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Accounting for Foreign Currencies

Introduction

When businesses trade internationally there are certain risks associated with foreign exchange. These risks are known as foreign currency risks. Such risk arises as a result of fluctuation in exchange rates. When the foreign currency appreciates it will make receipts more attractive and at the same time the payments will become less attractive. On the other hand, if foreign currency depreciates it will make payments more attractive then receipts .The world leading currencies are Great British Pound, US dollar, Japanese yen and European Euro.

Discussion

Businesses are subjected to various kinds of risks. Three of them are Economic risk, Transaction risk/exchange rate risk and Translation/Accounting risk.

Transaction Risk

Transaction risk is a financial risk that arises as a result of exposure to unanticipated changes in the exchange rate between countries. This is the risk that arises as a result of time delay between entering in to a contract and settling it. The longer the time period between entering in to a contract and settling the contract, the higher the chances of transaction risk.

Economic Risk

Economic risk is a long term version of transaction risk that is in transaction risk the effect of exchange rate fluctuation is short term. Economic risk reflects the long term impact of on the value of the company (present value of future cash flows) due to changes in exchange rate. For example reducing the likelihood of turnover or changes in the price of factors of production and finished goods as compared to the other prices in the domestic market. The risk may be due to changes in the severity of competition both on the part of the producer of similar good, as well as the manufacturer of other products, as well as changes in consumer's commitment to a particular brand.

There are two ways in which businesses are exposed to economic risks. The first one is direct impact and the second one is indirect impact. In direct impact, the appreciation of local currency makes the imported product more attractive due to lower price as compared to the price of local products. This increases the sales of imported products at the expense of sales of local products. In Indirect Impact, if the currency of the competitor depreciates (located in another country) then it makes his product more attractive (cheaper) compare to our product.

Translation Risk

Translation risk is the risk that the net investment of the company will change in value as a result of change in exchange rate. This usually occurs when a majority portion of company's assets and liabilities are in foreign currency. So, if a majority of the portion of company's investments are in foreign currencies the higher will be the translation risks. This risk is a serious threat to those businesses that operate in foreign markets.

Companies usually report their earnings on quarterly basis and changes as a result of fluctuating exchange rate can cause significant variances between the reported figures.

It is necessary for the companies to have a proper system of to ...