Translation Exposure

Translation exposure is a type of foreign exchange exposure that causes the domestic currency value of foreign subsidiary assets, liabilities, equity, income and expenses to fluctuate due to changes in foreign exchange rate between two reporting dates. There are two main methods for translation exposure: current method and temporal method.

Parent companies are required to prepare consolidated financial statements which involves clubbing together the parent’s balance sheet and income statement with balance sheets and income statements of the subsidiaries. In many cases, the subsidiaries operate in foreign countries which means that the currency in which they do business is different from the currency of the parent company. In such cases, the parent must translate the financial statements of the subsidiary to its own currency to make the consolidation possible.

Functional currency and reporting currency

The functional currency is the currency in which a company earns most of its revenues and incurs most of its expenses. The choice of the functional currency depends on whether a foreign subsidiary is just an extension of the parent company set up to facilitate the business of the parent company in a foreign country or whether it is an entity with a separate business model and revenues and expenses.

The reporting currency is the currency in which the financial statements amounts are presented. It may be different than the function currency in which case the functional currency financial statements must be converted to the reporting currency.

There are two methods used to translate foreign currency financial statements to domestic reporting currency: the current method and the temporal method. They primarily differ in their treatment of foreign exchange gain or loss.

Current method

In the current method of translation, all the assets and liabilities on the balance sheet are converted to reporting currency based on the exchange rate on the date of the balance sheet. All income statement amounts are translated based on the foreign exchange rate that applied to the actual revenue or expense transaction or some approximated weighted average if there is no major fluctuation over the financial periods. Common stock and other shareholders equity accounts other than the retained earnings are translated at historical exchange rates. The closing retained earnings amount can be worked out using the following formula:

$$ {Closing\ RE}_D={Opening\ RE}_D+{\rm NI}_D-D_D $$

Where Closing RED and Opening RED equal the closing and opening retained earnings balance in domestic currency respectively. NID equals the net income translated based on actual exchange rate or the weighted average exchange rate and DD equals dividend payments translated based on the exchange rate on the date of dividend payment.

In the current method, any foreign exchange gain or loss is recorded as part of other comprehensive income on balance sheet.

Example: current method

You work for a US company that has a subsidiary in Europe. The functional currency of the subsidiary is Euro. The company’s total assets and total liabilities as at 31 December 2017 are EUR 200 million and EUR 140 million. Common stock is worth EUR 20 million (equivalent to USD 25 million when it was raised) and the rest represents retained earnings. USD equivalent balance of retained earnings was USD 32 million last year. Net income for the year is EUR 15 million which is earned equally through out the year. Average exchange rate that prevailed over the year was €0.82/$ and the closing exchange rate is €0.85/$

The following table summarizes the whole current method process:

Item Euro in millions Exchange Rate USD in millions Calculation
Assets 200 0.85 235.29 EUR 200 million converted at €0.85/$ closing exchange rate
Liabilities 140 0.85 164.71 EUR 140 million converted at €0.85/$ closing exchange rate
Common Stock 20 25.00 Based on the historical USD value of the common stock
Retained Earnings 40 50.29 Opening value of retained earnings of USD 32 million + net income of USD 18.3 million
Foreign exchange reserve 0 (4.70) Total assets of USD 235.29 minus total liabilities of USD 164.71 minus common stock historical value of USD 25 million minus current retained earnings balance of USD 50.29 million.
Total liabilities plus equity 200 235.29 Equal total assets value in USD.
Net income 15 0.82 18.29 EUR 15 million converted based on weighted average exchange rate of €0.82/$

Temporal method

Under the temporal method of foreign currency translation, assets and liabilities are classified into monetary assets and liabilities and non-monetary assets and liabilities. Monetary assets and liabilities are those that are to be settled in future through receipt or payment of a pre-determined units of currency. Monetary items include cash, accounts receivable, notes receivable, investments, accounts payable, salaries payable, taxes payable, etc. Non-monetary items include inventories, fixed assets, etc. Monetary items (assets and liabilities) are translated at the closing foreign exchange rate while the non-monetary items are translated at the exchange rate applicable to the date when these assets or liabilities were recognized. Further, under the temporal method, income statement items are converted at the average exchange rate that existed during the period except for revenue and expense items linked to non-monetary assets which are translated based on the exchange rates that apply to the relevant non-monetary asset. Any foreign exchange gain or loss under the temporal method is recognized as a line item on income statement. Common stock and other equity items other than the retained earnings are translated based on historical exchange rates. Retained earnings are calculated based on the following formula:

$$ {Closing\ RE}_D={Opening\ RE}_D+{NI}_D+FX\ -D_D $$

FX is the new term in this equation which stands for foreign exchange gain or loss.

Example: temporal method

Let’s illustrate the temporal method using the data in the above example with following modification: (a) 50% of assets and liabilities are non-monetary items which were acquired when the exchange rate was €0.80/$.

Item Euro in millions Exchange Rate USD in millions Calculation
Monetary assets 100 0.85 117.65 Monetary assets are converted at €0.85/$ closing exchange rate
Non-monetary assets 100 0.80 125.00 Non-monetary assets are translated at the historical exchange rate of €0.80/$.
Total assets 200 242.65
Monetary liabilities 70 0.85 82.35 Monetary liabilities are converted at €0.85/$ closing exchange rate
Non-monetary liabilities 70 0.80 87.50 Non-monetary liabilities are translated at the historical exchange rate of €0.80/$.
Total liabilities 140 169.85
Common Stock 20 25.00 Based on the historical USD value of the common stock
Retained Earnings 40 47.79 Calculated as the balancing figure.
Total liabilities plus equity 200 242.65 Equals total assets value in USD.
Net income before FX gain or loss 15 0.82 18.29 EUR 15 million converted based on weighted average exchange rate of €0.82/$
FX gain or loss (2.50) Equals the difference between income after foreign exchange gain or loss and the net income before such gain or loss.
Net income after FX gain or loss 15.79 Equals closing RE + dividedns - opening RE.

Balance sheet hedge

Translation exposure can be managed by employing a balance sheet hedge strategy. A balance sheet hedge is where a company’s matches its assets in foreign currency X with equals amount of liabilities in the same foreign currency such that its net exposure in each currency is zero. It is because a movement in foreign exchange rate changes the value of both assets and liabilities such that net translation effect is zero. A company should consider the cost of borrowing in each currency before attempting a balance sheet hedge.

Written by Obaidullah Jan, ACA, CFA and last modified on