What is the Temporal Method?
The temporal method is an accounting approach used to convert the local currency involved in foreign transactions into the functional currency of a company. This method translates assets, liabilities, equity, revenue, and expenses based on the exchange rates active on the date each transaction occurs. When exchange rates do not vary significantly, an average rate for the period can substitute for the exact rate. Any resultant gains or losses from exchange differences are recorded in the profit and loss account.
Key Concepts
- Transaction Date Exchange Rate: The exchange rate on the date the foreign transaction was initially recognized.
- Average Exchange Rate: Utilized when exchange rates are stable.
- Profit and Loss Recognition: Exchange differences are recorded in the profit and loss statement.
Temporal Method vs. Closing-Rate Method
The temporal method contrasts with the closing-rate method, which uses the exchange rate at the balance sheet date to translate foreign transactions, with exchange differences taken to reserves instead of directly impacting profit and loss.
Regulatory Compliance
While UK accounting practices have in the past allowed flexibility in choosing either the temporal or closing-rate method, current regulations are governed by the Financial Reporting Standard applicable in the UK and Republic of Ireland (Section 30).
Examples
Example 1:
A UK company purchases equipment in the US for $50,000 on January 1st when the exchange rate is £1 = $1.25. Using the temporal method, the UK company would record £40,000 (50,000 ÷ 1.25) as the cost of the equipment. If the UK company opts to use the average rate and rates are stable at £1 = $1.30 over the month, the transaction is recorded as £38,462 ($50,000 ÷ 1.30).
Example 2:
A German company earns revenue of ¥100,000 from Japan when the exchange rate is €1 = ¥125. The temporal method translates the revenue to €800 (€100,000 ÷ 125). If average rate stability merits its use, and the average rate is €1 = ¥130, then the revenue is recorded at approximately €769 (€100,000 ÷ 130).
Frequently Asked Questions
What differentiates the temporal method from the closing-rate method?
The temporal method uses exchange rates from the transaction date, affecting the profit and loss account, whereas the closing-rate method uses the balance sheet date’s exchange rate and records differences in reserves.
When can an average exchange rate be used under the temporal method?
An average exchange rate can be used when exchange rates do not fluctuate significantly during the period.
What exchange gains or losses are recognized in profit and loss?
Any exchange differences resulting from the translation process are recognized in the profit and loss account under the temporal method.
Are there specific items excluded from the temporal method?
Yes, foreign currency monetary items and items that are required to be measured at fair value are exceptions and not typically translated using the temporal method.
Related Terms
- Closing-Rate Method: Uses the period-end exchange rate for translating foreign currency transactions and records the resulting differences in reserves instead of profit and loss.
- Financial Reporting Standard (UK and ROI): Regulations that govern financial reporting practices in the UK and Republic of Ireland.
- Fair Value: The price at which an asset or liability could be exchanged between knowledgeable parties in an arm’s length transaction.
- International Accounting Standard (IAS) 21: An IFRS standard that outlines how accounting for transactions and operations in foreign currencies should be conducted.
Online References
- Investopedia: Foreign Currency Translation
- IFRS: IAS 21 The Effects of Changes in Foreign Exchange Rates
Suggested Books for Further Reading
- “Financial Reporting and Analysis” by Charles H. Gibson
- “International Financial Reporting Standards (IFRS) 2021” by Ernst & Young
- “Accounting for Value” by Stephen Penman
Accounting Basics: “Temporal Method” Fundamentals Quiz
Thank you for exploring the detailed intricacies of the temporal method in accounting. Through understanding these principles and terms, you build a solid foundation in financial accounting and reporting.
