What is Translation Risk?
Translation Risk is the risk of change in the financial position of the company (assets, liabilities, equity) due to exchange rate changes. It is usually seen while reporting the consolidated financial statements of multiple subsidiaries operating overseas in domestic currency.
The effect is mainly on the multinational firms which operate in international transactions intentionally because of their customer and supplier base. In this scenario, translation risk is more like a continuous phenomenon that needs to be recorded every year in the financial statements. Additionally, it also affects the firms that have assets in the foreign currency, and the same need to be realized or reported in the domestic currency. This is mostly a one-time phenomenon, and proper accounting procedures need to be implemented else it may lead to legal hassles.
Since currency fluctuations are difficult to predict, translation risk can be unpredictable, making it more complex to report and hence is watched closely by regulatory bodies. Translation risk is different from transaction risk, which affects the firm’s cash flow due to the currency volatility risk.
Example of Translation Risk
Let’s consider a simple example of translation risk and how it affects the firms. Consider a multinational corporation operating in UK and US geographies. By operating, we mean, the firm has assets and liabilities in both the countries.
Let’s assume the US office of this firm suffers an operating loss of $ 10,000. However, the UK division in the same reporting period makes a net profit of £ 8,000. Since the conversion rate of dollar and pound is 0.80, the firm effectively doesn’t make any loss or profit.
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The loss in the US branch has nullified its profit in the UK. So far, so good. Before the parent company consolidates all these figures and prepares the interim reports, there is a change in macroeconomic scenarios.
The BREXIT discussions have intensified, which has affected the price of the Pound sterling. Similarly, because of economic tensions between the US and Iran in the middle east, the crude price and dollar price have fluctuated. These scenarios lead to the shift in the dollar pound exchange rate from .80 to 1.0.
The profit which was canceled out due to gain in the UK division suddenly became very small, leading to a net gain for the parent company. The table below summarizes both the scenarios.
This effectively means that even though at the time of realization, there was no profit/loss, now the company should report a loss as the scenarios have changed because of currency fluctuations. Although hypothetical, this is one of the simplest examples of Translation risk.
Important Points to Note About the Change in Translation Risk
- Translation risk is usually a legal driven change required by regulators. It arises only when the parent company decides to report a consolidated financial statement. For example, if FMCG major Unilever reports a consolidated financial statement for its US, UK, and Europe subsidiary, it will face translation risk. However, if it keeps these subsidiary companies independent, there is no translation risk. Simply put, translation risk is not a change in the cash flow but only a result of reporting consolidated financials.
- Since this risk does not affect the cash flow but only the reporting structure, no question arises of any tax exemption that the firm can make use of. Also, there is no change in the value of the firm because of translation risk, unlike other risks and exposures. In simple terms, it is more of a measurable concept rather than the cash flow concept. An important point to note is that it is recorded when reported and not when realized. Hence it won’t be wrong to say that it results only in notional gain or losses.
- The risk arising because of translation risk sits on the balance sheet of the firm as translation exposure. There can be multiple methods to measure it like Current/no current method, monetary/ non-monetary method, temporal method, and current rate method. Similarly, firms can utilize multiple ways to manage this exposure, like using derivative/exotic financial products like currency options, currency swaps, and forward contracts. We will skip the details around these as these are complex topics and can be covered separately.
- Translation risk poses a threat in presenting unexpected figures upfront, which can lead to some difficult questions raised by shareholders for the management. However, if the situation is a temporary one and the unpredictable fluctuations in currency might return to normal, it should not affect the firm much. This is because these might get reversed in the next accounting period when the macroeconomic situations have improved, and the currency market has moved in the favorable direction of the firm. However, this should not be a reason for not preparing for translation risk, and management should have proper procedures to counter such unfavorable movements in currency.
Translation exposure arising from translation risk is specific for firms that operate in foreign transactions or deal in foreign currencies. It is more of a corporate treasury concept to describe risks that a company faces when it deals with foreign clients, thereby foreign transactions.
These foreign transactions can be anything like paying their suppliers in a different currency or getting payments from their customers in foreign currency. An entity that wants to mitigate translation risk should engage in hedging through derivatives or exotic financial products so that the currency fluctuations have minimal effect on its numbers.
Failing to do so may result not in legal hassles but also investor fury even though the firm might be dealing only in a one-time international transaction. For a listed firm, it becomes all the more important as any such red flag might lead investors to lose confidence in the firm.
This has been a guide to what is translation risk and its definition. Here we discuss how Translation Risk affects firms along with practical examples and key points. You may learn more about Risks from our articles below –