Page 97 - DMGT549_INTERNATIONAL_FINANCIAL_MANAGEMENT

International Financial Management

Notes 6.3.2 Types of Exposure

There are mainly three types of foreign exchange exposures:

Translation Exposure
It is the degree to which a firm’s foreign currency denominated financial statements are affected
by exchange rate changes. All financial statements of a foreign subsidiary have to be translated
into the home currency for the purpose of finalizing the accounts for any given period.

If a firm has subsidiaries in many countries, the fluctuations in exchange rate will make the
assets valuation different in different periods. The changes in asset valuation due to fluctuations
in exchange rate will affect the group’s asset, capital structure ratios, profitability ratios, solvency
ratios, etc.
FASB 52 specifies that US firms with foreign operations should provide information disclosing
effects of foreign exchange rate changes on the enterprise consolidated financial statements and
equity. The following procedure has been followed:

Assets and liabilities are to be translated at the current rate that is the rate prevailing at the
time of preparation of consolidated statements.
All revenues and expenses are to be translated at the actual exchange rates prevailing on
the date of transactions. For items occurring numerous times weighted averages for
exchange rates can be used.
Translation adjustments (gains or losses) are not to be charged to the net income of the
reporting company. Instead these adjustments are accumulated and reported in a separate
account shown in the shareholders equity section of the balance sheet, where they remain
until the equity is disposed off.

Measurement of Translation Exposure

Translation exposure = (Exposed assets – Exposed liabilities) (change in the exchange rate)

Example: Current exchange rate

$1 = ` 47.10
Assets Liabilities
` 15,300,000 ` 15,300,000

$ 3,24,841 $ 3,24,841
In the next period, the exchange rate fluctuates to $1 = ` 47.50
Assets Liabilities
` 15,300,000 ` 15,300,000
$ 3,22,105 $ 3,22,105

Decrease in Book Value of the assets is $ 2736
The various steps involved in measuring translation exposure are:

First, Determine functional currency.
Second, Translate using temporal method recording gains/losses in the income statement
as realized.

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