The existence of different exchange rates allows using different approaches and methods when converting currencies. One of these methods is the current rate method, which is very actively used throughout the world. This method converts revenues and expenses into US dollars using the exchange rate so that any article of their accounting will be recognized during the period. In practice, an average exchange rate is used for this period. Revenues and expenses are converted at the exchange rates prevailing at the balance sheet data. Accounts for the movement of capital used the exchange rate of the period when the branch is purchased. For paying out dividends the exchange rate to the date of these payments is used. The final balance is made using the balance and the exchange rate used in the previous year, plus net converted income from current income, minus dividends paid.
The temporal method is one of the main methods of allocation of currency in the accounting business. It is based on the combined use of the original exchange rate and the closing rate. This method is based on the fact that the article should be recalculated according to the exchange rate in effect put on when their value is established in the accounting documents. For monetary items it will be the closing rate as their monetary value expresses their value at the close of the accounting report. For accounting reports with unchanged initial value of merchandise articles will be converted to their original value.
In drawing up the plans it is difficult to predict exchange rates. Budgeting for international operations is interconnected with the fact that budget, including the transfer of capital and materials between the companies, based on an assessment of the exchange rate. Fluctuations in exchange rates make the pricing of products for budgeting very uncertain. Political changes after the preparation of budgets may limit the ability of firms, which budgets are aimed at the transfer of capital from one country to another. Change in exchange rates affects the budgeting of capital. Changes in exchange rates that change all the time, turn the prediction of long-term flows unreal, and the budgeting process difficult.
It should be noted that the use of any of the above methods of currency translation results in different values of the exchange rate differences. This is due to the fact that the basis of these methods put different assumptions as to what types of assets and liabilities denominated in foreign currencies are affected by changes in exchange rates, and what – no. None of the methods considered currency conversion of financial statements is not perfect and has some drawbacks. Thus, both methods have the same disadvantages. Firstly, they are based on the classification of objects into account certain criteria. At the same time the question why such a division of financial reporting may determine which course to apply the translation, because the currency translation associated with the assessment and not the classification, remains unreasonable. Characteristics of assets and liabilities, which determine their classification in the financial statements, are not necessarily suitable for the selection of appropriate courses for foreign currency translation. Second, if monetary and nonmonetary methods of currency translation of non-monetary balance sheet items at historical rates would make sense only if they are reflected in the balance sheet at historical cost rather than fair.
Temporal method is the basis for the US standard SFAS 8 “Accounting for foreign currency transactions and translation of financial statements denominated in foreign currencies”. This standard is obliged to conduct foreign exchange translation of the financial statements only on a temporary basis. In this case, the exchange differences need to be immediately recognized as profit or loss in the period in which they arise. Postponement of exchange rate differences is prohibited.
Consequently, the application of the current / non-current conversion method the foreign bank’s branch (subsidiary) with a positive net working capital denominated in the currency of the home country, will suffer losses on translational devaluation of the local currency against the currency of the parent company for the accounting period in consolidation balance. On the contrary, it will get more profit in the event of a revaluation of the local currency. If the net working capital of a foreign operation is negative, the results are opposite.
An example of using a temporal method comes from the fact that the currency of transactions of subsidiary in Canada is the US dollar. The current rate method based on the fact that the temporal currency of Canadian branch is the Canadian dollar. Canadian subsidiary was formed at the beginning of the year. The current exchange rate is 0.80 US dollars per 1 Canadian dollar. The actual rate used in the creation of a branch and formation of equity is 0.90 US dollars.
The average rate for the year is thus 0.85 US dollars. Temporal method losses related to the restatement in the amount of 10,406 US dollars were due to the fact that the branch held its financial net assets in Canadian dollars, while its rate against the US dollar goes down. The probability of losses associated with conversion of corresponding financial position in terms of changed exchange rates, as a rule, is not identical to the concept of economic losses as a result of the above process. Economic losses are due to many factors, including the rate of inflation, control methods of economic processes, changes in the levels of interest rates and other factors. Losses associated with the process of conversion to another currency, depending on what financial accounts should be translated at the current exchange rate. The open foreign currency position represents the net balance of all accounts are translated at the current exchange rate. Accounts and positions are translated at actual rates unchanged, are not subject to adjustment on translation that is the same conversion rate used each year. Exposure to any company losses associated with conversion of their accounts and positions on current exchange rates can be explained as follows:
Articles that increase the risk of losses are current assets (excluding prepayments), investments denominated in fixed amounts of local currency (the German mark, the British pound sterling) and long-term accounts receivable (net of discounts and benefits provided). Articles that reduce the risk of losses are inventories, assets in US dollars in the above positions and liabilities in local currency.
The algebraic sum of these items demonstrates the company’s exposure to the risk of incurring losses as a result of currency fluctuations (or benefit). This open foreign currency position can be adjusted, as a rule, by monitoring the status of the securities included in the listing, as well as by means of forward currency transactions.
Campbell, B. (2014). Current Rate vs. Temporal: Why Two Methods? Retrieved from http://financialexamhelp123.com/current-rate-vs-temporal-why-two-methods/
Khan & Jain (2005). Basic Financial Management. Tata McGraw-Hill Education.