Definition: The Translation Exposure or Accounting Exposure is the risk of loss suffered when stock, revenue, assets or liabilities denominated in foreign currency changes with the movement of the foreign exchange rates.
In other words, the translation exposure stems from the requirement of converting the subsidiary’s assets and liabilities (operating in another country) denominated in foreign currency in the home currency of the parent company, at the time of preparing the consolidated profit and loss statement and the balance sheet. Thus, any change in the foreign exchange rate will have a considerable impact on the financial statements.
In translating the items denominated in foreign currency in the domestic currency, an accountant encounters two issues:
- Whether the financial statement items denominated in foreign currency are converted at the current exchange rate or at the rate which was prevailing at the time the transaction occurred (historical exchange rate)?
- Whether the profit or loss that arises from the rate adjustments be taken into the current period profit and loss statement or be postponed?
If there is any change in the exchange rate over the previous accounting period, then the translation of the items denominated in the foreign currency will result in foreign exchange gains or losses, except when there is a tax implication on these items.
The translation exposure is concerned with the recorded profits and the balance sheet values and does not affect the overall value of the firm. Since the gains or losses suffered due to the translation of financial items has no significant impact on the stock prices of the firm. And the investors do believe that such risk can be diversified and hence does not demand any extra premium for it.