Updated July 20, 2023
Introduction to Temporal Method
Temporal Methodis the method that is used by the companies having subsidiaries in foreign countries with different currencies in which the financial statements prepared by the foreign subsidiary in their local currency values are converted into the currency of parent company in order to calculate the exact amount of profit/loss and to publish the consolidated financial statements in front of the users.
The Temporal Method is the way by which the financial statements of the foreign subsidiary are translated into the currency used by the parent company while preparing the financial statements. It is used if the currency of the parent company and foreign subsidiary is different. The currency that is used by the parent company is known as the functional currency. The companies having subsidiary companies are required to prepare the consolidated financial statements in order to figure out the overall gain or losses and to present that in front of the users where users include investors, shareholders, lenders, vendors, etc. The difference of the rate fluctuations is reported as the gain/loss in the consolidated income statement.
The characteristics of Temporal Method are as follows:
- In Temporal Method, companies need to estimate the liabilities and the assets by using the exchange rates that existed at the time when such liability and assets was created. But there is one exception to this which states that such liabilities and assets whose value in fixed foreign currency is fixed are converted using the exchange rate which prevails.
- In the temporal method, firstly the balance sheet is translated after that the income statement is translated.
- The technique of valuation employed by the management determines the exchange rate to be used. For liabilities and assets that are required to be valued at current prices, the present rate of exchange is used whereas for the for such liabilities and assets that require a valuation on the basis of historical cost then historical costs are used to value them. Even the weighted average exchange rates are used to see the fluctuations in the exchange rates over the accounting period.
Steps in Temporal Method
Steps are explained below:
- Balance Sheet Items Translation: The items are classified as monetary items and non-monetary items in this temporal method. The items are monetary in nature which means that in future these items will create outflow and inflow of cash at pre-determined currency such as cash, long term debt, taxes payable, accounts payable accounts receivable, etc. These monetary items are converted using the closing/prevailing exchange rates. Further, the non-monetary includes fixed assets, intangible assets, and inventories that are recorded at the historical costs and then are translated using the historical rate of exchange that existed at the time when that asset or liability was created. The capital stock is translated using the rate of exchange that was prevailing on the date of the issuance of the stock and the retained earnings are not translated but are the plug values that are used to balance the total assets of the business with the total of liabilities and owners’ equity.
- Income Statement Items Translation: The items that in the income statement are converted using the weighted average rates of exchange except for the items that are related to non-monetary assets such as depreciation, amortization, etc. are converted using the rates that are used in the translation of such non-monetary assets to which they are related. Like the rate applied for conversion of a fixed asset is applicable for the conversion of the values of depreciation.
Example of Temporal Method
Suppose there is a company Mobley incorporation that has its headquarters at the US where the currency used is US Dollar. They have a wholly-owned subsidiary named Webley incorporation where the currency used is Pound. Therefore, at the end of the year when they need to prepare the consolidated financial statements the values of the financials of Webley Incorporation that are reported in Pound are to be converted into the US Dollar to bring the uniformity.
Temporal Method Exchange Rates
The exchange rates used in the temporal method of exchange are:
- Closing/current Exchange Rates: These exchange rates are those that existed at the time of conversion of assets and liabilities i.e. at the time of reporting of financial statements. These rates are used for the translation of monetary assets and liabilities such as cash, accounts payable, accounts receivable, etc.
- Historical Exchange Rates: The historical exchange rate is the rate that existed on the creation of a particular asset or liability.
- Weighted Average Exchange Rate: The weighted average rate is the rate that is the average of the movements of rate fluctuations that happened over an accounting period.
Temporal Method vs Current Method
- In the temporal method, the assets and liabilities are bifurcated as monetary such as cash, accounts receivable, and non-monetary such as fixed assets, inventories. The monetary items are converted using current exchange rates and non-monetary items are converted using historical rates of exchange whereas in the Current method the current exchange rate is used to convert all the assets and liabilities.
- In temporal method, all expenses and revenues are converted using weighted exchange rates except the ones like depreciation that are linked with non-monetary assets because they are converted using the rate that is used to convert the asset to which they are linked whereas in Current method the rate of exchange used is weighted average on all the items.
Applications of Temporal Method
The temporal method is used to translate the values of assets and liabilities of a foreign subsidiary that are reported in their local currency to the currency that is used by foreign currency while preparing financials. The present rate is applied on all monetary items but the non-monetary items are reported at the historical rates. Since the rates of exchange are not stable therefore, various exchange rates are applied for conversion. The use of this method will obviously result in the fluctuations in the figure of financial ratios as the assets and liabilities figures have been changed.
This is a guide to Temporal Method. Here we also discuss the introduction and characteristics of the temporal method along with an example. You may also have a look at the following articles to learn more –