Foreign Currency Risk Essay

Expanding business to international markets comes with some risks that business operators need to take into consideration. Managers need to measure the magnitude of risk, input required and if the risk is worth considering. One of those risks is foreign currency risks. This essay aims at analyzing the foreign currency risk that the CEO of XYZ company expects in expanding the business to three foreign nations. The essay expounds on how the foreign currency risks affect their company, XYZ.

1. Accounting exposure refers to the risk attached to a company's liabilities, assets, capital, income, and equities due to the ever-fluctuating money exchange rates especially when the company invests in other nations apart from its home country. It is also referred to as translation exposure. Each of the three different nations that Albert wishes to invest in has its different currency, different exchange rates that fluctuate differently depending on the country's economic status and its relation with the international markets. The financial statement for the goods, services and all forms of income in the foreign country have to get translated to the country's currency, which involved the unexpected change in exchange rates that bring about the accounting exposure. The risk can't be avoided in any way, whether the exchange rate fluctuates favors the value of the assets, or devalues them. It reflects a gain or loss on the balance sheets, because of the change in exchange rate, although the asset remains the same (Du & Schreger, 2016).

After a company has signed up for international business, it faces the risk of change of money exchange rates, which will be hard to escape since they are already involved in financial transactions with the foreign country. It is referred to as transaction exposure. Such sudden changes can cause tremendous losses to a firm. Albert's company should expect such risks after locating their business extension in the three countries. The three countries won't feel the effect of the changing exchange rates, but the foreign investing company will significantly get affected. It can cause the XYZ Inc. to have to invest more income in the foreign country than expected, with fewer returns, which yields losses, as reflected in the financial statements (Du & Schreger, 2016).

Operating exposure is a type of international business risk that affects a company in the case of the effects of unforeseen currency waver to the future of a company's income, foreign business activities and earnings. It is also known as economic exposure. It causes changes in the market value of a company investing in foreign nations because it operates in long-term activities and has far-reaching effects. It is the most challenging problem among the risks of currency exposure only because it is hard to measure. This risk would lead XYZ Inc. into major losses if the three countries fell under operating exposure, which is apparently hard to control (Du & Schreger, 2016).

2. FOREX hedge includes methods used to mitigate or reduce the effects of the foreign exchange risks that accompany that operates the international trade, as the XYZ Inc. wishes. Cash flow hedge is one of the ways used to reduce global trade money exchange problems. Cash flow hedge works in the case of a particular risk identified towards one asset or liability in the case of changes in the exchange rates. It is applicable in the reduction or elimination of losses that arise due to changes in cash flow associated with exchange rate fluctuations. For instance, it could help avoid losses attached to future interest payments or debt settlement that could go high due to increased foreign exchange rates at the time of payment (Judge, 2015).

Another method used to curb foreign exchange risks is the fair value hedge. It is mostly applicable where a company commits itself in an international business that attributes profits or losses depending on the nature of the changes in international markets money exchange rates. It reduces the losses that come about due to the changes of the fair value of an asset supplied by a company that the firm did not expect. It acts to shield a current liability or asset through buying instruments that act as the hedging instrument. The hedging instrument attracts a fair value same as that of the asset in question, hence responding against the particular risk involved when prices of supply and demand change in the foreign countries (Judge, 2015).

The Fair Value Hedge is more appropriate for XYZ Inc. because it provides and hedge that compensates for any losses attached to changes in market price, ensuring that the company never undergoes any losses due to foreign exchange risks (Judge, 2015).

3. Current rate method represents its values on the balance sheets after the translation of the money values to the current exchange rate values of the foreign country that a company conducts business. It attracts large amounts of translation risks due to rate fluctuations. It assumes the associated gains or losses as unnoticed, as indicated on the balance sheets. Related gains and losses appear on a reserve account (Judge, 2015).

Temporal method prefers the application of exchange rates at the point of assets and liabilities acquirement and uses those particular values on the balance sheets. The monetary measure of the assets and liabilities that appear on the balance sheet get calculated depending on the rate of foreign exchange rates at the time the balanced sheet gets written. However, non-monetary assets and liabilities get their value translated at the date of the actual transaction date, using the exchange rates operating at that particular time. The temporal method is appropriate when there exists a notable difference between the local currency and the functional currency. However, different from the current rate method, losses and profits get recorded on a net income account (Judge, 2015).

4. The temporal method is more applicable for the XYZ Company since it reflects its losses and gains in the net income accounts, making it easier for the company to keep track on their financial status and progress. It minimized balanced sheet exposure because it makes its Balance sheet calculations for all its monetary transaction depending on the current market exchange rates. It is also precise on accounting for the value of non-monetary assets as it applies the exchange rates at the time of the transaction (Judge, 2015).

5. Both U.S GAAP approach and IFRS approach apply the balanced sheet, use income statements and provide cash flow statements. Moreover, the two methods recognize revenue when it appears and can get noted when preparing a financial statement. However, GAAP functions under rules while IFRS bases its activities on set principles. GAAP doesn't give room for financial errors while IFRS gives way to different interpretations of a particular transaction, which makes it less strict in its accounting practices. Another difference occurs in "Last In First Out" (LIFO) where GAAP fully supports and applies the LIFO methods, but IFRS has to combine LIFO method with Average Cost technique in case of inventory valuation (Beck, Behn, Lionzo & Rossignoli, 2017).

Regarding FASB, integration of both the GAAP and IFRS methods would be appropriate in improving the financial accounting for XYZ Inc. The GAAP ensures strictness in making financial records, while the IFRS gives a chance for analyzing complex transactions to view them different prom perspectives, mainly because the XYZ is to get involved with foreign countries with fluctuating currency exchange rates (Beck, Behn, Lionzo & Rossignoli, 2017).

Conclusion

In conclusion, attaining a successful international business requires appropriate mitigation of the issues that arise with operating within the fluctuating currency exchange ratios. It also calls for proper financial accounting to mark areas of losses and profits, and also for prediction of future expected international exchange risks for earlier preparation.

References

Beck, A. K., Behn, B. K., Lionzo, A., & Rossignoli, F. (2017). Firm Equity Investment Decisions and US GAAP and IFRS Consolidation Control Guidelines: An Empirical Analysis. Journal of International Accounting Research, 16(1), 37-57.

Du, W., & Schreger, J. (2016). Sovereign risk, currency risk, and corporate balance sheets.

Judge, A. (2015). The determinants of foreign currency hedging by UK non-financial firms.