Translation of Foreign Currency Financial Statements Using the Temporal Method

✦ The temporal method translates the financial statements of foreign operations into the reporting currency by applying historical, average, and current exchange rates based on the monetary or non-monetary nature of accounts.

✦ It is typically used when the foreign entity’s functional currency is the same as the parent’s reporting currency or when remeasurement is required under hyperinflationary or integrated operations.

✦ Translation gains and losses are recorded in the income statement, unlike the current rate method where such effects are captured in other comprehensive income (OCI).

✦ Accurate classification of monetary and non-monetary items is essential for correct application and compliance with ASC 830 and IAS 21.

Let’s explore how to apply the temporal method for foreign currency translation, including rate selection, measurement impacts, and presentation requirements.

1. When to Use the Temporal Method

✦ Applied when the foreign subsidiary’s functional currency is not its local currency, or when remeasurement into the parent’s reporting currency is needed.

✦ Used for: 

• Highly integrated subsidiaries 

• Operations in hyperinflationary economies 

• Entities whose books are maintained in a different currency than their functional currency

✦ The goal is to translate as if the entity had always used the reporting currency.

2. Classification of Monetary vs. Non-Monetary Items

✦ Monetary items: Fixed in terms of units of currency 

• Cash 

• Accounts receivable and payable 

• Notes and loans payable 

• Accrued expenses

✦ Non-monetary items: Not fixed in currency units 

• Inventory 

• Fixed assets 

• Intangibles 

• Equity investments 

• Prepaid expenses

Correct classification determines which exchange rate to apply.

3. Exchange Rate Application

Account Type	Exchange Rate Used
Monetary assets/liabilities	Current exchange rate
Non-monetary items at historical cost	Historical rate
Non-monetary items at fair value	Rate at valuation date
Revenues and expenses	Average rate (if periodic)
COGS, depreciation, amortization	Historical rate (linked to asset)

Example:

• Cash: Translated at spot rate on balance sheet date

• Inventory (historical cost): Translated at rate when acquired

• Depreciation: Translated at rate when fixed asset was purchased

• Rent expense: Translated at average monthly rate

4. Translation Gains and Losses

✦ Under the temporal method, all translation adjustments flow through the income statement, not OCI.

✦ Recognized as: 

• “Foreign exchange gain/loss” 

• Operating or non-operating item depending on policy

✦ Fluctuations in exchange rates affecting monetary items directly impact net income.

5. Journal Entry Example — Temporal Translation

Assume:

• Foreign subsidiary uses local currency books

• Parent reports in USD

• Functional currency = USD → temporal method required

Inventory purchased at LC 1,000 when USD/LC = 1.2Year-end USD/LC rate = 1.5Cash = LC 1,000No change in inventory value

Translated values:

• Inventory = 1,000 × 1.2 = USD 1,200

• Cash = 1,000 × 1.5 = USD 1,500

Gain recognized: Dr. Cash – USD 1,500  Cr. Foreign Exchange Gain – USD 300  Cr. Inventory – USD 1,200

6. Financial Statement Presentation

✦ Financials translated using the temporal method are remeasured into the functional currency, then translated using the current rate method (if needed) to the reporting currency.

✦ Net income includes translation effects.

✦ Balance sheet must reflect mixed exchange rates—current for monetary, historical for others.

7. Comparison to Current Rate Method

Aspect	Temporal Method	Current Rate Method
When used	Functional currency = parent	Functional currency ≠ parent
Translation gains/losses	Income statement	OCI (CTA)
Rate for assets/liabilities	Mixed: current/historical	Current rate for all
Income statement rates	Historical/average	Average rate

8. IFRS vs. US GAAP

✦ Both IFRS (IAS 21) and US GAAP (ASC 830) require the temporal method in similar situations.

✦ Main alignment areas: 

• Classification of monetary vs. non-monetary items 

• Use of historical rates for specific asset-linked expenses 

• Gain/loss recognition in net income

✦ Differences may arise in hyperinflationary guidance (refer to IAS 29 and ASC 830-10-45-11).

9. Common Pitfalls

✦ Misclassifying items (e.g., inventory as monetary)

✦ Applying average rate to depreciation or COGS (should use historical rate)

✦ Ignoring currency-linked liabilities (e.g., fixed-interest foreign bonds)

✦ Failing to isolate and disclose exchange gains and losses separately in the income statement