Chartered Financial Analyst (CFA) Practice Exam Level 2

In which scenario would you use the Temporal Method?

1. When the local currency is depreciating

2. When the functional currency is strong

3. When valuing equity shares

4. When translating a balance sheet

The correct answer is: When the local currency is depreciating

The Temporal Method is employed primarily in situations where the functional currency of an operation's financial statements is different from its presentation currency, particularly in the context of translating financial statements. This method is applied when dealing with monetary and non-monetary items using different exchange rates reflective of their timing of conversion into the local currency. In the case of a depreciating local currency, using the Temporal Method allows for the translation of non-monetary items at historical exchange rates while monetary items are translated at the current exchange rate. This approach captures the real economic impact of currency depreciation on financial statements, as assets that were historically acquired at higher values in the local currency become less valuable when expressed in the foreign currency. Choosing this method in a scenario of local currency depreciation highlights how financial positions can shift based on the timing of valuation and currency fluctuations, aligning with how changes in currency impact the underlying assets and liabilities. The Temporal Method thus provides a more accurate reflection of an entity's financial condition under such circumstances. In contrast, other scenarios provided do not align with the usefulness of the Temporal Method. For example, a strong functional currency and the valuation of equity shares are typically more relevant to the current rate method. Translating a balance sheet generally employs this current rate method