Assignment 2: Foreign Currency Risk, Methods of Translation
Assignment 2: Foreign Currency Risk
Albert, CEO of XYZ, Inc., desires to expand the company's sales through exports to three (3) foreign subsidiaries. Albert knows that the target subsidiaries are located in countries that require transactions to be denominated in the local currencies. Albert has researched foreign currency risk and knows that there is accounting exposure in accounting statements, operating exposure in future cash flows, and transaction exposure in outstanding obligations. Albert does not understand how these risks apply to XYZ, Inc. under his proposal or if there are any mitigating risk strategies available. Albert requests you, the head of the Risk Management division, to prepare a report that he can present to the Board of Directors on the potential foreign currency risk if XYZ, Inc. expands sales into these markets. XYZ, Inc.'s reporting currency is the U.S. dollar and the subsidiaries would purchase the merchandise as inventory items.
Note: You may create and / or make all necessary assumptions needed for the completion of this assignment.
Write a three to five (3-5) page paper in which you:
Specify accounting exposure, operating exposure, and transaction exposure. Determine the main financial statement effects of each type of exposure if XYZ, Inc. expands as proposed.
Determine two (2) types of hedges regarding foreign exchange risk, in general, and recommend the most advantageous risk mitigation strategy for XYZ, Inc. Provide support for your rationale. Note: Refer to Chapter 9 of the textbook for more information on corporate strategies regarding hedging foreign exchange risk.
Determine the main accounting assumptions underlying each currently used method (e.g., current rate method and temporal method). Determine the fundamental differences in balance sheet exposure from the application of each method.
Suggest the translation method that XYZ, Inc. should use in order to minimize balance sheet exposure. Provide support for you choice.
Compare the U.S. GAAP approach to the IFRS approach of translating foreign currency financial statements. Determine the main similarities and differences between the two (2) methods of translation. Assuming one (1) of the subsidiaries of XYZ, Inc. is located in a highly inflationary country, determine the appropriate translation method under FASB and provide the theoretical justification for your response.
Use at least two (2) quality academic resources in this assignment. Note: Wikipedia and other Websites do not qualify as academic resources.
Your assignment must follow these formatting requirements:
Be typed, double spaced, using Times New Roman font (size 12), with one-inch margins on all sides; citations and references must follow APA or school-specific format. Check with your professor for any additional instructions.
Include a cover page containing the title of the assignment, the student's name, the professor's name, the course title, and the date. The cover page and the reference page are not included in the required assignment page length.
The specific course learning outcomes associated with this assignment are:
Examine and prepare the accounting entries for intra-entity asset transactions.
Examine the impact that specific differences between IFRS and U.S. GAAP have on financial statements.
Explain foreign currency transactions and analyze the accounting requirements for the translation of financial statements of foreign entities.
Use technology and information resources to research issues in advanced accounting.
Write clearly and concisely about advanced accounting using proper writing mechanics.
Foreign Currency Risk
Student’s Name
Institutional Affiliation
Abstract
A business's situation is affected by the differentiation in the exchange rates in diverse currencies. This situation is attributed to several reasons including the source of import, exports, the foreign currency denomination of expenses, receipt of external proceeds, income paid in the foreign legal tender as well as business loans denominated in foreign currency.
This risk is, therefore, an outcome of investments held in foreign currency thereby affecting a company's capital due to unforeseen fluctuations in the exchange rates.
It, therefore, becomes the variance between domestic and foreign legal tender.
Risk management on these exchanges is important for organizations to moderate on foreign currency exposure. The abolition of the Bretton Woods system saw the advent of market determination of the rates of exchange, a system of irregular rates of exchange was established, and the subsequent inflation led to the oil shock and markets became unpredictable( Sivakumar et al., 2008). The financial offshoot of foreign money markets, rates of interest and product prices then became the determinants of risk management in the corporate world.
Keywords: foreign currency, risk management, exchange rates, currency risk, interest rates.
Introduction
Once companies trade in their goods and services in the international arena, they get paid in the currency of that country. It is highly likely for these companies to receive lower payments than anticipated. For those engaged in imports and pay in foreign currency, they are also likely to pay more than they intended (EDC, Managing Foreign Exchange Risk, p3).Because of these unforeseen variations, companies need to make use of hedging for transactions, translation and other operations to avoid diminishing in their market value and profits.
Exposure
According to Papaioannou, this risk refers to the outcome of change in the worth a company because of the differences in the money market. This can result in the value of the company running into a loss either directly or indirectly. To mitigate this risk, a company needs first to determine its existing risk exposure and then come up with a hedging strategy and eventually evaluate the available instruments to manage these risks, he further argues.
It is necessary to identify a firm's risks and how extensive they may impact it. Three types of risks that are established include; transaction risk, translation risk, and economic risk. Each of these types of risk requires a different technique to manage, according to Sivakumar et al., in the manuscript "Corporate Hedging for Foreign Exchange Risk in India."
Accounting exposure is also called the translation exposure. It is as a consequence of integrating foreign partners' financial statements as part of the home company's prevalent legal tender. This becomes the net aggregation of the difference in the rates of exchange between a foreign partner and its local affiliate.
Economic exposure is regarded to be the sensitivity of a firm's market worth to unforeseen changes in the foreign legal tender. Also referred as the operating exposure, competitive exposure or strategic exposure, it is used to determine the difference in the current worth of an organization consequential from any adjustments in expected operating streams of cash caused by unforeseen changes in market rates. This is borne out of currency variations, which affect the organization's flow of cash, revenue statement, and competitiveness and hence, it also affects markets and stocks. They also affect the balance sheet. This is also referred to as balance sheet exposure.
Transaction exposure is short term. This kind of exposure arises out of a contract within an unstable currency environment. The contracts are usually fixed price. The firm's value is the sure measure of sensitivity and is determined by its stock return to unexpected variation in market rates of exchange. This exposure arises from four main transactions, namely; transactions where repayment are in foreign currency, purchases and sales of goods are in foreign currency, non-performing contracts done in foreign currency and acquisitions in foreign currency.
Financial Statement Effects of Exposure
The impact of the accounting exposure on the main financial statement results in ...