Page 281 - DMGT514_MANAGEMENT_CONTROL_SYSTEMS

Management Control Systems

Notes 14.6.4 Translation Exposure

Translation exposure arises from the need to “translate” foreign currency assets or liabilities
into the home currency for the purpose of finalising the accounts for the given period. A typical
example of a translation exposure is the treatment of foreign currency loan (medium term) to
finance. The import of capital goods worth US $ 1 million. When the import materialised, the
exchange rate was ` 43/- per $. The imported fixed asset was capitalised in the books of the
company at ` 430/- lakhs. In the ordinary course and assuming no change in the exchange, the
company would provide depreciation on the asset values at ` 430/- lakhs for finalising the
accounts for the year in which the asset was purchased.
Suppose at the time of finalisation of the accounts, the exchange rate has moved to ` 440 involving
a translation loss of ` 10 lakhs. Under the earlier accounting standards, the effect of translation,
gain or loss was capitalised by altering the book value of the fixed asset financed by the loan and
consequently the provision of higher depreciation was required to reduce the net profit.

Did u know? As per IAS (certified) with effect from 1/4/2004, translation differences have
now to be accounted in the profit and loss account.

14.6.5 Operating Exposure (also known as Economic Exposure)

The second group of exposure consists of contingent and competitive exposures and together
also known as operating exposures. The principal focus is on items which will have an impact on
cash flows of the firm and whose values are not (yet) contractually fixed in foreign currency
terms.

Of the two categories, contingent resources have a much shorter time horizon. Typical situations
giving rise to such exposure are:

1. An import or export deal is being negotiated. Quantities and prices are to be finalised.
Fluctuation in exchange rate will probably influence both and then it will be converted
into transaction exposure.

2. The firm has submitted a tender bid on an equipment supply contract. If the contract is
awarded, transaction exposure will arise.

3. A firm imports a product from abroad and sells it in the domestic market. Supplies from
overseas are received continuously but for marketing convenience, the firm publishes
selling price in home currency which holds good for six months. While the sales proceeds
in domestic currency may be more or less certain, costs measured in home currency are
exposed to currency fluctuations.

In all the cases, currency movement will affect future cash flows.
Competitive exposure is the most crucial dimension of currency exposure. Its home horizon is
longer than that of transaction exposure, say around three years. The focus is on future cash
flows and hence a long run survival and value of the firm. We have already discussed this kind
of exposure in our example of the denim jeans exporter.

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