KEY TAKEAWAYS
- Translation exposure is the risk that the liabilities, assets, equities, or income of a company can change. This relates to a change in value if there are changes to the exchange rate.
- Translation exposure happens if a company has liabilities, assets, equities, or income held in a foreign currency.
- Accounting exposure and translation risk are interchangeable
- Translation risk can often lead to what looks like financial gains or losses. This happens due to the current value of the assets based on fluctuations in the exchange rate.
What Is Translation Exposure?
Translation exposure, also known as translation risk, relates to the risk that certain liabilities, assets, equities, or income of a company will change in value. This usually happens due to changes in exchange rates.
It can also happen when a company has liabilities, assets, equities, or income in a foreign currency. Sometimes these risks are referred to as accounting exposure. To avoid these risks, accountants implement different methods to help protect their company.
For example, accountants can use consolidation techniques. These include using cost accounting evaluation procedures for financial statements. When this happens, translation exposure is recorded as an exchange rate gain or loss in financial statements.
Translation Exposure: An Overview
Translation exposure can be most common in multinational organizations. This is since a large portion of assets and operations will typically be held in a foreign currency.
As well, companies that produce goods or services that are sold in a foreign market can also be affected. This can be the case regardless if they don’t have any other business dealings in that country.
For reporting the financial situation of a company, assets and liabilities get adjusted to the home currency. This is when translation exposure can happen. Exchange rates can fluctuate in a short period.
When translation exposure happens it can lead to a gain or loss. But it doesn’t necessarily mean that there has been a change in assets. Instead, it can mean that the current value of assets has changed due to the fluctuations in the exchange rate.
How to Measure Translation Exposure
One of the biggest challenges that come with translation exposure is that it can create a false representation of a company’s holdings. This is because a foreign currency might depreciate compared to the company’s home currency.
Yet, accountants have a few options when this happens. They can choose to convert the foreign holdings back into their domestic currency. Or they can choose to convert the foreign holdings at the current exchange rate. They might also have the opportunity to convert at a historical rate that’s relatable to the time of occurrence.
That all said, whichever method the company’s accountant decides to use should be implemented for the long term. Doing this keeps the accountant in accordance with the consistency accounting principle.
There then becomes four distinct methods for measuring the translation exposure of a company.
The Current and Non-Current Method
With this method, the values of any current assets and liabilities get converted at whatever the exchange rate is on the date of the balance sheet. On the flip side, any non-current assets and liabilities are converted at a historical rate.
Current items on a balance sheet can include several things. These include bills payable, accounts receivable, short-term loans, and sundry creditors and debtors. Any of the items that are still on the balance sheet after a year are then considered non-current assets. These can include things like investments, long-term loans, building, and machinery.
The Monetary and Non-Monetary Method
Here, any of the monetary accounts of the company get converted at the current rate of exchange. Any of the non-monetary accounts are then converted at a historical rate.
Within monetary accounts, you will find any items that are related to a fixed amount. And these can be either paid or received, including loans, creditors, debtors, and cash.
Non-monetary items would include things such as capital, buildings, or machinery. This is since they’re going to have market values that can differ from the ones on the balance sheet.
The Current Rate Method
This is usually the easiest method for accountants to implement. Every value of every item on the balance sheet is converted using the current rate of exchange, except capital. With capital, it is evaluated based on the prevailing rate when it was issued.
The Temporal Method
Similar to the monetary and non-monetary method, the main difference is how the temporal method deals with inventory. The actual value of any inventory is often converted with a historical rate. However, if the balance sheet records the inventory at market value, it would be converted using the current exchange rate.
How to Manage Translation Exposure
There are a few ways to effectively manage translation exposure. These include:
- Balance sheet hedging
- Derivatives hedging
- Currency swap agreements
- Currency options
- Forward contracts.
Translation Exposure Example
Let’s say a multinational company has a domestic division that incurs a net operating loss of $5,000. However, a foreign subsidiary of the company made a profit of the same amount, but in a foreign currency.
At the time this happened the exchange rate was 1 to 1, meaning the profit canceled out the operating loss. However, the exchange rate changes and now one unit of foreign currency is only worth half of what it was. The company ends up having to report a loss since it can no longer cover the operating loss of the domestic division.
Summary
Translation exposure is the risk that can come from a company’s liabilities, assets, equities, or income being affected by exchange rates fluctuating. It can be most common in multinational companies. This is since they often have liabilities, assets, equities, and income in a foreign currency.
It can also relate to foreign subsidiaries that have dealings in foreign countries. And if they have to regularly monitor the currency exchange rate. To reduce economic exposure, accountants of a company have a few methods they can implement. This is so they can create a better representation of the holdings a company has.
FAQs About Translation Exposure
What Factors Affect a Company’s Translation Exposure?
The primary factor is the economic environment where the company conducts business. As well, the currency where sales are invoiced and the currency where it negotiates purchases are also factors to consider.
What Is the Difference Between Translation Exposure and Transaction Exposure?
Translation exposure is the accounting representation of risks from exchange rate changes. Transaction exposure, on the other hand, relates to the actual foreign currency transactions.
What Is Translation Exposure in Accounting?
Often referred to as accounting exposure, it measures the effect that an exchange rate can have on the financial statements of a company. This is because foreign assets and liabilities need to get translated at the current exchange rate in the home currency.
