Accounting for corporate finance: foreign exchange: foreign operations: temporal method: when to use
When should a company use the temporal method?
SSAP 20 under Old UK GAAP
While the closing rate/ net investment method is the ‘normal’ method a company will use to translate the results of a foreign operation, SSAP 20 under Old UK GAAP says that the temporal method must be used in some circumstances.
These are where the foreign operation can be regarded as an extension of the parent company’s trade or business. The cash flows of the foreign operation impinge directly on the cash flows of the parent, so that the exchange rate between its local currency and sterling is of major importance in the foreign operation. SSAP 20 gives some examples:
- The foreign operation acts as a selling agency, receiving stocks from the parent company, selling them locally and remitting the proceeds to the parent.
- The foreign operation is a supplier of raw materials or components to the parent company.
- The foreign operation is located overseas for tax, exchange control or similar reasons to act as a means of raising finance for other group companies.
In such situations, the temporal method - which treats the operations of the subsidiary as though they were the parent’s own operations - better reflects the underlying reality.
FRS 23 under Old UK GAAP, IFRS and New UK GAAP
Under FRS 23, IFRS and New UK GAAP, a foreign operation with no real operational independence from its parent (such as one which falls to be accounted for using the temporal method under SSAP 20), should adopt the same functional currency as its parent. In the parent company’s accounts, this would have the same practical effect as adopting the temporal method under SSAP 20.