A Critical Evaluation of XYZ Foreign Exchange Risk and Recommendation

A Critical Evaluation of XYZ Foreign Exchange Risk and Recommendation

XYZ Inc.’s CEO, Albert, aspires to expand its sales revenue through exports that the organization’s three foreign subsidiaries would perform. Albert knows the target subsidiaries require the transactions to be denominated in the local currencies. He has researched foreign currency risk and has identified accounting exposure in the accounting statements, operating exposure in future cash flows, and transaction exposure in outstanding obligations. Notably, Albert fails to comprehend how the identified risks apply to XYZ; thus, he requested I prepare a foreign risk assessment that identifies and analyzes each threat associated with XYZ’s expansion into the foreign markets. The CEO would present this report to the board to aid in decision-making. This report analyzes XYZ’s risk exposure in the foreign markets and their management, and evaluates the accounting techniques for its foreign subsidiaries and their similarities and differences.

XYZ’s Main Exposure.

XYZ experiences translation, transaction, and operating exposure that impact its financial statements. Translation exposure gauges the accounting-derived exchange rate gains and losses resulting from converting the affiliates’ foreign currency into the parent company’s currency unit (Schroeder, Clark, & Cathey, 2019). This risk arises from the nominal exchange rate change from the previous accounting period. The gain is not realized. The translation’s impact does not affect the cash flow. Managing risk from the cash flow perspective is not justified, save for the limited circumstances. The transaction exposure evaluates the value changes in the outstanding nominal financial obligations incurred during the period before the change in the exchange rate but is not settled until the exchange rate changes (Schroeder et al., 2019). The transaction exposure results from unexpected exchange rate changes on the components of the nominal exchange and substantially impacts the company’s cash flow. The operating exposure examines the change in cash flows from a company’s future transactions resulting from variations in the real exchange rate. They correspond with changes in relative competitiveness. Lastly, the company experiences tax exposure when the foreign losses are deducted in computing the income taxes.

Strategies for Hedging Against the Foreign Exchange Rate Risk

Money market hedges and forward and futures contracts comprise effective strategies to be implemented by XYZ in hedging against the interest rate risk. The money market entails hedging against the exposure to foreign currency risk by borrowing or depositing the required amount of funds in servicing payments and receipts in the domestic currency (Buehler, Gonon, Teichmann, & Wood, 2019). A business that ventures into foreign markets experiences foreign exchange risk, whereby the currency’s value may change between the transaction date and that of payment or receipt. In hedging against the foreign exchange rate, XYZ should borrow in foreign currency amount equivalent to the present value of the debt receivable in the future. At the end of the exposure period, the amount of principal and interest on the foreign currency will be equivalent to that owed by the customer. Hence the receipt would be utilized in repaying the loan. XYZ could hedge against the risk by engaging in futures contracts that entail legal agreements between parties that set a fixed foreign current rate for a future transaction scheduled at a specified future date (Ciorciari, 2019). This contract is effectively hedging the company against unforeseen currency changes by specifying the price on the agreement’s day. On the flip side, the company may miss out on the benefit of the exchange rate appreciation in customer receipts. Even so, the forward contract is the most suitable for XYZ Company.

IFRS and US GAP Differences and Balance Sheet Exposure

Notably, IFRS and US GAAP require that multinationals whose subsidiaries are situated in t foreign nations consolidate the financial statements by adding the components in the foreign affiliate financial statements to those of the parent firms (Stafievskaya et al., 2016). The preparation of the consolidated financial statements requires that the parent firms undertake the translation of the foreign currency into the parent company’s currency. If the foreign affiliate and parent company utilize different currencies, the current rate approach should be employed. The current rate method exchanges the foreign currency utilized by the subsidiaries into the parent company’s exchange rate by implementing by translating the liabilities and assets at the prevailing exchange rate on the date of the balance sheet preparation (Schroeder et al., 2019). It is important to note that this technique assumes common stock is exchanged at historical rates. The revenues and expenses are translated at the exchange rate that prevailed during the transaction date. Lastly, this technique assumes the net translation gain or loss is realized when the entity is sold and is not reflected in the income statement. Notably, the translation adjustment reflects equity. Alternatively, companies employ the temporal method whereby the affiliates’ financial statements are translated into the parent company’s currency. The balance sheet components are exchanged at the prevailing rate, while the non-financial debt obligations and assets are stated at the historical cost and exchanged at historical rates.

The primary concept of the current rate method is the affiliates’ operations are predisposed to substantial foreign exchange rate risk; hence, the financial statement components of such assets should be exchanged at the current rate. Notably, the balance sheet exposure is equivalent to the net investment. On the other hand, the temporal technique requires that the foreign affiliates translate the transactions to US dollars, assuming they were performed using this currency.

IFRS requires that the parent company restate the foreign statements following the IAS 29 provisions before translating the financial statements to the currency of the parent company while following the current rate technique under IAS 21. On the other hand, the US GAAP requires the financial statements to be translated following the temporal method. According to US GAAP, hyperinflation is a cumulative three-inflation period that is higher than 100%. Notably, IAS 29 does not define hyperinflation.

Main Similarities and Differences Between the Two Methods of Translation

The two techniques are similar in that they capture the differences in the exchange rate between the parent company and its affiliate. The major differences underlying the current and temporal translation methods relate to the non-monetary assets carried at the historical cost and the related costs, such as the stock and cost of goods sold, PPE, depreciation cost, intangible assets, and amortization costs (Ito, Koibuchi, Sato, & Shimizu, 2016). In the temporal method, the PPE is exchanged at the historical rates, while the current rate translates at the current rate whilst the related costs are translated under the average exchange rate. The foreign assets and liabilities are measured in foreign currency and are hence exposed to transaction risk. The balance sheet exposure is similar to the net transaction exposure resulting from the receivables and payables’ translation in a specified foreign currency.

The Appropriate Translation Method Under Fasb in Highly Inflationary Nations

FASB requires that multinational companies operating in high inflationary states utilize the temporal method. It discourages the current rate technique because it features a “disappearing plant” challenge whereby the fixed assets decrease with respect to their carrying amount because inflation is not restated in this method (Stafievskaya et al., 2016). The temporal method counters this challenge by utilizing the same historical rate in translating fixed assets between periods. FASB requires that companies should not restate the foreign affiliates’ financial statements due to the absence of reliable inflation indices in most nations, hence predisposing the accounting process to imprecision.

References

Buehler, H., Gonon, L., Teichmann, J., & Wood, B. (2019). Deep hedging. Quantitative Finance, 19(8), 1271-1291.

Ciorciari, J. D. (2019). The variable effectiveness of hedging strategies. International Relations of the Asia-Pacific, 19(3), 523-555.

Ito, T., Koibuchi, S., Sato, K., & Shimizu, J. (2016). Exchange rate exposure and risk management: The case of Japanese exporting firms. Journal of the Japanese and International Economies, 41, 17-29.

Schroeder, R. G., Clark, M. W., & Cathey, J. M. (2019). Financial accounting theory and analysis: text and cases. John Wiley & Sons.

Stafievskaya, M. V., Sarycheva, T. V., Nikolayeva, L., Vanyukova, R. A., Shakirova, R. K., Ryzhova, L. I., … & Norkina, K. V. (2016). Provision for accounting risks. The Social Sciences (Pakistan), 11(8), 1776-1779.

Tiwary, A. R. (2019). Study of currency risk and the hedging strategies. Journal of Advanced Studies in Finance (JASF), 10(19), 45-55.

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Albert, CEO of XYZ, Inc., desires to expand the company’s sales through exports to three foreign subsidiaries. Albert knows that the target subsidiaries’ countries require transactions to be denominated in the local currencies. Albert has researched foreign currency risk and knows accounting exposure in accounting statements, operating exposure in future cash flows, and transaction exposure in outstanding obligations. Albert does not understand how these risks apply to XYZ, Inc. under his proposal or if any mitigating risk strategies are available.

A Critical Evaluation of XYZ Foreign Exchange Risk and Recommendation

Albert requests you, as head of the risk management division, prepare a report that he can present to the board of directors on the potential foreign currency risk if XYZ, Inc. expands sales into these markets. XYZ, Inc.’s reporting currency is the U.S. dollar, and the subsidiaries would purchase the merchandise as inventory items.

For more information on corporate strategies regarding hedging foreign exchange risk, refer to Chapter 9 of Advanced Accounting.
You may make any assumptions needed for the completion of this assignment.
Instructions
Write a 3–5 page paper in which you:

Specify accounting exposure, operating exposure, and transaction exposure.
Determine the main financial statement effects of each type of exposure if XYZ, Inc. expands as proposed.
Determine two types of hedges regarding foreign exchange risk in general and recommend the most advantageous risk mitigation strategy for XYZ, Inc.
Provide support for your rationale.
Determine the main accounting assumptions underlying each currently used method (e.g., current rate method and temporal method).
Determine the fundamental differences in balance sheet exposure from the application of each method.
Suggest the translation method that XYZ, Inc. should use to minimize balance sheet exposure. Provide support for your choice.
Compare the U.S. GAAP approach to the IFRS approach of translating foreign currency financial statements.
Determine the main similarities and differences between the two methods of translation.
Assuming one of the subsidiaries of XYZ, Inc. is in a highly inflationary country, determine the appropriate translation method under FASB and provide the theoretical justification for your response.
Use Basic Search: Strayer University Online Library to find at least two academic resources. Note: Wikipedia and similar websites are not considered quality references.
This course requires the use of Strayer Writing Standards. For assistance and information, please refer to the Strayer Writing Standards link in the left-hand menu of your course. Check with your professor for any additional instruction