Accounting exposure occurs when a company’s liabilities, assets, and equities are captured in a foreign currency. Hicks (2000) contend that accounting exposure is likely to occur due to exchange rate fluctuations, especially for companies that list their assets, liabilities, and equities in foreign currencies. When using the XYZ example, it is arguable that the value of the company’s asset, as captured by its balance sheet, may be low if it opens a subsidiary in a country having a weak currency. However, this can be mitigated through consolidation of financial statements, which shows the specific exchange rate loss or gain. Alternatively, XYZ can deploy an objective cost accounting evaluation approach that takes into consideration the prevailing foreign exchange rates.
On its part, operation exposure occurs when there are changes in a company’s import and export activities. As evidence adduced by Jacque (2013) shows, operation exposure occurs when the currency of a target export country is weaker than that of the exporting company’s home country. Such weaknesses makes the exported goods to be more expensive and therefore, less competitive when compared to goods from the home country or those sourced from other countries having weak currencies. For example, the revenue portion of XYZ income statement will be low if the company opens a subsidiary in a country with a weak currency.
Transaction exposure is common when companies engage in cross-border trade. Hicks (2000) illustrates that transaction exposure risk occurs when there is an exchange rate difference between the time an import or export transaction is agreed and when actual payment is made or received. If the exchange rate increases, the party receiving the payment makes a gain. However, the party receiving the payment incurs a loss when the exchange rate decreases. For example, XYZ may agree to sell goods worth $10,000 to its UK subsidiary and receive payment after three months. Assuming that the exchange rate is $/£1.80 at the time of the sale agreement and $/£1.85 at the time of receiving payment, XYZ will incur a loss of about $150.15. The loss is arrived at by subtracting $5,405.41 (derived from dividing $10,000 by $/£1.85) from $5,555.56 (derived by dividing $10,000 by $/£1.80).
Futures and option are the two most common exchange risk-hedging strategies for a company such as XYZ. According to Warner and Pierce (2016), futures hedging occur when a company sells its future payment obligations at current exchange rate and buys the obligation back at future rate. For example, XYZ can sell goods worth $10,000 to be paid in three months’ time through its overseas subsidiary. Assuming that the exchange rate is $/£1.80, the company could incur a loss if the future (after three months) exchange rate has decreased to $/£1.70. To cushion against this loss, the company can sell its future $10,000 obligation for $/£1.80 and buy later for $/£1.70.
Notably, options allow a company to buy and sell a specific amount of currency at put (sell) and call (buy) prices. According to Hicks (2000), options do not give a company an obligation, as is the case with futures. Additionally, options have a fixed exchange rate and do not involve the bidding or speculation that comes with futures. For instance, XYZ could be expecting payments worth $10,000 from its UK subsidiary in three months. Supposing the current exchange rate is $1.70, the company will make a gain if the value falls to, say, $£1.80 within the three months period. To mitigate this loss, the company can buy call options at $£1.80 and exercise the rights if the $/£ rates increases to $£1.80.
Looking at the discussion above about futures and options, it emerges that options may be more suitable for XYZ. This argument draws from the reality that options will give the company more cover against potential exchange rate losses. Most importantly, the company will not suffer any losses even if the value does not fall to $£1.80 from $£1.70.
The current rate method of foreign currency translation assumes that the functional currency is the foreign currency. Whilst Warner and Pierce (2016) posits that the current rate method cushions exchange rate volatility by allocating gains or losses to a reserve account, the sweeping assumption is that the reported value of assets, liabilities, and equities reflects the prevailing exchange rates of the foreign currency. However, this approach exposes a company’s balance sheet to more exchange rate volatility, especially when its subsidiary’s currency is more volatile when compared against the functional currency. Moreover, the temporal method is based on the assumption that the functional currency is the parent company’s home currency. The approach considers the value of core items such as assets, liabilities, and equities should be determined by using the exchange rate at the time of acquisition or realization (Jacque, 2013). This approach has less exposure to a company’s balance sheet since it captures the actual value of core items at the time of realization.
XYZ should deploy a 50:50 debt-to-equity funding strategy to combat its translation exposure risks. As elucidated by Warner and Pierce (2016), this method will lower translation exposure risks by 50 percent in the event the export (subsidiary) country currency becomes weaker than XYZ’s home country currency. However, the debt facility should be financed by a foreign loan for the above mitigation measure to apply.
There are differences between the US GAAP the IFRS approach when determining functional currency. Whilst both approaches agree that there are several indicators that determine the functional currency, the US GAAP does not set up a hierarchy yet the IFRS sets a hierarchy defining primary and secondary indicators. For example, if one of XYZ subsidiaries were located in a country with high inflation, the most preferred translation approach under FASB would be the IFRS. As Abdel-Khalik (2013) asserts, this position is based on the reality that the IFRS does not change the functional currency as opposed to the US GAAP, which re-measures financial statements by shifting the functional currency to the parent company’s reporting currency.
