Foreign Exchange Risks for Global Businesses
The Global Economy
Over the past several decades business has become more interconnected around the world as disparate national economies have given way to a more centralized global economy. This process of globalization has created a great many new opportunities for businesses in all phases of their operational cycle. The availability of foreign suppliers can help businesses keep their costs low through lower prices for raw materials and increased competition, while new foreign customer markets can help raise revenue through increased sales. Businesses are also able to benefit from advantageous tax laws and lower wage and benefit costs by basing some of their operations in foreign countries. All these factors have helped global business to thrive, but there are also risks associated with operating in foreign markets. One of the most significant risks is that of foreign currency exchange rates.
Foreign exchange rates fluctuate, sometimes in the extreme, on an almost continuous basis. This volatility can be impacted by a variety of factors, including, but not limited to, changes in a country’s political leadership or policies, changes in monetary policy, like inflation rates, and environmental events or natural disasters. A change in an exchange rate could potentially affect the operating income and balance sheet of a business that operates in a foreign market in a manner that cannot be easily predicted. Businesses that choose to operate on a global scale need to be aware of these risks, as well as the steps they can take to help mitigate them.
Foreign Exchange Risks
There are two major types of risk associated with foreign exchange rates and financial reporting - transactional risk, and translational risk. Transactional risk is involved when a company completes a transaction in a foreign currency. This would include purchases by foreign customers, payments on accounts receivable or accounts payable that occur in a foreign currency, and the sale of foreign-held assets, among others. Because of their volatility, exchange rates may change between the instigation and the conclusion of the transaction, resulting in a realized gain or loss. These realized gains and losses are reported in a company’s net income for the period in which they occur, as per generally accepted accounting principles (GAAP).
Translational risk is related to the foreign based operations of a multinational business, that is any operations located in a country outside of the one in which the company is based. This can include assets and liabilities, both current and long-term, as well as equity holdings that are valued and held in a foreign currency. For American based companies, GAAP requires that these balance sheet holdings be translated into U.S. dollars for reporting purposes. Additionally, the income statement of the foreign division also needs to be translated into U.S. dollars for reporting. Changes in foreign exchange rates from period to period can result in gains and losses that must be accounted for in financial reporting. Unlike transactional gains and losses, translational gains and losses are unrealized, and are reported as other comprehensive income, separate from both operating income on the income statement and retained earnings on the balance sheet. Foreign exchange translation can also make it difficult to compare financial statements from year to year, as each has been translated at a different current exchange rate. An income statement may appear to show an increase in revenue, but the increase may be the result of a change in a foreign exchange rate, rather than an actual increase in sales.
Transactional and translational risk can both have a negative impact on a company’s bottom-line. Transactional risk is primarily short-term risk, and companies can manage this risk in several ways. Companies can seek to complete transactions with foreign parties in their own base currency which eliminates the risk on their part. This may not be possible, as the foreign party may not be willing to take all the risk on themselves and may be disinclined to continue doing business. Companies can also practice hedging of foreign transactions, which involves seeking to offset the risk of the transaction. An example would be an American company buying raw materials from a Japanese company that is requiring payment in Japanese yen. The American company may seek to offset any potential loss by also agreeing to sell finished goods of a similar value to another Japanese company. They could also choose to try and limit their risk through offsetting foreign currency transactions like futures contracts or forward contracts.
The risk associated with foreign currency translation is more long-term in nature, as foreign operations are likely to be ongoing. Hedging can also be an option to mitigate translation risks, but it may take on a different form. Companies may seek to limit risks by selling products and services in the same markets where they buy supplies or pay workers. This means that any change in foreign exchange rate will impact both revenues and expenses, resulting in no net change. Additionally, companies may seek to do business in many foreign countries, thereby spreading out their risk into different markets with different exchange rates. Companies can also use a constant-dollar approach to internal reporting to account for year over year changes in exchange rates. This method involves revaluing prior periods’ financial statements using current exchange rates. This allows for comparability between periods, which will allow for better evaluation and decision making. Constant-dollar reporting is not allowed under GAAP, but it can be utilized for internal reporting purposes.
When it comes to business the world is getting smaller. To compete more effectively, companies must take advantage of foreign markets for suppliers, customers, and operations. Doing this comes with substantial risk related to changing foreign exchange rates and the potential for loss. If companies understand these transactional and translational risks, they can work to mitigate them while taking advantage of all the opportunities the worldwide economy can provide. Hedging and constant-dollar reporting are just two examples of techniques that can be used to help a company survive and thrive in the global marketplace.
DeCristofaro, John. "Remember Foreign Exchange Fluctuations When Reporting and Analyzing Operating Results." CPA Journal, vol. 78, no. 1, Jan. 2008, pp. 32-34. EBSCOhost, search.ebscohost.com/login.aspx?direct=true&db=bth&AN=30037696&site=bsi-live.
Mishler, Mark D. "Currency Turmoil, Price, and Profit in Global Markets." Journal of Accountancy, vol. 223, no. 3, Mar. 2017, pp. 1-6. EBSCOhost, proxy-wcupa.klnpa.org/login?url=http://search.ebscohost.com/login.aspx?direct=true&db=lgh&AN=121816591&site=ehost-live&scope=site.
Mishler, Mark D. "Don't Let Foreign Currency Fluctuations Impair Performance Measurements." Journal of Accountancy, vol. 220, no. 6, Dec. 2015, pp. 60-66. EBSCOhost, proxy-wcupa.klnpa.org/login?url=http://search.ebscohost.com/login.aspx?direct=true&db=lgh&AN=111314570&site=ehost-live&scope=site.
© 2018 Kristin Kitzinger