Question

Explain the current rate method and the temporal method for translating accounting financial statements.

Answer 1

Current Rate Method:

The current rate method is a method of foreign currency translation where most items in the financial statements are translated at the current exchange rate. When a company has operations in other countries, it may need to exchange the foreign currency earned by those foreign operations into the currency used when preparing the company's financial statements — the presentation currency. The current rate method is utilized in instances where the subsidiary isn't well integrated with the parent company, and the local currency where the subsidiary operates is the same as its functional currency.

Example:

An Canadian subsidiary of a U.S. company who does business using the Looney. When converting foreign currencies to the company's presentation currency, the assets and liabilities listed on the balance sheet are converted to the presentation currency using the spot exchange rate as of the date on the balance sheet. Stock and retained earnings are translated at their historical rates. Income statement items are translated at the weighted average rate for the accounting period.

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.

Example:

An 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.