What is Translation Risk?

In this scenario, translation risk is more like a continuous phenomenon that must be recorded yearly in the financial statements. The effect is mainly on the multinational firms which operate in international transactions intentionally because of their customer and supplier base. It also affects the firms that have assets in the foreign currency, and the same need to be realized or reported in the domestic currency. This is mostly a one-time phenomenon, and proper accounting proceduresAccounting ProceduresThe accounting procedure is the process of standardized nature that performs a specific accounting function designed to incorporate better risk management policies to complete these functions efficiently. It includes billings, invoices to suppliers, bank reconciliation, requiring comprehensive and streamlined procedures.read more need to be implemented else it may lead to legal hassles.

Since currency fluctuations are difficult to predict, translation risk can be unpredictable, making it more complex to report and hence is watched closely by regulatory bodies. Translation risk is different from transaction riskTransaction RiskTransaction risk is the uncertainty or loss caused to the contracting party due to a change in the foreign exchange rate or currency risk on delay in settlement of a foreign transaction.read more, which affects the firm’s cash flow due to the currency volatility risk.

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Example of Translation Risk

Let’s assume the US office of this firm suffers an operating lossOperating LossThe term “net operating loss” refers to an operating loss that occurs when a company’s expenses exceed its revenues in a given period and is reflected in the accounting books in the period when the company’s allowable tax deductions exceed current taxable income.read more of $ 10,000. However, in the same reporting periodReporting PeriodA reporting period is a month, quarter, or year during which an organization’s financial statements are prepared for external use uniformly across a period of time in order for the general public and users to interpret and evaluate the financial statements.read more the UK division makes a net profit of £ 8,000. Since the conversion rate of dollar and pound is 0.80, the firm effectively doesn’t make any loss or profit.

The loss in the US branch has nullified its profit in the UK. Before the parent company consolidates all these figures and prepares the interim reports, there is a change in macroeconomic scenarios. So far, so good.

The BREXITBREXITBrexit refers to the combination of Britain and Exit, which signifies the withdrawal or exit of Britain from the E.U. or European Union. The residents of Britain actually voted for the exit of Britain from the E.U. and these votes were split amongst the constituent nations of the UK, for asking the stay of Wales and England and exit of Northern Ireland and Scotland.read more discussions have intensified, which has affected the price of the Pound sterling. Similarly, the crude and dollar prices have fluctuated because of economic tensions between the US and Iran in the Middle East. These scenarios lead to a shift in the dollar pound exchange rate from .80 to 1.0.

The profit which was canceled out due to gain in the UK division suddenly became very small, leading to a net gain for the parent companyParent CompanyA holding company is a company that owns the majority voting shares of another company (subsidiary company). This company also generally controls the management of that company, as well as directs the subsidiary’s directions and policies.read more. The table below summarizes both scenarios.

This effectively means that even though there was no profit/loss at the time of realization, now the company should report a loss as the scenarios have changed because of currency fluctuations. Although hypothetical, this is one of the simplest examples of Translation risk.

Important Points to Note About the Change in Translation Risk

  • Translation risk is usually a legally driven change required by regulators. It arises only when the parent company decides to report a consolidated financial statementConsolidated Financial StatementConsolidated Financial Statements are the financial statements of the overall group, which include all three key financial statements – income statement, cash flow statement, and balance sheet – and represent the sum total of its parents and all of its subsidiaries.read more. For example, if FMCGFMCGFast-moving consumer goods (FMCG) are non-durable consumer goods that sell like hotcakes as they usually come with a low price and high usability. Their examples include toothpaste, ready-to-make food, soap, cookie, notebook, chocolate, etc.read more major Unilever reports a consolidated financial statement for its US, UK, and Europe subsidiary, it will face translation risk. However, if it keeps these subsidiary companiesSubsidiary CompaniesA subsidiary company is controlled by another company, better known as a parent or holding company. The control is exerted through ownership of more than 50% of the voting stock of the subsidiary. Subsidiaries are either set up or acquired by the controlling company.read more independent, there is no translation risk. Simply put, translation risk is not a change in the cash flow but only a result of reporting consolidated financials.Since this risk does not affect the cash flow but only the reporting structure, no question arises of any tax exemptionTax ExemptionTax-exempt refers to excluding an individual’s or corporation’s income, property or transaction from the tax liability imposed by the federal, local or state government. These exemptions either allow total relief from the taxes or provide reduced rates or charge tax on some items only.read more that the firm can use. Also, there is no change in the firm’s value because of translation risk, unlike other risks and exposures. In simple terms, it is more of a measurable concept than a cash flow concept. The important point is that it is recorded when reported and not when realized. Hence it won’t be wrong to say that it results only in notional gains or losses.The risk arising because of translation risk sits on the balance sheet of the firmBalance Sheet Of The FirmA balance sheet is one of the financial statements of a company that presents the shareholders’ equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner’s capital equals the total assets of the company.read more as translation exposureTranslation ExposureTranslation Exposure is defined as the risk of fluctuation in the exchange rate that may cause changes in the value of the company’s assets, liabilities, income, equities. It is usually found in multinational companies as their operations and assets are based in foreign currencies while its financial statements are consolidated in domestic currency. Many companies prefer to hedge such kinds of risks in the best possible way.read more. There can be multiple methods to measure it like Current/no current method, monetary/ non-monetary method, temporal methodTemporal MethodTemporal rate method, or the historical rate method, is employed to convert the financial statements of a parent company’s foreign subsidiaries from its local currency to its “reporting” or “functional” currency when the functional currency and the local currency are not the same. Temporal method is also utilized at the time of acquiring assets and liabilities.read more, and current rate method. Similarly, firms can utilize multiple ways to manage this exposure, like using derivative/exotic financial products like currency optionsCurrency OptionsCurrency Options are derivative contracts that allow market players, including both buyers and sellers of these Options, to purchase and sell a currency pair at a predetermined price (also known as the Strike Price) on or before the expiration date of such derivative contracts.read more, currency swapsCurrency SwapsCurrency Swap is an agreement between the two parties for exchanging notional amount in one currency with that of another currency. It’s interest rate can be fixed or floating rates denominated in two currencies. read more, and forward contractsForward ContractsA forward contract is a customized agreement between two parties to buy or sell an underlying asset in the future at a price agreed upon today (known as the forward price).read more. We will skip the details around these as these are complex topics and can be covered separately.Translation risk poses a threat in presenting unexpected figures upfront, which can lead to some difficult questions raised by shareholders for the management. However, if the situation is temporary and the unpredictable fluctuations in currency might return to normal, it should not affect the firm much. This is because these might get reversed in the next accounting periodNext Accounting PeriodAccounting Period refers to the period in which all financial transactions are recorded and financial statements are prepared. This might be quarterly, semi-annually, or annually, depending on the period for which you want to create the financial statements to be presented to investors so that they can track and compare the company’s overall performance.read more when the macroeconomic situations have improved and the currency market has moved in the favorable direction of the firm. However, this should not be a reason for not preparing for translation risk, and management should have proper procedures to counter such unfavorable movements in currency.

Conclusion

Translation exposure arising from translation risk is specific for firms that operate in foreign transactions or deal in foreign currencies. It is more of a corporate treasury concept to describe risks that a company faces when it deals with foreign clients, thereby foreign transactions.

These foreign transactions can be anything like paying their suppliers in a different currency or getting payments from their customers in foreign currency. An entity that wants to mitigate translation risk should hedge through derivativesDerivativesDerivatives in finance are financial instruments that derive their value from the value of the underlying asset. The underlying asset can be bonds, stocks, currency, commodities, etc. The four types of derivatives are - Option contracts, Future derivatives contracts, Swaps, Forward derivative contracts. read more or exotic financial products so that the currency fluctuations have minimal effect on its numbers.

Failing to do so may result not in legal hassles but also in investor fury even though the firm might be dealing only in a one-time international transaction. For a listed firm, it becomes all the more important as any such red flag might lead investors to lose confidence in the firm.

This has been a guide to what translation risk is and its definition. Here we discuss how Translation Risk affects firms along with practical examples and key points. You may learn more about Risks from our articles below –

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