Consolidation of financial statements, which involve foreign currency denominated assets and liabilities automatically, gives rise to translation exposure, sometimes termed as accounting exposure. Consolidation of foreign subsidiaries account into group financial statements denominated in home currency requires the application of a rate or rates of exchange to foreign subsidiaries accounts, in order that they may be translated into the parent currency. Both balance sheets and income statements must be consolidated and they both give rise to translation exposure. Translating foreign currency profit and loss accounts at either the average exchange rate during the accounting year or at the exchange rate at the end of the accounting year (both methods are currently permissible as per British accounting procedures) will mean that expected consolidated profit will vary as the average or that the expected closing rate changes. So the whole amount of profit earned in the foreign currency is exposed to translation risk in the sense that the home currency’s consolidated profit may vary as exchange rates vary.
Balance sheet exposure is somewhat more complex. Some items in a foreign subsidiary’s balance sheet may be translated at their historical exchange rates (the rate prevailing at the date of acquisition or any subsequent revaluation). Thus their home currency translated value cannot alter as exchange rates alter; such assets and liabilities are not exposed in the accounting sense. Other items may be translated at the closing exchange rate – the rate prevailing at the balance sheet date at the end of the accounting period. While the value of such items is fixed in the foreign subsidiary’s currency, the amount translated into the parent currency will alter as the exchange rate alters. Hence all foreign currency items, which are consolidated at the current rate, are exposed in the accounting sense.
Accounting exposure, therefore, reflects the possibility that foreign currency denominated items, which are consolidated into group published financial statements at current or average rates will show a translation loss or gain as a result. This kind of exposure does not give an indication of the true effects of currency fluctuations on a company’s foreign operations.
Translation exposure can affect any company that has assets or liabilities that are denominated in a foreign currency or any company that operates in a foreign marketplace that uses a currency other than the parent company’s home currency. The more assets or liabilities the company has that are denominated in a foreign currency, the greater the translation risk.
Economic exposure is a far better measure of true value exposure. Translation exposure is really a function of the system of accounting for foreign assets and liabilities on consolidation, which a group of companies uses. Clearly it has little to do with the true value in an economic sense.
A company with foreign operations can protect against translation exposure by hedging. The company can protect against the translation risk by purchasing foreign currency, by using currency swaps, by using currency futures, or by using a combination of these hedging techniques. Any one of these techniques can be used to fix the value of the foreign subsidiary’s assets and liabilities to protect against potential exchange rate fluctuations.
Translation Exposure – Moving towards a Consensus
Internationally, the accounting profession has been concerned about the position on translation of foreign currency accounting statements. Indeed, the accounting professions in the USA and the UK now have almost identical rules for foreign currencies in published accounts.
Generally speaking, the translation of foreign balance sheets uses the current rate method. Transaction gains, whether realized or not, are accounted for through the profit and loss account. But there is a major exception. Where a transactional profit or loss arises from taking on a foreign currency borrowing in a situation in which the borrowing can be designated as a hedge for a net investment denominated in the same foreign currency as the borrowing, then the gain or loss on the borrowing, if it is less than the net investment hedged, would be accounted for by movements in reserves rather than through the income statement. If this kind of transactional gain or loss exceeds the amount of the loss or gain respectively on the net investment hedged, the excess gain or loss is to be reported in the profit and loss account. Non-transaction gains and losses are to be dealt with by reserve accounting direct to the balance sheet rather than through the profit and loss account.
While translation methods affect group balance sheet values, the key point is that they have nothing to do with economic value. If we are concerned with how the true value has changed because of exchange rate movements, we should be looking at economic value and how it changes in sympathy to moving exchange rates. This is what true exposure to exchange rate movements is all about.