What is Translation Exposure?
Translation Exposure is defined as the risk of fluctuation in the exchange rate that may cause changes in the value of the company’s assets, liabilities, income, equities and is usually found in multinational companies as their operations and assets are based in foreign currencies. At the same time, its financial statements are consolidated in domestic currency. Many companies prefer to hedge such kinds of risks in the best possible way.
4 Methods to Measure Translation Exposure
#1 – Current/Non-Current Method
In this method, current assets and liabilities are valued at the currency rate, while non-current assets and liabilities are valued as per the historical rate. All amounts from income statements are value based on the currency exchange rate, or in some cases, an approximated weighted average can be used in case there are no significant fluctuations over the financial periods.
#2 – Monetary/Non-Monetary Method
In this method, all monetary accounts in balance sheets such as Cash/Bank, bills payable are valued at the current rate of foreign exchange, while remaining non-monetary items in the balance sheet and shareholder’s equity is calculated at the historical rate of foreign exchange when the account was recorded.
#3 – Temporal Method
In this method, current and non-current accounts that are monetary in the balance sheet are converted at the current foreign exchange rate. In addition, non-monetary items are converted at historical rates. All accounts of a foreign subsidiary company are converted into the parent company’s domestic currency. The basis of this method is items are translated in a way they are carried as per the firm’s books to date.
#4 – Current Rate Method
By this method, all items in the balance sheet except shareholder’s equity are converted at the current exchange rate. All items in income statements are converted at an exchange rate at the time of their occurrence.
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For eg:
Source: Translation Exposure (wallstreetmojo.com)
Translation Exposure Examples
Company XYZ is a US Company that has a subsidiary in Europe. Since the operating currency in Europe is the EURO.
#1 – Current/Non-Current Method
#2 – Monetary/Non-Monetary Method
#3 – Temporal Method: Continued to translate as per policy.
#4 – Current Rate Method
How to Manage Translation Exposure?
#1 – Balance Sheet Hedge
This method focuses on the elimination of mismatch between assets and liabilities in the balance sheet denominated in one currency.
#2 – Derivatives Hedge
The use of derivative contracts for hedging purposes might involve speculation. But, if done carefully, this method manages the risk
- Swaps: Currency swap agreement between two entities for the exchange of cash flows in the given period will help manages risk.
- Options: Currency optionsCurrency OptionsCurrency Options are derivative contracts that allow market players, including both buyers and sellers of these Options, to purchase and sell a currency pair at a predetermined price (also known as the Strike Price) on or before the expiration date of such derivative contracts.read more give right but not the obligation to the party to exchange a particular amount of currency on decided exchange rate.
- Forwards: Two entities enter into a contract with each other for the specific exchange rate for settlement of transactions on a fixed date in the future. All forward contractsForward ContractsA forward contract is a customized agreement between two parties to buy or sell an underlying asset in the future at a price agreed upon today (known as the forward price).read more are predefined in all aspects, which manages the risk of fluctuation in the exchange rate but still involves speculation.
Differences Between Translation Exposure vs. Transaction Exposure
| Difference | Translation Exposure | Transaction Exposure |
|---|---|---|
| Definition | The risk involved in reporting consolidated financial statements due to fluctuation in exchange rates; | The risk involved due to changes in the exchange rate, which affects the cash flow movement arises in the company’s daily operations. |
| Area | Legal Requirements and accounting issues; | Managing daily operations; |
| Foreign Affiliate/Subsidiary | It only occurs while consolidating financial statements of parent company and subsidiary or foreign affiliate. | The parent company does not require having a foreign subsidiary for transaction exposure. |
| Profit or Loss | The result of Translation exposure is notional profit or loss. | The result of transaction exposure is realized profit and loss. |
| Occurrence | By the end of every quarter of the financial year while consolidating financial statementsConsolidating Financial StatementsConsolidated Financial Statements are the financial statements of the overall group, which include all three key financial statements – income statement, cash flow statement, and balance sheet – and represent the sum total of its parents and all of its subsidiaries.read more. | It only arises at a time of transaction involving foreign currency. |
| Value Impact | The value of the company is not affected. | Since it Directly affects the cash flows of the companyCash Flows Of The CompanyCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more, it changes the value of the company. |
| Tax | Translation exposure is more concept instead of an actual impact on the value of the company. Hence it does not affect tax payment and does not provide any benefits in case of loss in terms of fluctuation in the exchange rate. | Since Transaction exposure affects cash flows, it affects the tax payments of the company. Provides benefits in case of loss due to changes in the exchange rate |
Conclusion
- Translation exposure is inevitable for companies operating in other countries than their home country. It is usually a legal requirement for regulators; it does not change cash flow but only changes the reporting of consolidated financials. The translation is done on time of reporting, not at the time of realization, only resulting in notional profit and losses.
- Translation exposure poses a threat at the time of presenting unpredicted figures in financial statements in front of shareholders, which might result in questions for the management of the company. Many times such kind of scenarios occur due to fluctuation in the foreign exchange rate and considered normal.
- A company trying to mitigate translation exposure have various measurements in hands through hedging and minimalizing effect on numbers. To maintain the confidence of investors and to avoid any legal hassles, a firm needs to report, manage as well as present such exposure.
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