The temporal method is used in accounting that deals with transactions in foreign currencies. It is a way of translating the value of the transaction in the foreign currency used by a foreign subsidiary back into the currency of the parent company’s base country, which is also called the parent currency. A company’s assets and liabilities are translated using different exchange rates depending on when they were created and how they are valued.
The name refers to the use of exchange rates that match the temporal setting of the assets and liabilities; if an item is historical, the temporal method assigns it a historical exchange rate. The alternative to the temporal method is the all-current method, in which all items on the balance sheet are translated using the current exchange method. This preserves the ratio between assets and liabilities, but it ignores the inherent value of objects that the temporal method preserves.
Currency translation is converting a balance sheet from one currency to another. This is done when a company owns more than 50 percent of the shares in a foreign company, which becomes a subsidiary of the parent. Its balance sheet is translated so that transactions made by the subsidiary may be reported as though they were made by the parent company.
When using the temporal method, the exchange rate used for each item on a company’s balance sheet depends on the way that the item is valued: as a historic or current asset. For example, if the company bought inventory valued at 5,000 foreign currency units a year ago, when the exchange rate was one to one, then that inventory will be valued at 5,000 units of parent currency even if the current exchange rate is 1.5 to one. If the subsidiary took out a loan that is still outstanding, however, it would be translated according to the current exchange rate because the funds that the company would use to repay it could only be transferred at the current rate.
This method of translating according to valuation means, in practice, that the current rate is used to translate monetary items, while historical rates are used to translate non-monetary items. The principle behind this is that an actual asset, like a piece of inventory, maintains its value regardless of the fluctuation of the exchange rate. It is worth more or fewer units, perhaps, but the units are different.
You can think of currency exchange in terms of one currency to elucidate the concept. You can pay for an ice cream cone with a dollar or 100 pennies, but it is not more expensive if you take the second option. Monetary items, however, are not intrinsically valuable because money is an exchange good. Thus, its worth is dependent on what it can be exchanged for, so it is valued at the current rate.
The different treatment of monetary and non-monetary items means that assets and liabilities are often translated differently. Assets are more likely to be non-monetary. The ratio of assets to liabilities can change because of a fluctuation in the exchange rate if the accounting is done using the temporal method. A seemingly unfavorable change in the exchange rate can lead to a gain on the company’s balance sheet.