Translation exposure (also known as translation risk) is the risk that a company’s equities, assets, liabilities, or income will change in value as a result of exchange rate changes. This occurs when a firm denominates a portion of its equities, assets, liabilities, or income in a foreign currency. It is also known as “Accounting exposure.”
Accountants use various methods to insulate firms from these types of risks, such as consolidation techniques for the firm’s financial statements and using the most effective cost accounting evaluation procedures. In many cases, translation exposure is recorded in financial statements as an exchange rate gain (or loss).
The assets, liabilities, equities, and earnings of a subsidiary of a multinational company are usually denominated in the currency of the country it is situated in. If the parent company is situated in a country with a different currency, the values of the holdings of each subsidiary need to be converted into the currency of the home country.
Such conversion can lead to certain inconsistencies in calculating the consolidated earnings of the company if the exchange rate changes in the interim period. It is translation exposure.
Methods of translation
Current/Non-current Method
The values of current assets and liabilities are converted at the exchange rate that prevails on the date of the balance sheet. On the other hand, non-current assets and liabilities are converted at a historical rate.
Items on a balance sheet that are written off or converted into cash within a year are called current items, such as short-term loans, bills payable/receivable, and sundry creditors/debtors. Any item that remains on the balance sheet for more than a year is a non-current item, such as machinery, building, long-term loans, and investments.
Current Rate Method
The current rate method is the easiest method, wherein the value of every item in the balance sheet, except capital, is converted using the current rate of exchange. The stock of capital is evaluated at the prevailing rate when the capital was issued.
Monetary/Non-monetary Method
All monetary accounts are converted at the current rate of exchange, whereas non-monetary accounts are converted at a historical rate.
Monetary accounts are those items that represent a fixed amount of money, either to be received or paid, such as cash, debtors, creditors, and loans. Machinery, buildings, and capital are examples of non-monetary items because their market values can be different from the values mentioned on the balance sheet.
Temporal Method
The temporal method is similar to the monetary/non-monetary method, except in its treatment of inventory. The value of inventory is generally converted using the historical rate, but if the balance sheet records inventory at market value, it is converted using the current rate of exchange.
Managing translation exposure
Currency Swaps
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.
Forward Contracts
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.
Currency Options
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.