13.4. ACCOUNTING EXPOSURE 521
corresponding from non-monetary sources (like depreciation of assets). These are
translated at the same rate as the corresponding balance sheet item. This again
creates an inconsistency between theaudandmtlP&Lfigures, and between the
translatedP&LandA&Lfigures.
The Temporal Method
The Temporal Method of translating the financial statements of a foreign subsidiary
is similar to the Monetary/Non-Monetary Method. One difference between the two
methods arises if “real” items have been marked to market inhc. As we saw, under
the monetary system, inventory is always translated at the historical exchange rate,
since it is a non-monetary asset. Under the Temporal Method, in contrast, inventory
may be translated at the current (i.e.closing) exchange rate if it is recorded in the
balance sheet at current market prices. The advantage of this approach is that it
is less inconsistent with the accounting rules used for the parent firm if the parent
marks to market its domestic inventory too. Another aspect of the temporal method
is that it makes translation effects part of reported income, which can lead to large
swings in reported earnings. Thus, under this methodCFOs tried to hedge exposures
that were just arbitrary paper results, not real cash flows.
Theusaccounting directive that was used from 1976 to 1981,FASB8, was based
on the Temporal Method. (Prior to that, theusimposed the Current-Noncurrent
method.) The Closing Rate Method, introduced byFASB52 in theus, is designed
to overcome some of these problems.
The Current- or Closing-Rate Method
This is the simplest approach for translating financial statements. According to the
Current Rate Method or Closing Rate Method, all balance sheet items are translated
at the closing exchange rate. Typically, exchange gains are reported separately in a
special equity account on the parent’s balance sheet, thus avoiding large variations
in reported earnings, and these unrealized exchange gains are not taxed.
Example 13.12
For the Australian subsidiary’s simplified balance sheet, the exposed amount is net
worth,aud3,100.
Evaluation- The main advantage is consistency between the parent’s and subsidiary’s rel-
ative numbers. Likewise, using one rate produces a number that is easier to
interpret than one resulting from mixtures of closing and historic translations.^6
(^6) If the subsidiary’s accounts themselves mix historic costs—some of them possibly very dated—