Accountingexpert4u -

Foreign Currency Risk

ACC401 Advanced Accounting

Question 1

With the rising globalization and worsened currency volatility exchange rates alterations have had extensive impact on companies’ profitability and operations. Exchange rate volatility affects both conglomerate businesses and small enterprises. In the XYZ Inc. volatility of exchange rates has a significant effect on the financial statement depending on the type of the exposure. Exchange rate risks attribute to accounting, economic and transaction exposures that affect the operation of the subsidiaries in international markets (Allayannis and Ofek, 2001).

Transaction exposure occurs from the impact that exchange rate variations have on XYZ Inc. obligations such as acceptance of payments made in foreign currency denominations. However, the exposure is short-term in nature therefore business can easily adapt to it (Allayannis and Ofek, 2001).

On the other hand, accounting exposures arises due to the currency variation that is recorded in the comprehensive company financial statements generated by XYZ Inc. subsidiaries. Furthermore, it affects owners’ equity due to the translation of foreign currency in financial statements. It significantly affects the medium and long term operation of the business. XYZ Inc. is unable to predict the company’s revenues from the foreign subsidiaries due to currency fluctuations on the financial statements. Besides, it affects the projected company profits. The operation exposure affects XYZ Inc. competitive position. Moreover, XYZ Inc. is unable to predict the company revenues from foreign subsidiaries that result in financial statement alterations. Operation exposures are difficult to deal with since exchange rates are tricky to predict, thus XYZ Inc. would be unable to make reliable budgets in its foreign subsidiaries since it wholly depend on the exchange rate forecast assumptions (Allayannis and Ofek, 2001).

Operation exposure also referred to as Economic exposure is a critical risk caused by the impact of unexpected currency variations on the projected company cash flows and estimated market value. XYZ Inc. cash flows would reduce or increase depending on the prevailing market exchange rates in its foreign subsidiaries. Thus, operating exposures results in changes in operating cash flows that affect the comprehensive financial cash flow (Allayannis and Ofek, 2001).

Question 2

Hedging involves taking a position that leads to the rise or fall in the value of a currency or offset that result in alteration in the worth of an existing financial position. There are various costs benefits associated with hedging such as improvement in company planning capabilities and reduction in the probabilities of the occurrence of financial distress. Furthermore, it improves the comparative advantages of the management over shareholders as it assists in the comprehension of company currency risks (Allayannis and Ofek, 2001).

In perfect markets, companies do not necessarily hedge against currency exchange risk although companies add values by hedging in an imperfect market. Businesses can take several risk mitigation strategies to help deal with foreign exchange risks that affect business operations. Various hedging methods are used to deal with currency exchange risks. These hedging methods include Forward or future contract hedging, Hedging through a Money-Market and using foreign currency option (Allayannis and Ofek, 2001). In Hedging by Money Market, companies borrow and lend using foreign currency. Moreover, Forward or Future Contracts can assist companies’ hedge against foreign currency risks. It involves the purchase of forward or futures. Forward contracts are the commitment made to pay given money either to a supplier or manufacturer or distributor a particular date in the future. Thus, companies can plan for the projected foreign currency changes and make their payments at a specific future dates. Companies use forward contracts to buy foreign currency to cover all their foreign currency payable denominated transactions (Adler and Dumas, 1984).

Question 3

There are two methods for foreign financial statement translations. These are the temporal and the current rate method. In the currency rate method, involve the translation of the foreign affiliate’s financial statements into the company reporting currency (Allayannis and Ofek, 2001). Moreover, all the company’s liabilities and assets are translated into the new market exchange rates. The current method assumes the accounting principle historical concept law (Adler and Dumas, 1984).

The temporal method assumes the various individual line item assets for instance net plant, inventory, and equipment. These items are regularly restated to show the current market value. Thus, temporal method result only in the translation of liabilities and assets in their present costs meaning the historic liabilities and costs assets are not exposed. However, the current process shows all the expenses of the assets and the liabilities (Allayannis and Ofek, 2001).

Question 4

Both temporal and current methods of translation are significant and critical for XYZ Inc. financial transactions and recording. It is because the temporal process is enabled foreign non-monetary assets to be recorded at their original costs in the XYZ Inc. consolidated financial statement. However, in the XYZ Inc. case it is reasonable for the company to utilize the current method in their financial translation since foreign exchange markets is a volatility market, therefore, the currency fluctuates (Allayannis and Ofek, 2001). The present method allows for the variability of the accounted earnings. It is because of the translation gains, or losses are removed. All these gains and losses on the translations are directed to the reserve account. They thus do not affect the XYZ Inc. financial statements such as the income statements even though it violates the historical concept accounting principle (Adler and Dumas, 1984).

Moreover, the current method is appropriate as it does not change the balance sheet ratios, for instance, the debt-to-equity ratio, current ratio, asset turnover ratio and company margins. It is because the relative amounts in the company balance sheet accounts are not altered whatsoever. Therefore, in dealing with the fluctuating foreign exchange markets it is significant for XYZ Inc. to use the current method in financial statement translation to reduce balance sheet exposure (Allayannis and Ofek, 2001).

Question 5

US GAAP and IFRIS have similar conditions as regard to the financial statement translation by an entity. For instance, the translation of financial transactions and accounts dominated in foreign currency are recorded at the current exchange rates due on the transaction date. The company’s liabilities and assets are also re-translated during the close of the financial year with the current exchange rates (Bellandi, 2012).

Similarly, the income statements proportions, non-monetary foreign currency liabilities and assets are translated by applying the historical exchange rates used in that time. Also, the exchange rates gains and losses from the subsidiary entities foreign currency transactions are accounted as part of the profit or loss in that financial year (Bellandi, 2012).

In consolidated financial year statement translation into other currency US GAAP and IFRIS require liabilities and assets to be translated by applying the exchange rates at the close of the exercise. Using the average rate, all the proportions in the income statements are translated in the present accounting period provided there is no significant fluctuation in the exchange rate (Bellandi, 2012).

However, US GAAP and IFRIS differ in the equity translation. For instance, IFRIS does not provide for capital account translation whereas US GAAP uses historical dates in equity account translation (Bellandi, 2012).

References

Allayannis, G., & Ofek, E. (2001). Exchange rate exposure, hedging, and the use of foreign currency derivatives. Journal of international money and finance, 20(2), 273-296.

Adler, M., & Dumas, B. (1984). Exposure to currency risk: definition and measurement. Financial management, 41-50.

Bellandi, F. (2012). Dual Reporting for Equity and Other Comprehensive Income under IFRSs and US GAAP (Vol. 10). John Wiley & Sons.