Translation Risk
July 4th, 2009
Translation risk is slightly more complex and is the result of the consolidation of parent company and foreign subsidiary financial statements. This consolidation means that exchange rate impact on the balance sheet of the foreign subsidiaries is transmitted or translated to the parent company’s balance. Translation risk is thus balance sheet currency risk. While most large multinational corporations actively manage their transaction currency risk, many are less aware of the potential dangers of translation risk.
The actual translation process in consolidating financial statements is done either at the average exchange rate of the period or at the exchange rate at the period end, depending on the specific accounting regulations affecting the parent company. As a direct result, the consolidated results will vary as either the average or the end-of-period exchange rate varies. Thus, all foreign currency-denominated profit is exposed to translation currency risk as exchange rates vary. In addition, the foreign currency value of foreign subsidiaries is also consolidated on the parent company’s balance sheet, and that value will vary accordingly. Translation risk for a foreign subsidiary is usually measured by the net assets (assets less liabilities) that are exposed to potential exchange rate moves.
Problems can occur with regard to translation risk if a corporation has subsidiaries whose accounting books are local currency-denominated. For consolidation purposes, these books must of course be translated into the currency of the parent company, but at what exchange rate? Income statements are usually translated at the average exchange rate over the period. However, deciding at what exchange rate to translate the balance sheet is slightly more tricky. There are generally three methods used by major multinational corporations for translating balance sheet risk, varying in how they separate assets and liabilities between those that need to be translated at the “current” exchange rate at the time of consolidation and those that are translated at the historical exchange rate:
The all current (closing rate) method
The monetary/non-monetary method
The temporal method
As the name might suggest, the all current (closing rate) method translates all foreign currency exposures at the closing exchange rate of the period concerned. Under this method, translation risk relates to net assets or shareholder funds. This has become the most popular method of translating balance exposure of foreign subsidiaries, both in the US and worldwide. On the other hand, the monetary/non-monetary method translates monetary items such as assets, liabilities and capital at the closing rate and non-monetary items at the historical rate. Finally, the temporal method breaks balance sheet items down in terms of whether they are firstly stated at replacement cost, realizable value, market value or expected future value, or secondly stated at historic cost. For the first group, these are translated at the closing exchange rate of the period concerned, for the second, at the historical exchange rate.
The US accounting standard FAS 52 and the UK’s SSAP 20 apply to translation risk. Under FAS 52, the translation of foreign currency revenues and costs is made at the average exchange rate of the period. FAS 52 generally uses the all current method for translation purposes, though it does have several important provisions, notably regarding the treatment of currency hedging contracts. Under SSAP 20, the corporation can use either the current or average rate. Generally, there has been a shift among multinational corporations towards using the average rather than the closing rate because this is seen as a truer reflection of the translation risk faced by the corporation during the period.
Translation risk is a crucial issue for corporations. Later in this blog, we will look at methods of hedging it. For now, it is important to get an idea of how it can affect the company’s overall value.
Filed under: Risk