The temporal method for translating foreign subsidiary financial statements

Temporal Method

When an American company prepares its financial statements for reporting to its stockholders and board of directors, it must also include the operating results and financial position of its foreign-based subsidiaries or branches translated in U.S. dollars. Financial statements of foreign-based entities must be translated or remeasured to American dollars so that it can be consolidated or combined with the parents company's statements, prepared in American dollars.

For an example, ABC Company, an American company, has a subsidiary, XYZ Company, which is incorporated in Thailand. The financial statements of XYX Company must be translated to American dollars so it can be consolidated with its parent company, ABC Company.

There are two methods used in translating financial statements of foreign-based subsidiaries or branches, the first is the current rate method and the other is the temporal method.

Temporal method will be discussed further below.

TEMPORAL METHOD

This method is also referred to as the remeasurement method and the monetary/nonmonetary method. It is used when the foreign operations of the foreign entity are direct and integral component or extension of the parents company's operations. If the foreign operations are not considered integral to the operations of the parent, the foreign financial statements are translated to American dollars using the current rate method.

The basic objective of the temporal method is to produce a set of American dollars translated financial statements as if the foreign entity had actually used American dollar in their operations.

The rule of translation under this method is as follows:

Monetary assets and liabilities (these are claims or obligations expressed in a fixed monetary amount) are translated at the current exchange rate.

Examples as follows:

Cash and cash equivalents

Short-term and long-term accounts receivable

Accounts payable

Bank loans

Common stock and preferred stock carried at issuance price

In the income statement, revenues and expenses are translated using the rates that correspond with the dates of the underlying transactions, however, if the transactions are numerous and spread over an extended period of time, an average of the rates that existed during the period may be used. In practice, a monthly or a quaterly weighted average may be computed.

But for expenses that are related to nonmonetary assets such as depreciation, amortization (of intangible assets and deferred charges except for deferred income taxes) and cost of goods sold are translated at appropriate historical rates.

This method will result in a net exchange gain or loss, which should be recognized in the income statement for the current period.

To determine whether a specific foreign operations is integral or not with the operation of the parent company, the concept of functional currency may be used as guidance. Functional currency is defined as the primary currency of the foreign entity's operating environment, it could either be the parent's currency or a foreign currency. Foreign operations are considered as integral to the operations of the parent if its functional currency is the same with its parent's.

Below is a list of indicators in determining the functional currency of the foreign entity.

Indicator

Foreign Currency

Foreign Operations is Not Integral)

Parent's Currency

Foreign Operation is Integral)

Cash flow

Primarily in foreign currency and do not affect parent company's cash flows.

Directly impact parent company's cash flows on a current basis.

Sales price

Not affected on short-term basis by changes in exchange rate.

Affected on short-term basis by changes in exchange rate.

Sales market

Active local sales market.

Sales market mostly in parent's country or sales denominated in parent's currency.

Financing

Primarily denominated in foreign currency and foreign currency cash flows adequate to service obligations.

Primarily from parent company or denominated in parent currency or foreign currency cash flows is not adequate to service obligations.

Intercompany transactions

Low volume of intercompany transactions and not extensive interrelationship with parent company's operations.

High volume of intercompany transactions and extensive interrelationship with parent company's operations.

II. Part 2

Long-term accounts receivable

Long-term accounts receivable is considered as a monetary asset, and as such is translated at the current exchange rate.

Deferred Income

Deferred or unearned income is a nonmonetary liability, as such, it is translated using its appropriate historical rate.

Inventory valued at cost

Inventory is a nonmonetary asset, as such, it is translated using its appropriate historical rate.

Long-term debt

Lont-term debt is considered as a monetary liability, and as such is translated at the current exchange rate.