Translation (accounting) exposure arises from the need to, for purposes of reporting and consolidation, to convert the financial statements of foreign operations from the local currency (LC) involved to the home currency (HC). If exchange rates have changed since the previous reporting period, this translation, or restatement, of those assets, liabilities, revenues, expenses, gains and losses that are denominated in foreign currencies will result in foreign exchange gains or losses.
The most common means of protecting against translation exposure is balance sheet hedging. This involves attempting equalize exposed assets and liabilities. For example, a company may try to reduce its foreign currency denominated assets if it fears a devaluation of the overseas currency, by running down cash balances, chasing debtors and reducing stock levels. At the same time it might increase its liabilities by borrowing in the local currency and slowing down payment to creditors. If it can equate its foreign currency assets and liabilities then it will have no net exposure to changes in exchange rates.
Asset-Liability Management– involves choosing the different currencies in which the assets and liabilities of a company are denominated. Essentially assets should be in strong currencies and liabilities in weak currencies. This is an example of balance sheet hedge.
Measuring Translation Exposure
The translation of subsidiaries’ financial statements from their functional currencies into reporting currency give rise to translation gain or loss if there has been exchange rate changes within the period covered by the translated financial statements. Such a gain or loss is the quantity of risk/ exposure to which such a group is/ was exposed. How ever, home-country and the entire financial community are interested in home-currency values, the foreign currency balance-sheet accounts and income statement must be assigned home currency values. In particular, the financial statements of an MNC’s overseas subsidiaries must be translated from local currency to home currency prior to consolidation with the parent’s financial statements.
Translation exposure is simply the difference between exposed assets and exposed assets. The controversies to among accountants center on which assets and liabilities are exposed and on when accounting –driven foreign exchange gains and losses should be recognized (reported on income statement). The crucial point to realize in putting these controversies in perspective is that such gains or losses are of an accounting nature-that is , no cash flows are necessarily involved.
Four principal translation methods are available: – the current/non-current method, the monetary/non-monetary method, the temporal method and the current rate method
- Current/Non-current method: With this, all the foreign subsidiary’s current assets and liabilities are translated into home currency at the current exchange rate. Each non-current asset or liability is translated at its historical exchange rate, that is, at the rate in effect at the time the asset was acquired or liability incurred. Hence, a foreign subsidiary with positive local-currency working capital will give rise to a translation loss (gain) from devaluation (revaluation) with the current/non-current method, and vice versa if working capital is negative. The income statement is translated at the average exchange rate of the period, except for those revenues and expense items associated with non-current assets or liabilities. The latter items, such as depreciation expense, are translated at the same rates as the corresponding balance-sheet items. Thus, it is possible to see different revenue and expense items with similar maturities being translated at different rates.
- Monetary/Non-monetary method: The monetary/non-monetary method differentiates between monetary assets and liabilities-that is, those items that represent a claim to receive, or an obligation to pay, a fixed amount of foreign currency units-and non-monetary, or physical, assets and liabilities. Monetary items (for example, cash, accounts payable and receivable, and long-term debt) are translated at the current rate; non-monetary items (for example,. Inventory, fixed assets, and long-term investments) are translated at historical rates. Income statement items are translated at the average exchange rate during the period, except for revenue and expense items related to non-monetary assets and liabilities. The latter items, primarily depreciation expense and cost of goods sold, are translated at the same rate as the corresponding balance-sheet items. As a result, the cost of goods sold may be translated at a rate different from that used to translate sales.
- Temporal method: This appears to be a modified version of the monetary/non-monetary method. The only difference is that under the monetary/non-monetary method, inventory is always translated at the historical rate. Under the temporal method, inventory is normally translated at the historical rate, but it can be translated at the current rate if the inventory is shown on the balance sheet at market values. Despite the similarities, however, the theoretical basis of each method is different. The choice of exchange rate for translation is based on the type of asset or liability in the monetary/non-monetary method; in the temporal method, it is based on the underlying approach to evaluating cost (historical versus market). Income statement items are normally translated at an average rate for the reporting period. However, cost of goods sold and depreciation and amortization charges related to balance sheet items carried at past prices are translated at historical rates.
- Current rate method: The current rate method is the simplest; all balance sheet and income items are translated at the current rate. Under this method, if a firm’s foreign-currency denominated assets exceeds its foreign-currency denominated liabilities, devaluation must result in a loss and a revaluation, in a gain. One variation is to translate all assets and liabilities except net fixed assets at the current rate.
Source: Scribd.com (38966428-International-Finance)