Understanding the Temporal Method for Currency Translation

The temporal method is a currency exchange method used to convert the currency that a foreign subsidiary ordinarily does business in into the currency used by its parent company. The parent company’s commonly used currency is referred to as the subsidiary’s “functional currency.” It may also be referred to as the “reporting currency” because it is the currency used in the parent company’s published financial statements.

The reason for the currency conversion is the fact that the parent company is required to produce consolidated financial statements – such as its income statementIncome StatementThe Income Statement is one of a company's core financial statements that shows their profit and loss over a period of time. The profit or and balance sheetBalance SheetThe balance sheet is one of the three fundamental financial statements. The financial statements are key to both financial modeling and accounting. – that include the financials of its subsidiary companies.

Summary

• The temporal method is a means of converting the currency used by a foreign subsidiary into the currency of its parent company.
• Various currency exchange rates are used in order to most accurately reflect the true value of the subsidiary’s assets and liabilities.
• Because of fluctuating exchange rates and the use of different exchange rates, the foreign subsidiary’s financial statements may reflect considerable volatility.

Example of Temporal Method

Assume Company ABC is headquartered in the United States, but it operates a subsidiary company in Australia. The Australian subsidiary will, of course, ordinarily conduct business in Australia using the Australian dollar. However, when the time comes for the parent company in the US to issue financial statements, the assets, liabilities, expenses, revenues, etc., of its Australian subsidiary must be converted from Australian dollars into US dollars.

How the Temporal Method is Applied

Converting all of the foreign subsidiary’s financial activity into another currency can get rather complicated. This is because the basis for the currency conversion rate varies according to exactly what it is being applied to. In other words, not just one, but several, currency exchange rates must be considered. Here’s a brief breakdown of how this works:

• Monetary items, such as cash on hand and accounts receivable and payable, are converted using the current exchange rate at the time of producing the financial report.
• Non-monetary items, which include things such as fixed assets (such as PP&E – property, plant, and equipmentPP&E (Property, Plant and Equipment)PP&E (Property, Plant, and Equipment) is one of the core non-current assets found on the balance sheet. PP&E is impacted by Capex,) and inventory, are converted using the currency exchange rate that was in effect when the assets were acquired. This is referred to as the “historical exchange rate.”
• Stock is converted using the prevailing currency exchange rate when the stock was issued, as it most accurately reflects the amount of capital that the company received from selling the stock shares.
• Sales and some expense items are converted using yet another currency exchange calculation – a weighted average of the exchange rate for the current reporting period.
• Some non-monetary items that appear on the company’s balance sheet, such as depreciation and amortization, are converted using whatever the associated exchange rate listed on the balance sheet is.

When converting the foreign subsidiary’s retained earnings figure to the company’s functional currency, it is important that the equation Retained Earnings (Ending) = Retained Earnings (Beginning) + Net Income – Dividends must balance so that the income and retained earningsRetained EarningsThe Retained Earnings formula represents all accumulated net income netted by all dividends paid to shareholders. Retained Earnings are part reported on the balance sheet match.

Importance of Currency Conversion

The rise of multinational companiesMultinational Corporation (MNC)A multinational corporation is a company that operates in its home country, as well as in other countries around the world. It maintains a made currency conversion operations necessary for accurate financial reporting by parent companies. As more companies domiciled in one country oversee subsidiary firms in foreign countries, the importance of the temporal method continues to grow.

Additional Resources

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To keep learning and developing your knowledge of financial analysis, we highly recommend the additional CFI resources below:

• Currency RiskCurrency RiskCurrency risk, or exchange rate risk, refers to the exposure faced by investors or companies that operate across different countries, in regard to unpredictable gains or losses due to changes in the value of one currency in relation to another currency.
• Foreign Exchange Gain/LossForeign Exchange Gain/LossA foreign exchange gain/loss occurs when a company buys and/or sells goods and services in a foreign currency, and that currency fluctuates
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