Accounting Implications of Foreign Currency Transactions Translation

Introduction

Over the past few decades, the contemporary business environment has been characterized by a rapid rate of expansion amongst business entities. The international market is one of the investment destinations that businesses are increasingly venturing in the recent times. Subsequently, the development of sufficient knowledge on international concepts such as international accounting is critical in order to attain operational efficiency. Some of the most important international accounting pragmatic aspects that businesses should consider in their operations relate to foreign currency hedging, foreign currency translation, and consolidation. According to Bogicevic (2013), foreign currency translation entails the process of restating accounting data, which is designated in a particular currency, into another. Foreign currency accounting is important in ensuring effective recording of transactions involving foreign currency in an organization’s accounting books. Therefore, an organization is in a position to prepare financial statements that reflect an organization’s financial performance. Moreover, foreign currency accounting enables companies to consolidate the financial statements of subsidiary firms, which are established in foreign markets (Bogicevic 2013).

International operations expose firms to different risks as opposed to firms whose dealings are domiciled in the home country. The risks originate from different sources. One of the major sources relates to foreign currency fluctuations arising from monetary transactions involving foreign currency. The incurred risk is directly reflected in an organization’s level of profitability and cash flows. In order to eliminate or avoid such negative impacts, it is imperative for firms operating in the international market to incorporate effective measures. One of the most effective strategies is hedging. Henderson, Pierson, and Herbohn (2013, p. 73) affirm that hedging is attained by ‘avoiding open positions in foreign exchange, viz. the imbalances in assets and liabilities are denominated in foreign currencies’. This paper highlights the major aspects involved in transactions made in foreign currency coupled with how to manage foreign exchange risks that arise from the fluctuation of foreign exchange rate.

Accounting aspects involved in foreign currency translation

According to Bogicevic (2013, p. 139), ‘foreign currency translation entails the expression of the financial data of a particular entity denoted in a particular currency into another using appropriate exchange rates’. Accountants can adopt either the historical rate or current rate in translating transactions involving foreign currency. The importance of foreign currency translation arises from the need to enhance an organization’s capacity to represent its financial performance from its international investments and operations due to currency fluctuations. Moreover, the need for currency translation is further anchored on the need to enhance transparency in reporting financial transactions involving inter-currency fluctuations. Translation of financial data increases enables an organization to eliminate information asymmetry that limits the relevance of data to local and foreign users. Therefore, the relevance of financial currency translation is considerably high for multinational enterprises [MNEs] as opposed to local entities. The subsidiaries established in the foreign countries are in a position to report their independent financial transactions to the parent company. Through currency translation, MNEs are capable of preparing consolidated financial statements.

Despite the advocacy by some Euro Union member countries for demonetization of currency, most EU countries are still characterized by currency heterogeneity, which further underscores the importance of currency translation. The available literature cites foreign currency translation and hedging as some of the most intricate international financial reporting aspects (Bogicevic 2013). The complexity originates from the high and progressive rate of currency fluctuation experienced in the money market. This aspect means that the rate of exchange is not constant. MNEs have a duty to translate transactions involving diverse currencies, whose rate of exchange vary. Henderson, Pierson, and Herbohn (2013) emphasize that MNEs’ accountants face two main challenges arising from the lack of a constant/fixed exchange rate. First, they have to make a decision on the rate of exchange to use [historical/current] in recording assets and liabilities involving transactions denominated in foreign currency. The second challenge entails making decisions about how to report gains and losses emanating from currency fluctuations [translation differences].

In order to succeed in undertaking accounting processes within the international context, it is imperative for accountants to focus on two main areas, which include:

1. Translating foreign currency transactions
2. Translating foreign currency financial statements

Currency translation methods

Accountants can integrate different currency translation methods. In addition, accountants can use alternative methods to assess translation [accounting] exposure. Some of the common currency translation methods are explained herein:

1. Closing rate method – According to Khan and Jain (2006, p. 878), ‘closing rate method entails the translation of all statements of financial position items and all statement of comprehensive income items including depreciation at the exchange rate at the close of a reporting period’.
2. Temporal method – under this method, the financial transactions are translated using the rate of exchange that existed during the transaction. Thus, historical cost is used in recording transactions.
3. Current/non-current rate method – Under this approach, multinational corporations translate current account entries involving foreign currency using the prevailing exchange rate. Conversely, non-current accounts are translated using historical exchange rates.
4. Monetary/non-monetary method – this method entails using the current rate in making translations related to monetary accounts such as accounts receivables, long-term debts, and accounts payable.

The existence of diverse methods of translation has led to the emergence of diverse translation results in addition to varying degree of foreign exchange risk exposures.

Treatment of foreign currency transactions

Accountants encounter diverse challenges in the process of making entries in books of accounts and preparing financial statements due to the requirement to undertake the translation of foreign currency transactions (Butler 2012). Moreover, accountants have a duty to distinguish between foreign import and export transactions. The distinction between import and export transactions originates from the view that international transactions are mainly conducted using a specified currency, and thus the need for currency translation is minimized. Multinational corporations also engage in other transactions involving foreign currency such as seeking loans from financial institutions within the host country. Other items involving foreign currency include purchasing forward exchange contracts and foreign currency units.

Accountants are of the view that it is imperative to adopt effective rate of exchange in making accounting entries involving foreign currency transactions. Moreover, unrealized amount should be adjusted accordingly in the balance sheet. However, the adjustment should be undertaken using the rate before the actual date of payment. Accountants also face challenges in treating differences arising from the actual amount settled and the recorded amount in a particular foreign transaction, which refer to the gains and losses encountered in foreign transactions. Therefore, foreign transactions can be treated based on two main perspectives, which include the single-transaction and the two-transaction perspectives.

According to the single-transaction approach, transactions involving foreign currency should not be decomposed into either monetary or real components. On the contrary, they should be regarded as single business events. Therefore, the changes arising from foreign exchange fluctuation are treated as sales revenue or accounts receivables on foreign currency account. The sales account balance should be considered as the retained earnings opening balance. Unlike, the single-perspective, the two-transaction approach assumes that transactions involving foreign currency should be categorized into

1. Purchase and sale of goods
2. Settlement/collection of receivables and debt obligations

The effects of sale and purchase transactions are recorded separately in the financial statement. The treatment of foreign currency transactions under the two perspectives differ considerably. First, under the single-transaction approach, an organization’s sales revenue is adjusted in order to incorporate changes in the rate of exchange. Thus, a high level of transparency is attained in recording the gains and losses incurred due to foreign currency transactions.

Modalities involved in translating monetary liabilities and assets

The lack of a standardized method is one of the major challenges encountered in dealing with foreign currency transaction. Therefore, accountants have adopted a general approach in treating foreign currency transactions, which involves adopting a historical approach in dealing with foreign currency transactions. However, different approaches have been adopted in recording financial currency transactions based on the historical rate of exchange.

1. Historical rate – the amount recorded using the home currency should not be changed. Moreover, no translation loss or gain should be reported.
2. Closing rate- the closing rate of exchange should form the basis upon which accountants translate foreign currency in making balance sheet entries.
3. Lower/higher value- under this modality, the monetary assets are stated using a lower rate [lower value of the existing historical rate] while liabilities are translated using a higher rate of the prevailing historical rate.

Despite the application of the single-transaction approach, this perspective is characterized by one major challenge, which entails understating liabilities and overestimating monetary assets. Thus, its application can lead to the contravention of the accounting principle of prudence. On the other hand, the two-transaction approach, which is founded on the accrual principle, is relatively practical as it emphasizes the importance of making accounting entries in accordance with the period when the transactions was made.

Bogicevic (2013) is of the view that the treatment of foreign currency transactions vary across countries. Some conservative economies such as France and Germany use lower historical exchange rates in translating monetary assets involving foreign currency transactions. Conversely, a high historical rate is used in translating foreign currency liabilities. The low/high approach adheres to the principle of prudence in that it eliminates the likelihood of overstating assets and understating liabilities.

Transaction exposure in foreign exchange risk

The increased adoption of the concept of internationalization has increased the extent to which organizations are exposed to foreign exchange risk. The risk originates from the existence of cross-currency instability. Thus, foreign currency entities have a duty to implement the concept of currency hedging in order to minimize the likely negative impact. However, some scholars are of the view that the degree of exposure to foreign currency risk can be used in assessing an organization’s profitability potential. In an effort to understand foreign exchange risk, the risk has been categorized into three main components, which include translation, transaction, and operation. Understanding the core components of foreign exchange risk is critical in determining the most appropriate hedging strategy that multinational corporations can adopt.

1. Transaction exposure- this type of exposure emanates from the adjustment in the value of contracts denominated in foreign currency. Butler (2012) asserts that this type of risk is mainly encountered in cases of contracts that are expected to be delivered in the future, hence leading to the generation of foreign currency cash flows. In such situations, business entities may incur exchange losses or gains. Transaction exposure can be categorized into three main sub-components. The first subdivision entails quotation exposure, which occurs between the duration when the price is quoted to when the order is actually placed. The second category entails backlog exposure, which occurs between the period when the order is placed and the actual delivery of the goods and invoicing. The last category entails the billing exposure, which refers to the time lapse between the delivery of products and when actual payment of the goods is made.
2. Translation exposure – this type of exposure mainly occurs when the value recorded in accounting books changes due to fluctuations in the rate of exchange.
3. Operating exposure- Khan and Jain (2006, p. 19) define operating exposure to include ‘changes in the amount of future operating value of the balance sheet assets and liabilities cash flows by an exchange rate’. Operating risk mainly affects an organization’s future operating cash flows, costs, and operating revenues. The level of operating exposure can be evaluated by assessing an organization’s future competitive position. Butler (2012) argues that operating exposure influences an organization’s future costs and revenues.

According to Butler (2012), transaction exposure is one of the most important exposures to foreign exchange risk as it provides managers with insight in making decision on the most appropriate hedging preferences. The chart below illustrates findings on a survey of the degree of importance attached to foreign exchange risk exposure. The chart depicts the existence of a significant variation in the degree of the relative importance of the various categories of foreign exchange exposure amongst organizational managers.

From the chart above, it is evident that organizational managers prefer hedging transaction exposure as opposed to economic and translation exposures.

Multinational corporations can adopt different techniques in order to successfully hedge against transaction exposure. Some of the most effective methods are outlined below.

1. Exposure netting – this technique involves adopting currencies that are not subject to fluctuation, hence minimizing losses arising from exchange rate changes. In order to implement exposure netting successfully, it is imperative for organizational managers to select currencies that are not directly correlated. By using this technique, the exposure associated with a particular currency is offset in another.
2. Currency dollars – under this technique, multinational companies undertaking transactions involving foreign currency enter contracts aimed at protecting their transactions from currency fluctuations. A specific rate is set if the rate fluctuates beyond the designated neutral zone.
3. Currency risk sharing – this technique entails formulating a customized hedge contract that is based on price adjustment.

Financial hedging of transaction exposure

Financial hedging in foreign currency transaction is based on a number of assumptions as outlined below.

1. The existence of foreign exchange rate risk
2. The existence of the item being hedged
3. A hedging instrument must be formulated in order to protect an organization involved in foreign currency transaction from exchange rate risk.

According to Bogicevic (2013), multinational corporations are exposed to diverse categories of risk. However, currency risk is one of the major and most complex risks encountered by MNCs. In most cases, currency risk management is similar to managing interest, rate equity price, and commodity price risks. In an effort to minimize the adverse effects of exchange rate risks, multinational corporations have a duty to implement effective hedging measures in managing their operations within the international context. Through hedging, multinational corporations can be in a position to offset the adverse effects of currency risk by integrating hedging instruments/currency derivatives.

Organizational managers within MNCs should integrate optimal hedging techniques in order to promote the equalization of change arising from exchange rate fluctuations with the hedging instrument selected. Bogicevic (2013, p. 148) affirms that the ‘goal of currency hedge accounting is to assure that the financial statements of entities, engaged in hedging activities reflect the results of those activities’. Businesses can adopt two main categories of hedging techniques. These techniques include natural and contractual hedges. Contractual hedges relate to options market hedge, future market hedges, money market hedges, and forward market hedge. According to Bogicevic (2013), multinational companies can mitigate currency risks by using currency derivatives such as currency forward contracts and currency options. Under the forward currency contract technique, an organization enters a contract, which outlines the amount of foreign currency that an entity is expected to receive in the future at a predetermined rate of exchange. Conversely, natural hedges include currency swaps, parallel loans, and risk sharing. Forward currency contract shields an organization against loss due to currency fluctuation. Thus, forward currency contracts are effective in countering losses involving purchase transactions.

In most cases, hedging arrangements are mainly entered amongst organizations engaged in foreign currency transactions. However, these arrangements mainly occur after receiving non-cancellable purchase or sales order, which has a stipulated price and expected date of delivery. The available literature cites the existence of a direct relationship between the degree of foreign exchange risk exposure and the amount of financial derivatives that an organization uses (Bogicevic 2013).

Conclusion

Organizations that engage in transactions involving foreign currency are exposed to unique challenges as opposed to firms whose transactions denominate in domestic currency. One of the major risks relates to a high degree of exposure to foreign currency fluctuation. Transactions involving foreign currency can be expressed in two main parts, which include real and monetary components. Accountants faced major challenges in making decision on whether to make accounting entries based on historical or current exchange rate. The challenge emanates from the existence of conflict between the prudence and accrual accounting principles. This aspect underscores the need for the formulation of effective principles to guide foreign currency accounting. Foreign exchange rate fluctuation can affect an organization’s level of profitability and cash flows. However, companies that engage in foreign currency transaction can mitigate the adverse effects by integrating effective hedging techniques. Some of the most effective techniques include incorporating currency derivatives.

Reference List

Bogicevic, J 2013, ‘Accounting implications of foreign currency transactions translation and hedging’, Economic Horizons, vol. 15, no. 2, pp. 137-151.

Butler, K 2012, Multinational finance; evaluating opportunities, costs, and risks of operation, John Wiley & Sons, New York.

Henderson, S, Pierson, G & Herbohn, K 2013, Issues in financial accounting, Pearson Higher Education, Chicago.

Khan, E & Jain, R 2006, Mafa ca final, Tata McGraw-Hill, London.