Temporal method is one of the methods of translating a local currency to a functional currency.
- In the instances where a foreign subsidiary’s local currency is different from the functional currency, the temporal method must be employed to convert the local currency to the functional currency.
- Temporal Method & the Income Statement: translation gains and losses that result from translation using the temporal method are reported on the consolidated income statement.
- Temporal Method & Exchange Rates: in order to employ the temporal method, three exchange rates are relevant.
- Current Exchange Rate: rate that exists on the date of financial statement reporting.
- Historical Exchange Rate: rate in place on the date of a specific transaction.
- Weighted Average Exchange Rate: rate that captures the exchange rate movements which took place over the accounting period.
- The temporal method translates the balance sheet first and the income statement second.
Steps in the Temporal Method
Step 1: Translate the different balance sheet items based on their exchange rate rules
|Monetary Items||Translate using current exchange rates; this includes: cash, accounts receivable, accounts payable, long-term debt, and other assets or liabilities that are measured in currency outside of general price level changes.|
|Nonmonetary Items||Items reported at historical cost are translated using historical exchange rates that existed when the assets were purchased. This includes: inventories, fixed assets, and intangible assets.|
|Capital Stock (Equity) Issued||Translate using the exchange rate in existence on the date of the stock issuance.|
|Retained Earnings||This is not translated, but is a plug value used in balancing assets with liabilities + owner’s equity on the balance sheet.|
Step 2: Move to the income statement and translate items based on their exchange rate rules:
|Non-Balance Sheet Items||Sales and some expenses (see Balance Sheet items below for the exceptions) are translated using the weighted average exchange rate for the accounting period.|
|Balance Sheet Items||Expense items linked to specific non-monetary balance sheet items are translated with the associated rate for the balance sheet item. Expenses translated in this manner include: cost of goods sold, depreciation, and amortization.|
Income Statement Translation Gain & the Temporal Method
Naturally, the income statement and the retained earnings segment of equity on the balance sheet must be consistent.
The following equation must balance: