Financial Currency risk is the possibility of currency depreciation negatively affecting the company’s assets, and investments value, or that of their linked interests and dividends payment streams. Such risks exist when a currency other than the company’s base currency dominates financial transactions. This paper analysis accounting, operating and transaction exposure, and their effects on financial statements. The paper also reports on the types of hedges regarding currency risks and examines accounting assumptions underlying various currency translation methods. This paper suggests the most appropriate currency translation method that XYZ, Inc. should adopt. Additionally, the paper compares GAAP and IFRS approaches to translating foreign currencies financial statements.
Accounting, Operating and Transaction Exposure
Accounting exposure refers to the risk faced by a company that variation in the foreign exchange rate may affect the value of their properties, ownership, obligations, like account payable or alters incomes derived from them, like account receivable ( Menkhoff, Sarno, Schmeling & Schrimpf, 2016) . Companies experience accounting exposure when international exposure dominates a portion of their equities, assets, liabilities or income. For instance, a decrease in value of a foreign currency causes a reduction in the cost of a company’s assets regarding its local currency.
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Financial Statement Effect: Accounting exposure changes owner’s equity in consolidated financial statements due to fluctuations in exchange rate.
Operating Exposure or Economic Exposure refers to the risk of change in a company’s present or market value due to unexpected fluctuations of the foreign exchange and inflation rates, which forms are the basis for corporate budgetary forecasts ( Menkhoff, Sarno, Schmeling & Schrimpf, 2016) . Such exposure has a long-term effect on a company, as they undermine a company’s monies inflows, foreign outlay, and incomes, as it is long-lasting.
Financial Statements Effects: Operating Exposure results in an overall alteration of a company’s value thus affecting the cash flow statement and the number of foreign investments and total assets.
Transaction Exposure is the risk of a company incurring losses due to change in exchange rates in the course of a business transaction that is, between booking and final settlement dates. Transaction exposure only applies to companies participating in operations in different currencies that are cross-currency transactions.
Financial Statements Effect: Transaction Exposure affects the obligations or liabilities of a company. If the foreign currency depreciates about the local currency, the company ends up incurring less. However, they also receive less foreign inflows and vice versa.
Hedges Regarding Foreign Currency Risks
Foreign Currency Hedging is the technique applied by multinational companies to exclude foreign currency exchange risks that may arise from multi-currency relations ( Singh, 2017) . Commonly, companies employ cash flow hedge and fair value technique to mitigate such risks.
Cash Flow Method
The hedging is designed to eliminate probable variation in monies inflows connected to specific risks related to certain recognized assets or liabilities, or associated with an extremely feasible projection transaction ( Singh, 2017) . Such variation is capable of affecting a company’s profits or losses, which is the method’s primary concern. The associated risk could influence the amounts recorded as the net income. The hedging instruments are recorded at fair value, and comprehensive income is the offsetting account. Cash flow hedging allows gains and losses on position to reflect in the net income.
Fair Value Method
The method mitigates exposure attributable to the change in the reasonable worth of properties and obligations recorded on the balance sheet. Both techniques record similar amounts. However, the method makes a direct adjustment on the asset or liability and not to the comprehensive income holding account, as for the cash flow hedge ( Singh, 2017) .
Appropriate for XYZ
Fair Value method is most appropriate for XYZ since the original company will be selling merchandise to subsidiaries as inventory items. Fair value method is most appropriate in hedging inventories, account receivable and account payable since they are items of the balance sheet. This method mitigates the value of such items, thus maintaining the wealth of the company, rather than concentrating on the profitability of the venture.
Accounting Assumptions Underlying Translation
Current Rate Approach translates all the company’s assets and liabilities at the present rate at the day of compiling the balance sheet and not the rate at the transaction date. Equity items, like dividends, are translated by using past rates, the rate at the day transaction happened. The method translates objects of income statement using actual rates. An average rate may apply due to the impracticality of applying various rates.
Temporal Method applies both current rate and historical rate in translating assets and liabilities. It translates balance sheet items based on the entity’s books. Items like receivable less are valued at a fair the market value while others like fixed assets are valued at historical purchasing costs. The method avoids translating the items at fixed rates that do no longer apply.
Differences in Balance Sheet Exposure
Eliminating or reducing exposure is more efficiently using a temporal method than when the current rate approach is adopted. In the temporal mode, a company may minimize exposure by selling currency, reducing equity and increase liabilities, which do not apply when using the current method. Under the current method, the company’s capital is its exposure for that currency, and need to be eliminated. On the other hand, the temporal method enables exposure to be reduced using monetary assets or liabilities.
Translation Method for XYZ to Adopt
The temporal method is the most appropriate approach for XYZ Inc. to adopt since it is more straightforward and more effective in reducing balance sheet exposure. Unlike the current rate method, which applies a fixed rate for all liabilities and assets, the temporal approach involves both the current and fixed rates. The company’s inventories would be valued at the prevailing rate, while non-current properties would be valued at the historical purchasing rate. In reducing the balance sheet exposure, the company needs to minimize equity, sell currency or increase liabilities. These methods are not available while using the current rate method, making it less favorable for the company. Valuing a company’s inventories and other possessions, and obligations at the current degree are important, as it avoids the use of fixed rates that do not apply. Exposure could also be reduced by using monetary assets or liabilities.
Comparison of GAAP and IFRS Translation Approaches
Similarity
In both GAAP and IFRS approach, the hedge value is derived from the value of the underlying asset or liability ( Singh, 2017) . Both methods, derivatives are grouped on the balance sheet and valuation indicated on the footnotes. Both entities also call for a company to unveil sufficient statistics that could allow reconciliation of balance sheet items.
Differences
US GAAP stated that a company’s properties and obligations should be noted at a reasonable value while IFRS felt that companies should report their assets and liabilities on their books at historical cost. GAAP discouraged hedging of an asset or liability that could result to a foreign exchange deal loss or gain, while two years later; IFRS allowed the hedging of such items using both the cash flow and fair value hedging methods ( Singh, 2017) . The amount recorded at payment or reception would differ from the value of derivative recorded under GAAP. The balance would be hedged in the IFRS approach, unlike in GAAP.
Translation Method under FASB
According to FASB Rule 52, a company that operates in a hyperinflation environment should apply the temporal foreign exchange translation method ( Menkhoff, Sarno, Schmeling & Schrimpf, 2016) . Unlike the current rate method, which involves a single rate in valuing properties and obligations, the temporal system includes both the current rate and historical rate. FASB provides that an asset and liability need to be prized at historical charge other than the fair value, which is in line with the temporal method. Valuation of properties and obligations is possible by means of the cash flow or fair value hedge. SFAS, a component of FASB requires derivative properties to be valued at a reasonable value based on the prevailing spot rate.
Conclusion
In conclusion, the paper explores the foreign currency risks associated with companies whose transactions involve different currencies. Accounting, operating and transaction exposure, and their effects on financial statements have been reported. Hedging enables entities to reduce exposure. Two commonly used types of hedges are cash flow and fair value ( Singh, 2017) . Additionally, this paper examines the fundamental differences between US GAAP and IFRS in dealing with current rate and temporal translation methods. The paper also illustrates the accounting assumptions underlying the two translation methods and concludes that the temporal approach is the most appropriate for XYZ to reduce or eliminate balance sheet exposure.
References
Menkhoff, L., Sarno, L., Schmeling, M., & Schrimpf, A. (2016). Information flows in foreign exchange markets: Dissecting customer currency trades. The Journal of Finance , 71 (2), 601-634.
Singh, J. P. (2017). Hedge accounting under IFRS 9&58; an analysis of reforms. Audit Financier , 15 (145), 103-113.
