Temporal Method: Definition and How It Works
The temporal method (also called the historical method) is a currency-translation technique used to convert a foreign subsidiary’s financial statements into the parent company’s reporting currency. It is applied when a subsidiary’s recorded currency differs from its functional currency or when remeasurement into the parent’s reporting currency is required.
Key concepts
- Functional currency — the currency of the primary economic environment in which the subsidiary operates.
- Reporting currency — the currency in which the parent prepares consolidated financial statements.
- Remeasurement (temporal method) — the process of translating the subsidiary’s financial statement amounts into the parent’s reporting currency using different exchange rates depending on the type and timing of items.
When the temporal method is used
Use the temporal method when the subsidiary’s books are not maintained in its functional currency or when the subsidiary’s functional currency differs from the currency used on its records. In such cases, amounts on the subsidiary’s books must be remeasured into the parent’s reporting currency rather than simply translated at a single current rate.
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Translation rules
- Monetary assets and liabilities (e.g., cash, accounts receivable/payable, investments) — remeasure at the exchange rate in effect on the balance sheet date (current rate).
- Non-monetary assets and liabilities (e.g., property, plant, equipment, inventory measured at historical cost) — remeasure at the historical exchange rate in effect when the asset was acquired or the liability was incurred.
- Income statement items — generally remeasured using rates that reflect the timing of the underlying transactions (often average rates for the period, except where tied to non-monetary items measured at historical rates).
- Foreign exchange gains and losses from the remeasurement process are recognized in the parent company’s net earnings (not in other comprehensive income).
Example
A subsidiary is domiciled in Great Britain and keeps its books in British pounds, but most of its revenues and expenses are denominated in euros (its functional currency). If the parent company reports in U.S. dollars, the subsidiary’s pound-denominated records must be remeasured into the parent’s reporting currency using the temporal method: current exchange rates for monetary items and historical rates for non-monetary items. Any resulting foreign exchange gains or losses flow through the parent’s net earnings.
Impact and takeaway
- Because remeasurement gains and losses hit net income, the temporal method can increase volatility in consolidated earnings for companies with significant foreign operations.
- The temporal method differs from the current-rate translation method, where most items are translated at the current rate and translation adjustments are typically recorded in other comprehensive income rather than net earnings.
Use the temporal method whenever remeasurement to the parent’s reporting currency is required, and apply the appropriate exchange rates for monetary versus non-monetary items to reflect the timing of acquisition or incurrence.