What Is the Temporal Method?
The temporal method (also known as the historical method) is a method of foreign currency translation that uses exchange rates based on the time assets and liabilities are acquired or incurred to convert values on the books of an integrated foreign entity into the parent company's currency. The temporal method is used in instances where the local currency of the subsidiary differs from its functional currency. Differing exchange rates are used depending on the financial statement item being translated. Monetary assets and liabilities are converted using the exchange rate in effect as of the balance sheet date. Non-monetary assets and liabilities are converted using the exchange rate in effect on the date of the transaction. Gains and losses due to foreign exchange are reported in net earnings.
Understanding the Temporal Method
When a company has operations or subsidiaries in a country other than where the parent company is domiciled, the parent company must convert the values on the foreign entity's financial statements back into the parent company's currency in order to calculate its profits and losses and generate the financial statements. If the subsidiary's functional currency differs from its local currency, the temporal method is used to perform these translations.
Example of the Temporal Method
An example of this would be subsidiary XYZ being domiciled in Great Britain. The local currency of XYZ is the pound. However, if the majority of XYZ's clients reside in continental Europe it may conduct its business in euros. The euro would be the functional currency. In this instance, the parent company of XYZ would use the temporal method to translate XYZ's financial statements back into the currency used by the parent company.
Monetary assets such as accounts receivable, investments, and cash are converted to the parent's currency at the exchange rate in effect on the balance sheet date. Non-monetary assets are longer-term assets, such as property, plant, and equipment, and are converted using the exchange rate in effect on the date the asset was obtained. All foreign exchange gains and losses are reported in net earnings of the parent company. This can increase the volatility of the parent company's earnings.