Translation Risk

What is Translation Risk?

Whenever a foreign exchange is involved, and the operations are in multiple countries. There is an accounting risk of converting books from one currency to another. The company must book foreign currency gains or losses based on accounting methods. Although they will affect reported earnings, they do not necessarily reflect real economic gain or loss. (i.e., no effect on cash flows)

Translation risk is the exchange rate risk associated with companies that deal in foreign currencies and list foreign assets on their balance sheets. Companies that own assets in foreign countries, such as plants and equipment, must convert the value of those assets from the foreign currency to the home country’s currency for accounting purposes.

In the U.S., this accounting translation is typically done on a quarterly and annual basis. Translation risk results from how much the assets’ value fluctuates based on exchange rate fluctuations between the two countries involved.

Examples of Translation Risk

Let’s take an example of a U.S. company that borrows from a Canadian bank. If the CADUSD exchange rate decreases during the year, the USD has appreciated, and the company has incurred a foreign exchange gain. If the CADUSD exchange rate increases, then the appreciation of the CAD means the company has incurred a foreign exchange loss.

Understanding Translation Risk

Companies must report their financial performance on a quarterly basis, which involves formulating their financial statements for that quarter. The balance sheet and income statement are two of the financial statements that need to be filed. If a company has assets or revenue in a foreign country, it would likely mean that those assets and revenue would be denominated in the foreign country’s local currency.

As a result, the company must translate the value of those assets and revenue into the company’s home currency when filing its quarterly financial report. When the exchange rate between the two countries fluctuates, the translation value of those assets and revenue will fluctuate as well.

A financial gain or loss is reported, depending on the extent of the exchange rate movements during the quarter. Any gain a loss would reflect the change in the value of the company’s foreign assets based solely on the move in the exchange rate.

In actuality, the value of the assets hasn’t really changed, but by translating the value of those assets, it provides a clearer picture of what the company owns and its financial performance for that quarter. The risk that the exchange rate could move against the company and depreciate the value of those foreign assets or revenue is called translation risk.

Impact of Translation Risk

Exchange rates can change significantly between the reporting of quarterly financial statements. It causes variances between the reported figures from quarter to quarter. This can sometimes cause volatility in the company’s stock price.

For example, let’s say a U.S. company has assets in Europe valued at 1 million euros, and the euro versus the U.S. dollar exchange rate has depreciated by 10% on a quarter-to-quarter basis. The value of the assets, when converted from euros into dollar terms, would also decline by 10%. However, it’s not just the assets on the balance sheet that would decline, but revenue and net income (profit) earned in euros would depreciate as well.

As a result, a company’s reported earnings can be lower due to exchange rate fluctuations leading to a poor quarterly performance and a declining stock price.

Translation risk tends to be higher in developing countries and emerging market economies. Oftentimes, these economies are not fully developed, and the political climate is unstable, which exacerbates the exchange rate volatility of the local currency.

Managing Translation Risk

There are various financial products that companies can use to mitigate or reduce translation risk. One of the most popular products is called a forward contract, which locks in an exchange rate for a period of time. The rate lock allows companies to fix the value of their foreign assets based on the forward contract’s exchange rate.

Companies that sell products overseas and earn foreign revenue can request that their foreign clients pay for goods and services in the company’s home currency. As a result, the risk associated with local currency fluctuations would not be borne by the company but instead by the client who is responsible for making the currency exchange prior to conducting business with the company. However, the policy of shifting the exchange rate risk onto a foreign customer can backfire, if the customer doesn’t want to take on the exchange rate risk, and as a result, finds a local company to do business with instead.

Measurement of Translation Exposure

Translation exposure can often depict a distorted representation of a company’s international holdings if foreign currencies depreciate considerably compared to the home currency.

Accountants can choose among several options while converting the values of foreign holdings into domestic currency. They can choose to convert at the current exchange rate or at a historical rate prevalent at the time of occurrence of an account.

Whichever rate they choose, however, needs to be used consistently for several years, in accordance with the accounting principle of consistency. The consistency principle requires companies to use the same accounting techniques over time to maintain uniformity in the books of account.

In case a new technique is adopted, it should be mentioned clearly in the footnotes of the financial statements.

Consequently, there are four methods of measuring translation exposure:

1. 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.

2. 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.

3. 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.

4. 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.

In the example above, if there is an inventory of goods recorded in the balance sheet at its historical value of, say €1,000, its value in dollars after conversion will be $(1,000 x 1.2), or $1,200.

However, if the inventory of goods is recorded at the current market value of, say €1,050, then its value will be $(1,050 x 1.15), or $1,207.50.

In each of the methods used above, there is a mismatch between the total values of assets and liabilities after conversion. While calculating income and net profit, variations in exchange rates can distort the amounts to a great extent, which is why accountants often use hedging to do away with this risk.