Question

A, What factors create a balance sheet (or translation) exposure to foreign
exchange risk? How does balance sheet exposure compare with
transaction exposure? (150 words)

B,What is hedge accounting? (150 words)

Answer 1

Translation exposure (also known as translation risk) is the risk that a company's equities, assets, liabilities, or income will change in value as a result of exchange rate changes. This occurs when a firm denominates a portion of its equities, assets, liabilities, or income in a foreign currency. It is also known as "accounting exposure.”

Accountants use various methods to insulate firms from these types of risks, such as consolidation techniques for the firm's financial statements and using the most effective cost accounting evaluation procedures. In many cases, translation exposure is recorded in financial statements as an exchange rate gain (or loss).

Transcation exposure risk:

Transaction exposure (or translation exposure) is the level of uncertainty businesses involved in international trade face. Specifically, it is the risk that currency exchange rates will fluctuate after a firm has already undertaken a financial obligation. A high level of vulnerability to shifting exchange rates can lead to major capital losses for these international businesses.

One way that firms can limit their exposure to changes in the exchange rate is to implement a hedging strategy. Through hedging using forward rates, they may lock in a favorable rate of currency exchange and avoid exposure to risk.

Let us understand the difference between Transaction and Translation exposure covering the following points of difference.

Points of Difference	Transaction Exposure	Translation Exposure
ACCOUNTING	Transaction exposure impacts the cash flow movement and arises while conducting purchase and sale transactions in different currencies.	Translation exposure is not a cash flow change and arises as a result of consolidating results of a foreign subsidiary. Translation exposure is usually driven by legal requirement asking the parent company to consolidate financials
NEED OF FOREIGN AFFILIATE	For a transaction exposure to arise, the parent company doesn’t necessarily need to have a foreign affiliate or a subsidiary	Translation exposure can arise only when a parent company is consolidating financials of a foreign affiliate or subsidiary
GAIN / LOSS	Transaction exposure results in realized gain or losses	Translation exposure results in notional / book gain or losses
TIMING IMPACT	Transaction exposure arises the moment a company enters into a transaction involving foreign currency and commits to make or receive payment in currency other than its domestic currency	Translation exposure arises on the balance sheet consolidation date and is at the end of a given financial period (quarter or year)
FIRM VALUE IMPACT	Because a transaction exposure has an actual cash flow impact, it impacts the value of a company	Since the translation exposure doesn’t create any cash flow impact, the value of a company doesn’t change due to this type of exposure
TAX	Transaction exposure measures gain or loss to the cash flow on account of forex movements. In case of loss, the cash flows reduce and hence you get tax benefit on the loss and vice versa	Translation exposure is a measurement concept rather than dealing with actual cash flow impact on account of forex. Hence, there is no tax exemption or benefit available on losses due to translation exposure

Transaction vs. Translation Exposure

There is a distinct difference between transaction and translation exposure. Transaction exposure involves the risk that when a business transaction is arranged in a foreign currency, the value of that currency may change before the transaction is complete.

Should the foreign currency appreciate, it will cost more in the business’s home currency. Translation risk focuses on the change in a foreign-held asset’s value based on a change in exchange rate between the home and foreign currencies.

B)

Hedge accounting is a method of accounting where entries to adjust the fair value of a security and its opposing hedge are treated as one. Hedge accounting attempts to reduce the volatility created by the repeated adjustment to a financial instrument's value, known as fair value accounting or mark to market. This reduced volatility is done by combining the instrument and the hedge as one entry, which offsets the opposing's movements.

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