Foreign Exchange and Financial Accounting and Principles of Exposure Management

The accounting professions in the USA, Britain and in many other advanced countries now have most identical rules for accounting for foreign currencies in publishing accounts. Generally speaking, translation of foreign currency items uses the current rate method.

Transaction gains, whether realized or not, are accounted for through the profit and loss account. But there is a major exception and this relates to a foreign currency denominated borrowing where a transaction profit or loss whether realized or not, arises from taking on a foreign currency borrowing in a situation in which the borrowing can be designated as a hedge for a net investment denominated in foreign currency, then the gain or loss on the borrowing, if it is less than the net investment hedged, would be accounted for by in reserves rather than through the income statement. If this kind of transaction gain respectively on the net investment hedged, then the excess gain or loss is to be reported in the profit and loss account.

Non- transaction gain and losses due to be dealt with by reserve accounting direct to the balance sheet rather than through the profit and loss account.

According to US accounting rules, translations of foreign currency denominated profit and loss account are to be made at the average exchange rate during the accounting period.

The British standard allows the use of either the current rate or the average rate for this purpose. It is fair to say that opinion in Britain is moving towards the average exchange rate method.

Principles of Exposure Management

Hedging exposures, sometimes called risk management or exposure management, is widely resorted to, by finance directors, corporate treasurers and portfolio managers. The practice of covering exposure is designed to reduce the volatility of the firms’ profits and/ or cash generation and it presumably fallows that this will reduce the volatility of the values of the firm.