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Home/ Questions/Q 122
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Pooja Sharma
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Pooja Sharma
Asked: July 16, 20192019-07-16T23:22:45+05:30 2019-07-16T23:22:45+05:30In: Commerce

What is translation exposure? Is management of translation exposure more important that economic exposure?

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What is translation exposure? Is management of translation exposure more important that economic exposure?
International Business Finance
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    2019-07-16T23:38:38+05:30Added an answer on July 16, 2019 at 11:38 pm

    Translation exposure is also referred to as accounting exposure. This arises because the financial statements of foreign subsidiaries must be restated in the parent’s reporting currency for the firm to prepare its consolidated financial statements. Translation exposure is the potential for an increase or decrease in the parent’s net worth and reported income caused by a change in exchange rates since the last transaction. Translation methods differ by country along two dimensions. One is a difference in the way a foreign subsidiary is characterised depending on its independence. The other is the definition of which currency is most important for the subsidiary.

    The restatement of foreign currency financial statements in terms of a reporting currency is termed translation. The exposure arises from the periodic need to report consolidated worldwide operations of a group in one reporting currency and to give some indication of the financial position of that group at those times in that currency.

    Economic Exposure: Economic exposure refers to the degree to which a firm’s present value of future cash flows can be influenced by exchange rate fluctuations. Economic exposure is a more managerial concept than an accounting concept. A company can have an economic exposure to say Pound/Rupee rates even if it does not have any transaction or translation exposure in the British currency. This situation would arise when the company’s competitors are using British imports. If the Pound weakens, the company loses its competitiveness (or vice versa if the Pound becomes strong).

    Thus, economic exposure to an exchange rate is the risk that a variation in the rate will affect the company’s competitive position in the market and hence its profits. Further, economic exposure affects the profitability of the company over a longer time span than transaction or translation exposure. Under the Indian exchange control, economic exposure cannot be hedged while both transaction and translation exposure can be hedged.

    Translation exposure is measured at the time of translating foreign financial statements for reporting purposes and indicates or exposes the possibility that the foreign currency denominated financial statement elements can change and give rise to further translation gains or losses, depending on the movement that takes place in the currencies concerned after the reporting date. Such translation gains and losses may well reverse in future accounting periods but do not, in themselves, represent realized cash flows unless and until, the assets and liabilities are settled or liquidated in whole or in part. This type of exposure does not, therefore, require management action unless there are particular covenants, e.g. regarding gearing profiles in a loan agreement, that may be breached by the translated domestic currency position, or if management believes that translation gains or losses will materially affect the value of the business.

    It is the degree to which a firm’s foreign currency denominated financial statements is affected by exchange rate changes. All financial statements of a foreign subsidiary have to be translated into the home currency for the purpose of finalizing the accounts for any given period. If a firm has subsidiaries in many countries, the fluctuations in exchange rate will make the assets valuation different in different periods. The changes in asset valuation due to fluctuations in exchange rate will affect the group’s asset, capital structure ratios, profitability ratios, solvency ratios, etc. FASB 52 specifies that US firms with foreign operations should provide information disclosing effects of foreign exchange rate changes on the enterprise consolidated financial statements and equity. The following procedure has been followed:

    • Assets and liabilities are to be translated at the current rate that is the rate prevailing at the time of preparation of consolidated statements.
    • All revenues and expenses are to be translated at the actual exchange rates prevailing on the date of transactions. For items occurring numerous times weighted averages for exchange rates can be used.
    • Translation adjustments (gains or losses) are not to be charged to the net income of the reporting company. Instead these adjustments are accumulated and reported in a separate account shown in the shareholders equity section of the balance sheet, where they remain until the equity is disposed off.
    • Measurement of translation exposure is defined as Translation exposure = (Exposed assets – Exposed liabilities) (change in the exchange rate).

    Since translation exposures are serious threats, there are special hedging strategies designed for translation exposures. These are fund flow adjustment, forward contracts, exposure netting. Fund flow adjustment technique involves altering the amounts or the currencies of the planned cash flows of the parent or the subsidiaries to reduce the firm’s local currency accounting exposure. In such cases, if the local currency devaluation occurs, direct fund adjustment method will include pricing exports in hard currencies and imports in the local currency, investing in hard currency securities and replacing hard currency borrowings with local currency loans. The indirect methods include adjusting transfer prices on the sale of goods between affiliates, speeding up the payment of dividends, fees and royalties, and adjusting the leads and lags of inter- subsidiary accounts.

    Forward contract can also be used to hedge translation exposure by creating an offsetting asset or liability in a foreign currency. Any loss (gain) on its translation exposure will then be offset by a corresponding gain (loss) on its forward contract. However, it is to be noted that the gain (or loss) on the forward contract is of a cash flow nature and is netted against an unrealized translation loss (or gain).

    Exposure netting is another hedging technique that can be used by multinational firms with positions in more than one foreign currency or with offsetting positions in the same currency. This technique involves offsetting exposures in one currency with exposures in the same or another currency such that gains and losses on the two currency positions will offset each other.

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