This guide is provided by Alt21 Limited, trading as Alt21, an FCA authorised payments and FX provider and is intended for UK businesses considering FX hedging as part of their treasury activity. All examples provided are illustrative only and not a current or guaranteed rate. Please read the full disclaimer at the bottom of the page.
Your overseas subsidiary hasn’t suddenly become less profitable. Its assets haven’t disappeared. But translation exposure can still change how those numbers look when they’re reported in your company’s home currency.
Suddenly, the numbers tell a slightly different story. Exchange rate movements can change the reported value of overseas assets, liabilities, revenue and earnings, even when little has changed in the underlying business.
That leaves you with a few questions to answer:
How much of the movement in your consolidated accounts reflects business performance, and how much comes from exchange rate changes? How significant is that exposure? And do you account for it, or actively manage it?
In this guide, we’ll look at where translation exposure comes from, how it differs from transaction exposure, how to measure it and what to consider when deciding whether to hedge it.
What is translation exposure in foreign exchange?
Translation exposure is the effect that exchange rate movements can have when a business converts the financial statements of a foreign operation from its functional currency into the reporting currency used for consolidated accounts.
It’s also sometimes called translation risk or accounting exposure.
Imagine a UK parent company owns a subsidiary in the Eurozone. The subsidiary operates in euros, while the group reports its consolidated results in pounds. Even if nothing changes within the subsidiary itself, movements in GBP/EUR can change the sterling value that appears in the group’s consolidated accounts.
The size of a company’s exposure will depend on factors including the currencies its foreign operations use, the value and composition of their assets and liabilities, and movements between those currencies and the group’s reporting currency.
For UK and European businesses reporting under IFRS, foreign currency translation is governed by IAS 21, The Effects of Changes in Foreign Exchange Rates.1
What is the difference between translation exposure and transaction exposure?
Translation exposure and transaction exposure both arise from exchange rate movements, but they affect a business in different ways.
- Transaction exposure relates to a specific financial obligation or expected cash flow denominated in another currency. If a UK company agrees today to pay a US supplier $500,000 in three months, for example, the sterling cost of that payment can change before settlement as GBP/USD moves. There is an underlying transaction that will require the business to exchange currency.
- Translation exposure arises when foreign-currency financial information is converted into the group’s reporting currency. A UK company may own a European subsidiary whose assets and liabilities are denominated in euros. Even if those assets aren’t being sold and no payment is due, their reported sterling value can change as GBP/EUR moves.
In simple terms, transaction exposure can affect cash flows, while translation exposure can affect reported financial values.
The two can also exist at the same time – A multinational business may have transaction exposure from invoices, supplier payments and other foreign-currency cash flows while also having translation exposure from overseas subsidiaries.
You may also be interested in reading our blog on financial fragmentation.
What are the risks of translation exposure in FX, and how to manage them
Translation exposure doesn’t necessarily mean something has changed operationally.
But once the financial results of overseas operations are translated into your reporting currency, exchange rate movements can affect how assets, liabilities, revenue and earnings appear in your consolidated accounts.
Investors, lenders and other stakeholders use those figures to understand how the business is performing. Translation exposure can change that picture, creating movement in the accounts that doesn’t necessarily reflect what’s happening operationally.
This can show up in several ways:
A different picture of operational performance
Translation gains and losses don’t necessarily represent cash entering or leaving the business. But they can still affect reported figures, making it harder to distinguish between changes in the underlying operation and changes created by exchange rates.
Changes in how investors see performance
Reported earnings or asset values can move partly because of currency translation rather than a change in business performance.
Being able to separate the two gives investors and other stakeholders more context when comparing results between reporting periods.
Changes to financial ratios
Exchange rate movements can also affect consolidated balance sheet figures used to calculate financial ratios.
Where lenders consider those ratios, or they form part of financing arrangements, translation exposure can have implications beyond how performance appears in the accounts.
Accounting for translation exposure
Managing translation exposure starts with understanding how foreign-currency figures make their way into your consolidated accounts.
Under IAS 21, the treatment depends on factors including the functional currency of the foreign operation.
Two methods you’re likely to encounter when looking at translation exposure are the current rate method and the temporal method.
Current rate method
Where a foreign operation has a functional currency different from the group’s presentation currency, its results need to be translated for consolidation.
Assets and liabilities are translated at the closing rate at the reporting date. Income and expenses are translated using exchange rates at the dates of the transactions, although an appropriate average rate may sometimes be used.
Translation differences arising from this process are generally recognised in other comprehensive income.
This treatment helps distinguish currency translation from the underlying operating results of the foreign business. A subsidiary could perform exactly as expected in its functional currency while its translated value changes in the consolidated accounts.
Temporal method
The temporal method becomes relevant where transactions or financial information need to be translated into an entity’s functional currency.
Rather than applying one exchange rate across the accounts, the rate depends on the nature and measurement basis of each item.
| Account | Treatment |
| Monetary assets and liabilities, including cash, receivables and payables | Closing exchange rate |
| Non-monetary items measured at historical cost | Exchange rate at the date of the original transaction |
| Revenue and expenses | Rates at the transaction dates, with an appropriate average sometimes used |
| Expenses linked to historical-cost assets, such as depreciation | Rate consistent with the related asset |
A company’s functional currency isn’t necessarily the currency of the country where it’s incorporated. It reflects the economic environment in which the business primarily operates.
For example, a European entity might receive funding, invoice customers and generate much of its cash in sterling. Depending on its wider economic circumstances, GBP could therefore be its functional currency despite the company being incorporated elsewhere.
Once you know which figures are exposed and how they’re translated, you can start measuring the potential effect of exchange rate movements.
That’s the next step in understanding how significant your translation exposure actually is.
How do you measure translation exposure?
Once you know how your foreign operations are translated into the group’s reporting currency, you can work out where the exposure sits.
Start by identifying the foreign operations and currencies that feed into your consolidated accounts. From there, you can look at the assets, liabilities and other financial statement items exposed to movements between each functional currency and your reporting currency.
Rather than looking only at the gross figures, consider where exposures in the same currency offset one another. This gives you a clearer view of your net translation exposure by currency.
From there, you can model how different exchange rate movements would change the reported value.
For example, imagine a UK parent has a European subsidiary with €10 million in net assets. At £1 = €1.15, those assets translate to approximately £8.70 million. If the rate moves to £1 = €1.20, their translated value falls to approximately £8.33 million.
The underlying €10 million hasn’t changed. The scenario simply shows how a movement in GBP/EUR changes its reported sterling value.
Finance teams can apply the same approach across different currencies and exchange rate scenarios to understand where translation movements could have the greatest effect on consolidated figures.
Once you can see the size of the exposure and how it responds to different currency movements, you have a clearer basis for deciding whether to leave it unhedged or consider managing it.
Should you hedge translation exposure?
There isn’t a universal answer to whether or not you should hedge translation exposure.
Because translation exposure primarily affects reported accounting values rather than creating a direct future payment or receipt, some businesses choose to accept the fluctuations. Others may consider hedging when the exposure is sufficiently material to their reporting or financial objectives.
One approach is a Forward Contract, which establishes an exchange rate for an agreed future currency transaction. A business could use an offsetting foreign-currency position designed to reduce the effect that exchange rate movements have on the value of its underlying exposure.
Forward Contracts carry risk. You will be obligated to exchange currency at the agreed rate even where the market subsequently moves in your favour; you may be required to post collateral, and you are exposed to the risk that ALT21 Limited does not meet its obligations under the contract.
Businesses may also consider natural hedging or exposure netting, where foreign-currency assets, liabilities, revenues or costs offset one another without requiring the entire exposure to be covered using a financial instrument.
A hedge designed to offset translation movements may introduce real cash flows and transaction costs against an exposure that was previously accounting-based.
Forward Contracts also create an obligation to exchange an agreed amount of currency at the agreed rate, meaning the business won’t benefit from favourable subsequent movements on the amount covered. Depending on the arrangement, collateral may also be required, and the arrangement carries counterparty risk.
For finance teams, the question is therefore broader than simply “Can you hedge translation exposure?”
It’s whether doing so supports the company’s objectives once the size and duration of the exposure, accounting implications, costs, existing natural offsets and wider currency exposures have been considered.
Translation exposure is ultimately one part of the currency picture. Understanding where it comes from, how large it is and how exchange rates affect your reported figures gives you the information needed to decide how it should fit within your wider approach to managing money across currencies.
ALT21 Limited is authorised and regulated by the Financial Conduct Authority (FRN: 783837) and is a company registered in England and Wales (number 10723112). The registered address is 45 Eagle Street, London WC1R 4FS, United Kingdom. This article has been produced by ALT21 Limited for information purposes only. It does not constitute financial advice or an offer to sell or the solicitation of an offer to buy any products referenced. Hedging products are not suitable for every business. Before entering into any FX product, you should consider whether it is appropriate for your needs and circumstances. ALT21 Limited assumes no liability for errors, inaccuracies or omissions. Eligibility criteria and terms and conditions apply to all products and services offered by ALT21 Limited. Not all applications will be accepted.
1. https://www.ifrs.org/issued-standards/list-of-standards/ias-21-the-effects-of-changes-in-foreign-exchange-rates/
