Translation exposure, also known as accounting exposure, arises from the need, for purposes of reporting and consolidation, to convert the financial statements of foreign operations from the local currencies (LC) involved to the home currency (HC). If exchange rates have changed since the previous reporting period, this translation, or restatement, of those assets, liabilities, revenues, expenses, gains, and losses that are denominated in foreign currencies will result in foreign exchange gains or losses. The possible extent of these gains or losses is measured by the translation exposure figures. The rules that govern translation are devised by an accounting association such as the Financial Accounting Standards Board (FASB) in the United States, the parent firm’s government, or the firm itself. Appendix 10A discusses Statement of Financial Accounting Standards No. 52 (FASB 52)—the present currency translation method prescribed by FASB.
Exhibit 10.1 Comparison of Translation, Transaction, and Operating Exposures
Transaction exposure results from transactions that give rise to known, contractually binding future foreign-currency-denominated cash inflows or outflows. As exchange rates change between now and when these transactions settle, so does the value of their associated foreign currency cash flows, leading to currency gains and losses. Examples of transaction exposure for a U.S. company would be the account receivable associated with a sale denominated in euros or the obligation to repay a Japanese yen debt. Although transaction exposure is rightly part of economic exposure, it is usually lumped under accounting exposure. In reality, transaction exposure overlaps with both accounting and operating exposure. Some elements of transaction exposure, such as foreign-currency-denominated accounts receivable and debts, are included in a firm’s accounting exposure because they already appear on the firm’s balance sheet. Other elements of transaction exposure, such as foreign currency sales contracts that have been entered into but the goods have not yet been delivered (and so receivables have not yet been created), do not appear on the firm’s current financial statements and instead are part of the firm’s operating exposure.
Operating exposure measures the extent to which currency fluctuations can alter a company’s future operating cash flows—that is, its future revenues and costs. Any company whose revenues or costs are affected by currency changes has operating exposure, even if it is a purely domestic corporation and has all its cash flows denominated in home currency.
The two cash-flow exposures—operating exposure and transaction exposure—combine to equal a company’s economic exposure. In technical terms, economic exposure is the extent to which the value of the firm—as measured by the present value of its expected cash flows—will change when exchange rates change.