Translation exposure definition
/What is Translation Exposure?
Translation exposure is the risk of having changes in foreign exchange rates trigger losses on business transactions or balance sheet holdings. These losses can occur when a firm has assets, liabilities, equity, or revenue denominated in a foreign currency and needs to translate them back into its home currency. Translation is required by the accounting standards when preparing consolidated financial statements.
What Causes Translation Exposure?
Translation exposure is most common in two situations. One is when a company has subsidiaries located in other countries, and the other is when a business engages in significant sales transactions in other countries. In both cases, there is a risk that an unfavorable change in the applicable exchange rates could cause a loss on the books of the reporting entity. These businesses can engage in hedging transactions to reduce their translation exposure.
How to Measure Translation Exposure
There are several ways to measure translation exposure; they are as follows:
Current rate method. The current rate method translates all assets and liabilities at the current exchange rate as of the balance sheet date, while equity accounts are translated at historical rates. Revenue and expense items are usually translated at the average rate for the period. Translation adjustments are recorded in a separate component of equity called the cumulative translation adjustment.
Temporal method. The temporal method translates monetary items (like cash and receivables) at current rates and non-monetary items (like inventory and fixed assets) at historical rates. Revenue and expenses related to non-monetary assets are translated at the same rate as the related asset. Any translation gain or loss flows through the income statement, making this method more volatile than the current rate method.
Monetary/non-monetary method. This method is similar to the temporal method but classifies items based solely on whether they are monetary or non-monetary, rather than by functional currency. Monetary assets and liabilities are translated at the current exchange rate, while non-monetary ones are translated at historical rates. Translation gains or losses are reported in the income statement, emphasizing the exposure of monetary items to exchange rate changes.
Closing rate method. Under the closing rate method, all balance sheet items are translated at the closing (current) exchange rate, regardless of their classification. Income statement items are typically translated at the average rate for the reporting period. This method simplifies translation but can distort asset valuations and does not reflect historical cost principles.
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How to Hedge Translation Exposure
There are several methods available for hedging translation exposure, which are as follows:
Require payment in home currency. One approach is for the business to require its customers to pay it in the entity’s home currency. This means that the firm never deals with foreign currency, and instead forces its customers to taken on this risk. This approach is possible, but only if the seller has so much market power that it can force its customers to take on the translation exposure.
Currency swap contract. The seller can enter into a currency swap contract, where it pays a fee to acquire or sell the necessary currency at a fixed exchange rate on a future date.
Currency forward contract. The seller can enter into a forward contract to sell the expected amount of foreign currency that will be received on a future date, at a predetermined exchange rate on that date. Doing so locks in the exchange rate, though the seller will incur the cost of the contract.
Terms Similar to Translation Exposure
Translation exposure is also called accounting exposure.