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Meaning of Translation Exposure
Translation exposure is a risk of the value of a company’s assets, equities, income or liabilities changing due to fluctuations in exchange rates. Firms which denominate a portion of their assets, liabilities, and equities in a foreign currency face this risk.
Translation exposure is mainly faced by multinationals as their operations and assets are based in foreign currencies. Firms that produce goods or services that are sold in foreign markets are also affected by this risk.
On knowing the meaning of translation exposure, let us have a look at how to measure the same.
Measuring Translation Exposure
The following are the methods of measuring translation exposure:
Current assets and liabilities having a maturity of one year or lesser are translated at the current exchange rate. Noncurrent assets and liabilities are converted at the past exchange rate that prevailed at the time the asset or liability was recorded in the books. Under this method, a foreign subsidiary owning current assets in excess of the current liabilities will incur a translation gain if the local currency appreciates. The income items are usually calculated at the prevailing exchange rate. While, the depreciating items, falling under non-current items are calculated at the historical exchange rate.
In this method, all monetary balance sheet accounts such as cash, notes payable, accounts payable and marketable securities of a foreign subsidiary are converted at the current exchange rate. The remaining nonmonetary balance sheet accounts and shareholder’s equity are converted at the past exchange rate when the account was recorded. This method works on the philosophy that monetary accounts are similar as their value is equivalent to an amount of money, the value of which changes with fluctuations in exchange rates. The monetary/nonmonetary method categorizes accounts on the basis of similarities of attributes rather than maturities.
In the temporal method, monetary accounts, both current and noncurrent, such as receivables, payables, and cash are converted at the current exchange rate. The other balance sheet accounts if carried out on the books at current value are converted at the current rate. However, if they are carried out in the past, they are converted into the historical rate of exchange that prevailed during that time. Cost of goods sold and depreciation are converted at the historic rates if the balance sheet accounts associated with it were carried out at historical costs.
Current Rate Method
Under this method, all balance sheet accounts except for stockholder’s equity, are converted at the prevailing current exchange rate. The income statement items are converted at the existing exchange rate on the dates the items are recognized.
After gaining an insight on measuring translation exposure, we will now have a look at how to manage the same.
Translation Exposure Management
The following are the ways to manage or hedge translation exposure:
Currency swaps are a settlement between two entities to exchange cash flows denominated for a particular currency for a fixed time frame. Currency amounts are swapped for a predetermined period and interest is paid during that time span.
The Currency option gives the right to the party to exchange the amount of a particular currency at an agreed exchange rate. However, the party is not obligated to do so. Nevertheless, the transactions must be conducted on or before a set date in the future.
Under the forward contracts, two entities fix a specific exchange rate for the interchange of two currencies for a future date. The settlement for the agreed amount of currencies is conducted on the particular future date which is pre-decided.
Translation exposure is bound to take place in entities having foreign operations or dealing with foreign currencies. Nevertheless, there are ways which can be adopted to mitigate the exposure risk involved.