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Foreign Exchange Exposures
The risks that are associated with expanding business operations into foreign economies vary from one country to another. To ensure a smooth entry and positioning into the foreign markets, a company should identify and mitigate these risks. The decision to expand into the three foreign countries will expose XYZ Inc. to accounting, operating, and transaction exposures. These three exposures are associated with foreign currency risks.
Accounting exposure arises when changes in the foreign exchange rate affect the conversion of the foreign subsidiary’s assets and liabilities (denominated in foreign currency) into the parent’s company currency when combining the financial statements. This type of exposure will mainly affect the balance sheet. Operating exposure is a risk that fluctuations in the exchange rate will cause a variation in the present value of the company due to changes in the future expected operating cash flow.
This type of exposure majorly affects the sales volume, selling prices, and the operating cost of a business. This has a direct effect on the income statement. Finally, transaction exposure is a risk that the fluctuations in foreign exchange rates will affect the value of unsettled financial obligations that the company incurred before the changes in exchange rates. Therefore, this type of exposure is likely to alter the contracted value of sales and expenses that have not been paid for. This exposure majorly affects the income statement (Jacque, 2013).
Types of Hedges
Hedging helps entities to reduce foreign exchange risks. The foreign currency risk can be hedged using either derivative such as forward contracts and foreign currency options or non-derivatives instruments such as borrowing in foreign currency. Derivatives are commonly used because they ensure better cash flow management. Also, they are flexible. The most advantageous risk-mitigating strategy for XYZ, Inc. is the use of foreign currency options.
These options will grant the company the right, but not the obligation, to transact a particular amount at a predetermined exchange rate. Thus, the company can choose not to use this right when the exchange rate is favorable. The company will have to pay a premium in order to have this right. This method is suitable for the company because it is in a better position to derive the advantage of a favorable change in the exchange rate. This is based on the fact that if the exchange rates change in favor of the company, then it can choose not to use the option (Graham, 2014).
Current and Temporal Methods
The main accounting assumption under the current method is that the entire foreign investment is exposed to foreign exchange risk. Thus, all the assets and liabilities are converted using the current exchange rate. The balance sheet exposure under this method is the net investment, and it is treated as an adjustment to the net worth using an equity account (cumulative translation adjustment). Therefore, no entry is made to the income statement.
The underlying assumption under the temporal method is that foreign currency conversion is regarded as a neutral measurement translation process. Therefore, it is possible to preserve the original features of foreign subsidiary accounts. In this case, translation is done using historical and current exchange rate. These two exchange rates ensure that the converted financial statements appear as if the transactions of the foreign subsidiary were carried out using the currency of the parent company. The balance sheet exposure is first recorded in the income statement using foreign exchange gains or loss account. Thereafter, they are passed to the balance sheet through the retained earnings account.
Appropriate Translation Method
The most suitable translation method is the current method. The choice is based on the fact that the transactions of the foreign subsidiaries of XYZ, Inc. will be denominated in the local currencies. Also, the subsidiaries will be purchasing commodities from XYZ, Inc. This translation method is based on the notion that the subsidiaries operate a relatively separate entity from the parent company and that it maintains its books of accounts in foreign currency. The current method will help to minimize the balance sheet exposure because it relies on the current exchange rate to convert all the balance sheet items except for some equity entries (Warner & Pierce, 2016).
Comparison of the U.S. GAAP and IFRS
A major similarity between the U.S. GAAP and IFRS approach of translating foreign currency is that both methods required companies to recalculate the income, expenses, assets, and liabilities into the company’s functional currency. This is the currency of the key economic environment in which the company operates. Secondly, the two sets accounting standards necessitate the recalculation of the reported balances into the foreign currency before converting into the reporting currency. The third similarity is that the two sets of accounting standards outlines that some foreign exchange effect that are associated with net investments in foreign operations should be accrued in shareholder’s equity (Marshall, McManus, & Viele, 2014).
Despite the similarities, there are also noteworthy differences between the U.S. GAAP and IFRS. First, the two standards differ in the process of ascertaining the functional currency. Under the U.S. GAAP (ASC 830), there are several indicators that should be taken into account when determining the functional currency of a company. However, these pointers are not outlined in an ordered structure. On the other hand, IFRS (IAS 21 and 29) has a hierarchical structure of indicators.
The structure outlines both the primary and secondary pointers that should be taken into account when ascertaining the functional currency for a company. The second difference is about the reporting the operations of subsidiaries that operate in hyperinflationary economies. Under the U.S. GAAP, the reported balances are remeasured as though the functional currency is the same as the reporting currency of the parent company. On the other hand, IFRS retains the functional currency even when an economy meets the requirements of hyperinflationary.
However, balances that have not been measured at the current rate at the end of the financial period should first be indexed using the general price index and then converted into the reporting currency using the current exchange rate. The third difference is the method of consolidation of foreign operations. The U.S. GAAP recommends the use of bottom-up approach for consolidation because it reveals the effects of foreign currency and hedges. On the other hand, IFRS does not stipulate a suitable method of consolidation. Therefore, either step-by-step or direct method is used (Horner, 2013).
Appropriate Translation Method For High Inflation
The most suitable translation method under FASB for a subsidiary of XYZ, Inc. that is located in a highly inflationary country is the temporal method. The choice is based on the fact that under this method, the reported balances are remeasured as though the functional currency is the same as the reporting currency of the parent company. Under the temporal method, current and historical exchange rates are used to convert assets and liabilities. For instance, some items such as receivables that are valued and carried at the fair market value are converted using the current rate. Also, item such as fixed assets that are carried at historical value are converted using historical rates (Goyal & Goyal, 2013).
Goyal, V. K., & Goyal, R. (2013). Financial accounting (4th ed.). New Delhi, India: PHI Learning Private Limited.
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Graham, A. (2014). Hedging currency exposure (2nd ed.). New York, NY: Routledge.
Horner, D. (2013). Accounting for non-accountants (9th ed.). Philadelphia, PA: Kogan Page Limited.
Jacque, L. L. (2013). Management and control of foreign exchange risk (2nd ed.). Norwell, MA: Kluwer Academic Publishers.
Marshall, D. H., McManus, W. W., & Viele, D. F. (2014). Accounting: What the numbers mean (10th ed.). New York, NY: McGraw-Hill/Irwin.
Warner, J. B., & Pierce, D. (2016). Managing foreign exchange risk. South Jordan, Utah: GPS Capital Markets, Inc.