Translation Exposure

Updated on April 4, 2024
Article byWallstreetmojo Team
Edited byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

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, and 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. Therefore, many companies prefer to hedge such risks in the best possible way.

4 Methods to Measure Translation Exposure

#1 – Current/Non-Current Method

In this method, current assetsCurrent AssetsCurrent assets refer to those short-term assets which can be efficiently utilized for business operations, sold for immediate cash or liquidated within a year. It comprises inventory, cash, cash equivalents, marketable securities, accounts receivable, etc.read more and liabilities are valued at the currency rate, while non-current assets and liabilities are valued per the historical rate. All amounts from income statements are valued based on the currency exchange rate. In some cases, an approximated weighted average can be used if there are no significant fluctuations over the financial periods.

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#2 – Monetary/Non-Monetary Method

In this method, all monetary accounts in balance sheets such as Cash/Bank and bills payable are valued at the current rate of foreign exchange, while remaining non-monetary items in the balance sheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company.read more and shareholder’s equity are 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 on the balance sheet are converted at the current foreign exchange rate. In addition, non-monetary items are converted at historical rates. For example, all accounts of a foreign subsidiary companySubsidiary CompanyA subsidiary company is controlled by another company, better known as a parent or holding company. The control is exerted through ownership of more than 50% of the voting stock of the subsidiary. Subsidiaries are either set up or acquired by the controlling company.read more 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 sheetItems In The Balance SheetAssets such as cash, inventories, accounts receivable, investments, prepaid expenses, and fixed assets; liabilities such as long-term debt, short-term debt, Accounts payable, and so on are all included in the balance sheet.read more except shareholder’s equity are converted at the current exchange rate. In addition, all items in income statementsIncome StatementsThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements.read more are converted at an exchange rate at their occurrence.

Translation-Exposure

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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

Translation Exposure Example 1

#2 – Monetary/Non-Monetary Method

Translation Exposure Example 1-1

#3 – Temporal Method: Continued to translate as per policy.

Translation Exposure Example 1-2

#4 – Current Rate Method

Translation Exposure Example 1-3

How to Manage Translation Exposure?

#1 – Balance Sheet Hedge

This method focuses on eliminating mismatches between assets and liabilities in the balance sheet denominated in one currency.

#2 – Derivatives Hedge

The use of derivative contractsDerivative ContractsDerivative Contracts are formal contracts entered into between two parties, one Buyer and the other Seller, who act as Counterparties for each other, and involve either a physical transaction of an underlying asset in the future or a financial payment by one party to the other based on specific future events of the underlying asset. In other words, the value of a Derivative Contract is derived from the underlying asset on which the Contract is based.read more for hedging purposes might involve speculation. But, if done carefully, this method manages the risk.

  1. Swaps: A currency swap agreementCurrency Swap AgreementCurrency Swap is an agreement between the two parties for exchanging notional amount in one currency with that of another currency. It's interest rate can be fixed or floating rates denominated in two currencies. read more between two entities to exchange cash flows in the given period will help manage risk.
  2. 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 the right but not the obligation to the party to exchange a particular amount of currency on a decided exchange rate.
  3. Forwards: Two entities enter into a contract for the specific exchange rate to settle 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, which manages the risk of fluctuation in the exchange rate but still involves speculation.

Differences Between Translation Exposure vs. Transaction Exposure

DifferenceTranslation ExposureTransaction Exposure
DefinitionThe 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.
AreaLegal Requirements and accounting issues;Managing daily operations;
Foreign Affiliate/SubsidiaryIt only occurs while consolidating financial statements of parent companyParent CompanyA holding company is a company that owns the majority voting shares of another company (subsidiary company). This company also generally controls the management of that company, as well as directs the subsidiary's directions and policies.read more and subsidiary or foreign affiliate.The parent company does not require having a foreign subsidiary for transaction exposure.
Profit or LossThe result of Translation exposure is notional profit or loss.The result of transaction exposure is realized profit and loss.
OccurrenceBy 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 ImpactThe 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.
TaxTranslation 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, resulting in notional profit and losses.
  • Translation exposure poses a threat when presenting unpredicted figures in financial statements in front of shareholders, which might result in questions for the company’s management. Many times such kinds of scenarios occur due to fluctuation in the foreign exchange rate and are considered normal.
  • A company trying to mitigate translation exposure has various measurements through hedgingHedgingHedging is a type of investment that works like insurance and protects you from any financial losses. Hedging is achieved by taking the opposing position in the market.read more and minimizing effect on numbers. To maintain investors’ confidence and avoid any legal hassles, a firm needs to report, manage, and present such exposure.

This article has been a guide. What translation exposure is & its Definition. Here we discuss the different methods of measuring translation exposure and how to manage along with examples and differences with transaction exposure. You can learn more about it from the following articles –

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