ACC 401 Advanced accounting

ACC401012VA016-1194-001 - ADVANCED ACCOUNTING

Week 9 Assignment 2 - Submit Here

Rachel Bright on Sun, Jun 02 2019, 1:25 PM

 

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· ACC 401 - WEEK 9 PAPER.docx

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16. 16 http://www.informasitraining.com/foreign-exchange-risk-management

Running head: 1 FOREIGN CURRENCY RISK 1

2 FOREIGN CURRENCY RISK 5

Foreign Currency Risk

Rachel Y. Bright

Professor Repp

ACC 401

Due June 3rd, 2019

Exposure

Differentiation in the exchange rate in diverse currencies may affect the business situation. This is the situation that XYZ Inc, is likely to experience in three countries where is targeting to expand company sales through export. Once companies sell goods and services in the international market, they get paid in the local currency of the country in which they sell goods to and the amount which they are paid is likely to be lower than what they expected. The difference that comes about due to changes in the value of the company which is caused by the differences in the money market is referred to as the exposure. This is a risk and therefore, risks management is required by companies in order to develop strategies such as hedging transactions, translations and other operations that help the company to avoid diminishing in the market value and also profits.

3 The three types of risk that are identified are accounting exposure, transaction exposure, and operating exposure.  4 Accounting exposure is also referred to as translation risk.  5 This occurs when reporting and consolidating financial statements requires conversion from the foreign currency to local currency, translating foreign assets or liabilities into home currency (Francis, 1).  Transaction exposure occurs from changes in the value of foreign currency contracts as a result of the exchange rate changes.  Lastly, we have operating exposure also referred to as economic exposure. 5 It arises because exchange rate change may alter the value of future revenues and costs (Shapiro, 2).  It is used to determine the difference in the current worth of the company consequential from the changes in the streams of the revenues and costs that are likely to be caused by the unforeseen changes in the exchange rate.

If XYZ Inc expands as proposed, accounting exposure will affect the balance sheet because liabilities incurred will be translated into foreign currency to home local currency and this will affects the balance sheet. Considering transaction exposure, the contractually fixed invoice is likely to change and this will affect income statement because sales revenue will be affected. Lastly, considering economic exposure, the income statement is likely to be affected due to future unforeseen changes in the streams of revenues and cost which may be caused by changes in the exchange rates.

2 Types of hedges regarding foreign exchange risk

Hedging a particular currency exposure means establishing an offsetting currency position. One type of hedging is forward contracts where a firm’s translation exposure by creating an offsetting asset or liability in the foreign currency. Another type of hedging that we must be aware of is money market hedge. 5 It is the borrowing and lending in two different currencies to lock in the dollar value of any future foreign currency cash flow.  Considering the case of XYZ, Inc the best risk mitigation strategy would be hedging for accounting exposure, operating exposure and translational exposure because these will help XYZ Inc to avoid diminishing in the market value and also making profits from the sales (Shapiro, 2).

6 Main accounting assumptions underlying current rate and temporal method

1 The main concept underlying the temporal method is that the translation process should result in a set of translated U.S.  dollar financial statements as if the foreign subsidiary's transactions had actually been carried out using U.S.  dollars. To achieve this objective, assets carried at historical cost and stockholders' 7 equity are translated at historical exchange rates;  assets carried at current value and liabilities (carried at current value) are translated at the current exchange rate.  1 Under this concept, the foreign subsidiary's monetary assets and liabilities are considered to be foreign currency cash, receivables, and payables of the parent who are exposed to transaction risk. Balance sheet exposure under the temporal method is analogous to the net transaction exposure which exists from having both receivables and payables in a particular foreign currency.  2 On the other hand, the major concept underlying the current rate method is that the entire foreign investment is exposed to foreign exchange risk.  8 Therefore all assets and liabilities are translated at the current exchange rate.  Balance sheet exposure under this concept is equal to the net investment.

1 Translation method that XYZ, Inc.  9 should use in order to minimize balance sheet exposure

10 The translation method that XYZ, Inc should use to minimize balance sheet exposure is the temporal method.  11 This is because a balance sheet hedge requires an equal amount of exposed foreign currency assets and liabilities on a firm’s consolidated balance sheet.  1 If this can be achieved, for each foreign currency, net translation exposure will be zero.  Therefore, the firms translate using temporal method to achieve zero net exposed position which cannot be achieved using the current method and this way, balance sheet exposure is minimized ( Haimes, 3).

12 Comparison of the U.S.  GAAP approach to the IFRS approaches of translating foreign currency financial statements.

13 The similarities that exist between IFRS and U.S GAAP in terms of translation of the foreign currency is that both U.S.  9 GAAP and IFRS require entities to remeasure assets, liabilities, income, and expenses into the entity's functional currency, which is the currency of the primary economic environment in which the entity operates.  Another similarity is that both U.S. 9 GAAP and IFRS require remeasurement into the functional currency before translation into the reporting currency.  However, there is a notable difference between the two approaches. 1 Differences exist between IFRS and U.S.  10 GAAP with regard to the hierarchy of factors used to determine the functional currency.  1 IAS 21 establishes primary factors and other factors to be considered in determining an entity's functional currency.  7 When the indicators are mixed and the functional currency is not obvious, the parent must give priority to the primary indicators in determining the foreign entity's functional currency.  U.S. GAAP does not have a similar hierarchy. 14 For XYZ Inc.  15 located in a highly inflationary country, the appropriate method of translation would be a temporal method.  This method avoids disappearing plants problems that exist when the current method is bused and this the rationale for choosing it ( Sanko & Koldovskyi, 4).

In conclusion, expanding your business into the global is of great importance. However, there are possibilities of the foreign currency risk that is associated with diverse exchange rates in various countries. Some of the risks include accounting exposure, translation, and operating exposure. It is important for the business to critically understand the risk mitigation strategies that need to put in place while considering other factors such as inflation. For a form like XYZ, Inc that targets to expand sales exports in three countries, given that these locations are associated with high inflation, the best method that it can use is the temporal method because this method significantly minimizes balance sheet exposure.

Citations

1. Francis, A., (2010). 16 Foreign exchange exposure;  managerial economics. http://www.mbaknol.com/managerialeconomics/foreign-exchange-exposure

2. Shapiro, A. C. (2014). Multinational financial management. John Wiley & Sons. https://www.studocu.com/en/document/university-of-new-south-wales/international-business-finance/book-solutions/alan-c-shapiro-multinational-financial-management-wiley-2014/3172385/view

3. Haimes, Y. Y. (2015). 4 Risk modeling, assessment, and management.  John Wiley & Sons. https://books.google.com/books?hl=en&lr=&id=JvowBgAAQBAJ&oi=fnd&pg=PP11&dq=Managing+Translation+Exposure,+minimizing+balance+sheet+exposure+by+temporal+method&ots=DZ2n-UMoqC&sig=Z9EnQHl4MkBUOD34CEHoGUGfp4Y

4. Sanko, H., & Koldovskyi, A. V. (2017). Comparative analysis of IFRS and US GAAP. http://r250.sudu.edu.ua/handle/123456789/61742