Concept Of Current Rate Method Of Translation And Temporal M

Concept of current rate method of translation and temporal method of translation

The current rate method and the temporal method are two primary accounting techniques used to translate foreign currency financial statements into the reporting currency of a parent company, typically for consolidation purposes. These methods are essential in accounting for foreign subsidiaries as they deal with the challenges posed by fluctuating exchange rates, impacting the reported financial position and results of operations.

The current rate method, also known as the closing rate method, involves translating all balance sheet items at the current exchange rate prevailing at the balance sheet date. Income statement items are translated using the average exchange rate for the reporting period. This method reflects the current spot rates, and the resulting translation adjustments are recorded as a component of other comprehensive income in equity. The method assumes that monetary and non-monetary items are best represented at current exchange rates, with monetary items (like cash and receivables) translated at the current rate, and non-monetary items (like inventory and fixed assets) translated at historical rates.

Conversely, the temporal method, also known as the historical rate method, primarily translates monetary assets and liabilities at current exchange rates, whereas non-monetary items (such as inventory, property, plant, and equipment) are translated at historical rates. Income statement translation under this method follows a different approach: cost of goods sold and expenses are translated at the rates in effect at the dates incurred, typically using average rates for the period. Gains or losses from translation adjustments are recognized in net income, making the income statement sensitive to currency fluctuations.

How does balance sheet exposure differ under these two methods?

Balance sheet exposure refers to the potential change in the reported financial statement items due to exchange rate fluctuations. Under the current rate method, the balance sheet is exposed because assets and liabilities are translated at the current exchange rate, which can fluctuate between reporting periods. Since all balance sheet items are translated at the current rate, the cumulative translation adjustments are recorded in equity as part of accumulated other comprehensive income, and changes in exchange rates directly influence the cross-period comparative balance sheets.

In contrast, the temporal method exposes the balance sheet differently. Since monetary assets and liabilities are translated at current rates while non-monetary items are translated at historical rates, the balance sheet reflects a mix of current and historical exchange rates. This results in less sensitivity to short-term exchange rate movements, especially in the non-monetary assets, which are carried at historical costs. The translation adjustments under the temporal method typically impact net income directly because changes in translation are recognized immediately, which can result in more volatility in reported earnings compared to the current rate method.

Application to Child Co. Inc's financial data

Given the data from Child Co. Inc’s 2010 financial statements, we analyze the amounts of ending inventory and cost of goods sold (COGS) under the two translation methods. The key is understanding how historical and current exchange rates affect the valuation of inventories and COGS, which depend on the exchange rates at the time of acquisition and sale.

Data Recap:

• Beginning inventory: 100,000 pesos (acquired at $0.50 per peso)
• Purchases during 2010: 500,000 pesos
• Ending inventory: 150,000 pesos (acquired at $0.40 per peso)
• COGS: 450,000 pesos
• Exchange rates during 2010:
  • January 1, 2010: $0.45
  • Average for 2010: $0.42
  • December 31, 2010: $0.38

Under the Current Rate Method

Since the current rate method translates all assets and liabilities at the current exchange rate as of the balance sheet date, ending inventory, which is a balance sheet account, will be translated at year-end rate of $0.38 per peso. The COGS, usually derived from sales transactions, would be translated at the average rate for the period, which is $0.42. This approach ensures that inventory and COGS reflect the most recent exchange rates, aligning with the current value of assets and liabilities.

Therefore, the ending inventory value under the current rate method is calculated as: 150,000 pesos × $0.38 = $57,000. The COGS, being an income statement item, would be translated at the average rate of $0.42, resulting in: 450,000 pesos × $0.42 = $189,000.

Under the Temporal Method

The temporal method treats monetary and non-monetary assets differently. Inventory is a non-monetary asset, so it is translated at historical rates pertinent to acquisition. The beginning inventory was acquired at a rate of $0.50, thus its translated value is: 100,000 pesos × $0.50 = $50,000. The ending inventory was acquired at the rate of $0.40, so its translated value is: 150,000 pesos × $0.40 = $60,000.

The cost of goods sold calculation considers the historical purchase prices, matching the inventory costs with the rates at the times of purchase. Since purchases during the year totaled 500,000 pesos (assumed to be at the average rate), the translation of purchases would be consistent with that rate. Therefore, the ending inventory value is based on the purchase price at the time the inventory was acquired, leading to a similar approach as for ending inventory values.

Summary

In conclusion, for Child Co. Inc's inventory under the two methods:

• Current Rate Method: Ending inventory = 150,000 pesos × $0.38 = $57,000.
• Temporal Method: Ending inventory = 150,000 pesos × $0.40 = $60,000.

And for COGS:

• Current Rate Method: COGS = 450,000 pesos × $0.42 = $189,000.
• Temporal Method: COGS is calculated at the historical rates of inventory purchased, but often translated at the average rate, resulting in approximately $189,000, matching the average rate for simplification.

Conclusion

The choice between the current rate method and the temporal method impacts reported inventory and COGS through their different approaches to translating assets and expenses at either current or historical exchange rates. The current rate method provides a more current valuation of the balance sheet, but can introduce volatility in earnings and equity due to exchange rate fluctuations. The temporal method aligns costs with historical rates, resulting in fewer translation-related adjustments in the balance sheet but more volatility in income recognition.

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