What is an Accounting Risk?

Accounting risk is the concept that a company's financial statements may have to be recalculated because of fluctuations in currency exchange rates. It is also known as accounting exposure or translation risk. The phrase refers to the possibility of recalculation and doesn't necessarily imply that the effect will be unfavorable.

The problem of accounting risk comes when a company owns assets listed in a foreign currency. At its simplest, this could be cash. In more complicated situations, it could be all the assets of a subsidiary company based in another country. If the exchange rate changes, the paper value of the assets to the company will change, even if the assets themselves remain unchanged.

It is, of course, perfectly possible that the exchange rate's change could make an asset more valuable rather than less valuable. Accounting risk does not specifically mean the risk of losing paper value. Instead it means risk in the wider sense, that being the lack of certainty.

The concept of accounting risk only applies to existing assets. It doesn't cover the risk that exchange rate fluctuations could affect future business. For example, a touring entertainment company may do well visiting a foreign country and book a tour for the following year. It may turn out that the exchange rate moves unfavorably in the meantime and, even if the tour attracts the same audiences as the year before, it would have been more profitable to have instead performed more domestic dates. As the income from hypothetical future sales isn't usually counted in current financial statements, accounting risk doesn't normally cover this situation.

There are differing ways of coping with the problem of accounting risk. Which are favored may vary depending on accounting customs and culture in a particular economy. Which are allowable will depend on national accounting laws.

As a general rule, there are two main approaches to making provisions for accounting risk. One is to simply value assets by using the actual exchange rate that applied when the assets were applied, known as the historical exchange rate. The other is to value them using the exchange rate from the point at which the accounts are prepared.

Supporters of the former method argue that it shows the underlying value of the assets and that using the current exchange rate is irrelevant until the assets come to be converted into local currency for real. Supporters of the latter method argue that it shows a more realistic picture. In some cases a firm will use a hybrid approach, listing monetary assets such as cash and securities using the current exchange rates, but physical assets such as stock and machinery using the historical exchange rate.