Getting Ahead of Foreign Exchange Exposure and Leveraging Accounting Practices to Manage Risk
Contributors: Brandon Goodwyn, Senior Associate, Accounting Advisory
Global businesses operating in multiple countries or investing in foreign currencies must have a thorough understanding of foreign exchange principles to manage risks (exposure). To operate at peak performance, management should understand the types of exposure present, available foreign exchange instruments, hedge accounting practices and accounting for foreign exchange transactions.
Types of Foreign Exchange Exposure
Exposure refers to the risk inherent in an investment. Foreign exchange exposure is the risk of foreign exchange rates changing and negatively impacting a company’s financial performance when the company holds assets and engages in transactions in a foreign currency. As part of the trade life cycle, there are risks from future foreign currency cash flows.
As items move from forecast to purchase order to invoice, there are actual changes in cash flows as foreign exchange rates change. Management must navigate and prepare for these challenges. There are three types of exposure: transaction exposure, translation exposure and economic exposure.
Transaction exposure occurs when transactions are made between jurisdictions with a potential risk that the transacted currency will rise or fall in an unfavorable direction. Transaction exposure typically arises from payments for imported goods and services or receipts of payments from foreign entities.
Translation Exposure is the risk that a company’s financials will be impacted by exchange rate fluctuations because it is headquartered domestically but has foreign operations. Foreign entities account using the currency of the primary economic environment in which they operate – better known as the functional currency. When the books are not maintained in the functional currency, the company must remeasure the accounts into the functional currency prior to translation. Translation exposure is the degree to which the business’s parent company financials are impacted by currency exchange rate volatility.
Economic exposure is the degree to which the business’s value is affected by currency fluctuations, also known as forecast risk. The value of the foreign currency can impact the operating cashflows and the value of the assets. Economic exposure increases as foreign exchange volatility rises and decreases as volatility declines. It is usually created by macroeconomic conditions such as geopolitical instability and/or government regulations. Companies try to manage economic exposure to reduce the impact foreign currency volatility has on their cashflows.
Companies can use derivative instruments to hedge against multiple types of exposures. Common derivatives consist of forward contracts (forwards), futures, foreign currency options (options), contracts for differences (CFDs) and currency swaps. Forwards and options are the primary instruments used for hedging.
Companies mitigate foreign exchange risks by entering into separate contracts that meet the definition of a derivative instrument. For such circumstances, FASB’s ASC 815 allows entities to use a specialized hedge accounting for qualified hedging relationships.
If hedge accounting cannot be applied, changes in the fair values of derivative instruments are recognized in earnings in each reporting period, which may or may not match the period in which the risks that are being hedged affect earnings. The goal of hedge accounting is to match the timing of income statement recognition of the effects of the hedging instrument with the timing of recognition of the hedged risk.
Accounting for Foreign Exchange Transactions
At the date a foreign currency transaction occurs, each asset, liability, revenue, expense, gain or loss that emerges from the transaction is recorded in the functional currency of the recording entity using the exchange rate in effect at that date. Using that exchange rate may not be practical, therefore a weighted average rate may be used. Transaction gains or losses arise due to changes in the exchange rate among the following:
- the transaction date and the settlement date
- the transaction date and a subsequent balance-sheet date
- a subsequent balance-sheet date and the settlement date
How Cherry Bekaert Can Help
While treasury, finance and accounting departments may be short staffed in your current talent pool, Cherry Bekaert’s Accounting Advisory practice has experienced advisors for every subject matter and can help you design and implement strategies with results in mind. Whatever your need or your timeline, you do not need to build a new team – we have solutions to meet you where you are.