Question

How does translation exposure affect a business with a high percentage of business conducted by subsidiaries? What factors come into play?

Answer 1

First we have to understand that what is Transaction Exposure:

• The Translation Exposure or Accounting Exposure is the risk of loss suffered when stock, revenue, assets or liabilities denominated in foreign currency changes with the movement of the foreign exchange rates.
• In simple words, risk of change in the exchange rates is called the transaction exposure.

How it affects Business:

• The translation exposure stems from the requirement of converting the subsidiary’s assets and liabilities (operating in another country) denominated in foreign currency in the home currency of the parent company, at the time of preparing the consolidated profit and loss statement and the balance sheet. Thus, any change in the foreign exchange rate will have a considerable impact on the financial statements.
• The translation exposure is concerned with the recorded profits and the balance sheet values and does not affect the overall value of the firm. Since the gains or losses suffered due to the translation of financial items has no significant impact on the stock prices of the firm. And the investors do believe that such risk can be diversified and hence does not demand any extra premium for it.

Factors come into play:

• The greater the percentage of business conducted by subsidiaries, the greater is the translation exposure. The greater the variability of each relevant foreign currency relative to the headquarters’ home (reporting) currency, the greater is the translation exposure. The type of accounting method employed can also affect translation exposure.

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