What is Translation Exposure
Translation exposure 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).
BREAKING DOWN Translation Exposure
Translation exposure is most evident in multinational organizations, since a portion of their operations and assets will be based in a foreign currency. It can also affect companies that produce goods or services that are sold in foreign markets even if they have no other business dealings within that country.
In order to properly report the organization's financial situation, the assets and liabilities for the whole company need to be adjusted into the home currency. Since an exchange rate can vary dramatically in a short period of time, this unknown, or risk, creates translation exposure. This risk is present whether the change in the exchange rate results in an increase or decrease of an asset's value.
Translation Risk With Foreign Assets
Translation risk can lead to what appears to be a financial gain or loss that is not a result of a change in assets, but in the current value of the assets based on exchange rate fluctuations. For example, should a company be in possession of a facility located in Germany worth €1 million and the current dollar-to-euro exchange rate is 1:1, then the property would be reported as a $1 million asset. If the exchange rate changes, and the dollar-to-euro ratio becomes 1:2, the asset would be reported as having a value of $500,000. This would appear as a $500,000 loss on financial statements, even though the company is in possession of the exact same asset it had before.
Hedging Translation Risk
A variety of mechanisms are in place that allow a company to use hedging to lower the risk created by translation exposure. One technique includes the purchasing of foreign currency, while others involve the use of currency futures or currency swaps.
Transaction vs. Translation Exposure
There is a distinct difference between transaction and translation exposure. Transaction exposure involves the risk that when a business transaction is arranged in a foreign currency, the value of that currency may change before the transaction is complete. Should the foreign currency appreciate, it will cost more in the business’s home currency. Translation risk focuses on the change in a foreign-held asset’s value based on a change in exchange rate between the home and foreign currencies.