The extent to which a firm is exposed or vulnerable to fluctuations in exchange rate is referred to as the exchange rate exposure and can be perceived in three different ways: Transaction exposure Translation exposure defines exchange rate risk in terms of the impact of exchange rate movement on the financial statement of the firm. When a business is organized as several separate corporations, then financial statements must be filed on a consolidated basis so as to give shareholders concise and complete information as to the financial position and the operating performance of the firm as a whole.
When subsidiary operate in a foreign country then major complications occur in consolidation process. This problem arises from the fact that financial statements of the foreign subsidiary are usually in a currency which is different form that of the parent company. The foreign currency must be converted into the home currency before accounts can be consolidated. Translation exposure therefore is the extent to which multinational firms consolidated financial statements are affected by the need to convert its foreign subsidiary accounts to the home currency.
As the value of the exchange rate fluctuates, so would be the value of the foreign subsidiary. (Shleifer A,Vishny R. 1986) Economic Exposure Economic exposure defines exchange rate risk as the total impact on all the cash flow of the firm (both contractual and non-contractual) It is broader than the other types of exposure and may be considered to be the overall impact of the foreign exchange fluctuations on the shareholders wealth. It affects both the companies that enter into foreign currency transactions and those that do not. ( Shleifer A,Vishny R. 1986) We can take care of exchange rate exposure using various techniques including:
a) Undertaking transactions denominated in home currency only. b) Entering into transactions denominated in foreign currency which is considered to be stable. E. g. dollar, sterling pound, Yen, etc. c) The use of leads or lags. Leads are advance payments while lags are delayed payments. d) A forward exchange contract is an immediate, firm and binding contract between the bank and its customer for the purchase or sale of a specified quantity of a stated foreign currency at a rate of exchange fixed when the contract is made but requiring performance at a specified future date.
A forward exchange contract can either be fixed or option. A fixed forward exchange contract requires performance to take place on a specified future date. While an option forward exchange contract requires performance to take place at any date between two specified dates e) A currency option is an agreement that gives the holder the right but not the obligation to buy or sell a certain quantity of foreign currency at a specified exchange rate at a specified future time.
f) A financial future is a standard contract between a buyer and a seller in which a buyer has a binding obligation to buy a fixed amount (i. e. the contract size) at a fixed price (the future price), on a fixed date (delivery date or the expiration date) of some underlying assets. As shown by the above discussion this is not necessarily a short-term measure and can extend to the long-term. This can be due to hedging loans among other issues. Foreign currency monetary amounts (Receivable and Payables) should be reported using the closing rate.
Non-monetary items (like property, plant and equipment) carried at historical cost should be reported using the exchange rate at the date of the transaction. Non-monetary items carried at fair value should be reported at the rate that existed when the fair values were determined. The objective of IAS 21 is to prescribe how to include foreign currency transactions and foreign operations in the financial statements of an entity and how to translate financial statements into a presentation currency.
The principal issues are which exchange rate(s) to use and how to report the effects of changes in exchange rates in the financial statements. (Needles, B. , Powers, M. , Crosson, S. (2008). ) Important definitions in IAS 21 Functional currency: This is the currency of the primary economic environment in which the entity operates. The term ‘functional currency’ is used in the 2003 revision of IAS 21 in place of ‘measurement currency’ but with essentially the same meaning. Presentation currency: This is the currency in which financial statements are to be presented. Exchange difference
Exchange differences arising when monetary items are settled or when monetary items are translated at rates different from those at which they were translated when initially recognized or in previous financial statements are reported in profit or loss in the period, with one exception. The exception is that exchange differences arising on monetary items that form part of the reporting entity’s net investment in a foreign operation are recognized, in the consolidated financial statements that include the foreign operation, in a separate component of equity; they will be recognized in profit or loss on disposal of the net investment.
If a gain or loss on a non-monetary item is recognized directly in equity (for example, a property revaluation under IAS 16), any foreign exchange component of that gain or loss is also recognized directly in equity. Prior to the 2003 revision of IAS 21, an exchange loss on foreign currency debt used to finance the acquisition of an asset could be added to the carrying amount of the asset if the loss resulted from a severe devaluation of a currency against which there was no practical means of hedging.
That option was eliminated in the 2003 revision. Foreign operation: This is a subsidiary, associate, joint venture, or branch whose activities are based in a country other than that of the reporting enterprise. This section deals with the second problem which a company may have in foreign currency translation namely the translation of complete financial statements of foreign entities (subsidiary, branches, and associate companies). The major problem is to determine which Currency to be used (determining the functional currency)
A holding company with a foreign operation must translate the financial statements of those operations into its own reporting currency before they can be consolidated into group accounts. There are two methods normally used and each method depends on whether the foreign operation has the same functional currency as the parent. IAS 21 requires the firm to consider the following factors in determining its functional currency: (i) The currency that influences the sales price for goods,
(ii) The currency of the country whose competitive forces and regulations mainly determine the sales price of its goods and services, (iii) The currency that influences labor, material and other costs. Translation Methods (a) The Presentation Currency Method (Formerly called Net investment or Closing rate method) (Chiapetta, B. , Larson, K. D. , and Wild, J. J. (2005) This approach is normally used if the operations of the operations of the subsidiary company are different from those of the parent company and therefore the subsidiary is considered to be semi autonomous from the holding company.
(b) The functional method (formerly referred to as temporal method) IAS 21 states that where the operations of the foreign entity is an integral part of the operations of the parent company i. e. the affairs of a foreign subsidiary company are so closely interlinked with those of the holding company that the business of the foreign entity is regarded as a direct extension of the business of the investing company rather than as a separate and quasi independent business – the functional currency method should be used instead of the closing rate method.
Each subsidiary company must be considered separately. The relationship between each subsidiary and the holding company must be established so that the appropriate translation method can be determined. The method should then be used consistently from period to period unless the financial and other operational relationships which exist between the investing company and the subsidiary changes. REFERENCES Chiapetta, B. , Larson, K. D.
, and Wild, J. J. (2005). Fundamental Accounting Principles (17th edition). New York: McGraw-Hill/Irwin. Needles, B. , Powers, M. , Crosson, S. (2008). Principles of Accounting (10th edition). Boston: Houghton Mifflin Company. IAS and IFRS Shleifer, A. ,Vishny,R. ,(1997), A survey of corporate governance, The Journal of Finance Shleifer A,Vishny R. (1986). Large shareholders and corporate control [J]. Journal of Political Economy.