The temporal method is a technique used in accounting to convert the financial statements of a foreign subsidiary from its functional currency to the presentation currency of the parent company. This method is applied when the functional currency of the subsidiary is the same as the presentation currency of the parent company.
Key Facts
- Purpose: The temporal method is used to convert the financial statements of a foreign subsidiary from its functional currency to the presentation currency of the parent company.
- Functional Currency: The functional currency of a subsidiary is the currency of the primary economic environment in which it operates and generates cash flows.
- Translation Process: Under the temporal method, assets and liabilities are classified as either monetary or non-monetary. Monetary items, such as cash, receivables, payables, and debt, are translated at the current exchange rate. Non-monetary items, such as inventory, fixed assets, and intangible assets, are translated at the historical exchange rate.
- Income Statement Items: Revenue and expenses related to non-monetary assets, such as the cost of goods sold and depreciation, are translated at the historical exchange rate. Other income statement items, such as revenue and other expenses, are translated using the average exchange rate.
- Shareholder’s Equity: Shareholder’s equity, including common stock and dividends, is translated at the historical exchange rate.
- Translation Gain/Loss: The temporal method may result in a translation gain or loss, which is reported on the income statement.
Functional Currency
The functional currency of a subsidiary is the currency of the primary economic environment in which it operates and generates cash flows. Factors considered in determining the functional currency include the currency of sales prices, operational costs, and cash flow generation.
Translation Process
Under the temporal method, assets and liabilities are classified as either monetary or non-monetary. Monetary items, such as cash, receivables, payables, and debt, are translated at the current exchange rate. Non-monetary items, such as inventory, fixed assets, and intangible assets, are translated at the historical exchange rate.
Income Statement Items
Revenue and expenses related to non-monetary assets, such as the cost of goods sold and depreciation, are translated at the historical exchange rate. Other income statement items, such as revenue and other expenses, are translated using the average exchange rate.
Shareholder’s Equity
Shareholder’s equity, including common stock and dividends, is translated at the historical exchange rate.
Translation Gain/Loss
The temporal method may result in a translation gain or loss, which is reported on the income statement. This gain or loss arises from the difference between the historical exchange rate and the current exchange rate.
Conclusion
The temporal method is a widely used technique for translating the financial statements of foreign subsidiaries. It provides a consistent and transparent approach to converting financial information into the presentation currency of the parent company.
References
- Investopedia. (2022, June 08). Temporal Method: What it Means, Examples. Investopedia. https://www.investopedia.com/terms/t/temporalmethod.asp
- AnalystPrep. (2023, February 25). Current Rate Method and Temporal Method of Translation. AnalystPrep. https://analystprep.com/study-notes/cfa-level-2/current-rate-temporal-methods-translation-applicable-scenarios-effect-parent-companys-balance-sheet-income-statement/
- Investopedia. (2022, June 06). Current Rate Method: Overview and Calculations. Investopedia. https://www.investopedia.com/terms/c/currentratemethod.asp
FAQs
What is the purpose of the temporal method?
The temporal method is used to convert the financial statements of a foreign subsidiary from its functional currency to the presentation currency of the parent company.
When is the temporal method used?
The temporal method is used when the functional currency of the subsidiary is the same as the presentation currency of the parent company.
How are assets and liabilities classified under the temporal method?
Under the temporal method, assets and liabilities are classified as either monetary or non-monetary. Monetary items are translated at the current exchange rate, while non-monetary items are translated at the historical exchange rate.
How are income statement items translated under the temporal method?
Revenue and expenses related to non-monetary assets are translated at the historical exchange rate. Other income statement items, such as revenue and other expenses, are translated using the average exchange rate.
How is shareholder’s equity translated under the temporal method?
Shareholder’s equity, including common stock and dividends, is translated at the historical exchange rate.
Can the temporal method result in a translation gain or loss?
Yes, the temporal method may result in a translation gain or loss, which is reported on the income statement. This gain or loss arises from the difference between the historical exchange rate and the current exchange rate.
What are the advantages of using the temporal method?
The temporal method is relatively simple to apply and provides a consistent approach to currency translation. It also helps to maintain the historical cost of non-monetary assets.
What are the disadvantages of using the temporal method?
The temporal method can result in volatility in the reported earnings of the parent company due to exchange rate fluctuations. Additionally, it may not accurately reflect the current value of non-monetary assets.