJS 14,960
Tax	TJS 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 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 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 costs	5.1	TJS 2,090/5.1	£ 410
Admin. Expenses	5.1	TJS 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
Tax	4.6	TJS 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:

• Non-monetary items: Items reported at the historical price translate by utilizing historical exchange rates that existed at the time the assets were purchased. Such items are inventories, fastened assets, and intangible assetsIntangible AssetsIntangible Assets are the identifiable assets which do not have a physical existence, i.e., you can't touch them, like goodwill, patents, copyrights, & franchise etc. They are considered as long-term or long-living assets as the Company utilizes them for over a year. read more, 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 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 EarningsRetained EarningsRetained Earnings are defined as the cumulative earnings earned by the company till the date after adjusting for the distribution of the dividend or the other distributions to the investors of the company. It is shown as the part of owner’s equity in the liability side of the balance sheet of the company.read more 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 COGSCOGSThe Cost of Goods Sold (COGS) is the cumulative total of direct costs incurred for the goods or services sold, including direct expenses like raw material, direct labour cost and other direct costs. However, it excludes all the indirect expenses incurred by the company. read more, depreciationDepreciationDepreciation is a systematic allocation method used to account for the costs of any physical or tangible asset throughout its useful life. Its value indicates how much of an asset’s worth has been utilized. Depreciation enables companies to generate revenue from their assets while only charging a fraction of the cost of the asset in use each year. read more, and amortizationAmortizationAmortization of Intangible Assets refers to the method by which the cost of the company's various intangible assets (such as trademarks, goodwill, and patents) is expensed over a specific time period. This time frame is typically the expected life of the asset.read more.
• 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 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

• The financial statements of the firmFinancial Statements Of The FirmFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels.read more will have a lot of volatility
• The mixing up of valuations makes a lot of confusion.

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.

Recommended Articles

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 –

• 28 Types of Financial Ratio
• Consolidated Financial Statement
• Balance Sheet vs Consolidated Balance Sheet
• What is Write-Off?