ACCOUNTING IMPLICATIONS OF FOREIGN CURRENCY TRANSACTIONS TRANSLATION AND HEDGING

Abstract

Due to the internationalization of business and frequent fluctuations in exchange rates, information about the impact of changes in exchange rates on individual companies' and multinational groups' financial position and profitability has become increasingly important. Data on the translation effects of both foreign currency transactions and foreign subsidiaries' financial statements, a company's exposure to different types of foreign exchange risks and taken currency hedging measures enable many users of accounting contents to obtain a better picture of an entity's financial position and its profitability. The key issues relate to the choice of the exchange rate to be used in accounting data translation and the financial reporting presentation of translation effects. While the effects of the foreign subsidiaries' financial statements translation can be shown in the balance sheet and the income statement, the effects of foreign currency transactions translation are incorporated in the income statement. This paper discusses the accounting aspects of the foreign currency transactions translation, an enterprise's transactional exposure to a currency risk, and the use of financial derivative instruments to hedge against foreign exchange risk. [PUBLICATION ABSTRACT]

Headnote

Due to the internationalization of business and frequent fluctuations in exchange rates, information about the impact of changes in exchange rates on individual companies' and multinational groups' financial position and profitability has become increasingly important. Data on the translation effects of both foreign currency transactions and foreign subsidiaries' financial statements, a company's exposure to different types of foreign exchange risks and taken currency hedging measures enable many users of accounting contents to obtain a better picture of an entity's financial position and its profitability. The key issues relate to the choice of the exchange rate to be used in accounting data translation and the financial reporting presentation of translation effects. While the effects of the foreign subsidiaries' financial statements translation can be shown in the balance sheet and the income statement, the effects of foreign currency transactions translation are incorporated in the income statement. This paper discusses the accounting aspects of the foreign currency transactions translation, an enterprise's transactional exposure to a currency risk, and the use of financial derivative instruments to hedge against foreign exchange risk.

Keywords: foreign currency transaction, transaction exposure, foreign currency financial statements, currency hedging

JEL Classification: M41, F3

(ProQuest: ... denotes formulae omitted.)

INTRODUCTION

The complex field of international accounting could be perceived in the easiest way on the basis of its descriptive/comparative and pragmatic domains. While the descriptive/comparative aspects of international accounting are primarily focused on the research and classification of national accounting systems, the pragmatic domains are related to the accounting dimension of international transactions and activities of multinational enterprises/MNEs (Radebaugh & Gray, 1997, 11) The key international accounting pragmatic aspects are related to the consolidation, segmental reporting, foreign currency translation and foreign currency hedging. The importance of studying the two latter interactive international accounting areas has particularly been evident in the recent years due to the expansion of international business, financial and investment activities, and the expressed flexibility in exchange rates.

In an accounting context, foreign currency translation is the restatement of accounting data expressed in one currency into another. The necessity of foreign currency accounting contents translation is particularly evident in the recording of foreign currency transactions in the books of accounts and the preparation of an individual company's financial statements as well as the consolidation of foreign subsidiaries' financial statements with their parent company's financial statements on condition that they are not expressed in a common currency (Nobes & Parker, 2010). Due to the impact of fluctuations in exchange rates on foreign currency transactions, enterprises face transaction exposure to exchange-rate risk, which directly effects their cash flows and profitability when they are settling a monetary transaction. In order to hedge against transaction exposure to foreign exchange risk, companies mainly enter into financial currency hedging arrangements. This type of hedging connects gains and losses on foreign currency financial derivatives (hedging instruments) with losses or gains on items that are the subject of currency hedging.

Therefore, the subject of this research paper will be focused on the analysis of the interaction of foreign currency accounting contents translation and a company's exposure to various types of foreign exchange risk. More specifically, the study focuses on the analysis of the accounting aspects of foreign currency transaction translation and their currency risk hedging in terms of fluctuations in exchange rates. Starting from a very high level achieved not only de jure but also de facto of international accounting harmonization in these areas, the international convergence of foreign currency translation accounting regulations and its repercussions for our country are imposed as a particularly important aspect of the research.

Having in mind the previously defined and explained research subject, the main goal of the paper, based on the consideration of the conceptual issues of transaction translation and transaction exposure to foreign exchange risk, is to point out their interaction with currency hedging as well as to interpret those causal relationships in the accounting context. The significant research objectives are reflected in the assessment of the effects of foreign currency transactions translation and currency hedging on a company's financial position and its profitability, as well as in the analysis of the existing practices of accounting for the effects of changes in exchange rates in representative enterprises in the Republic of Serbia (RS).

According to the subject exposed and the research objectives set, the following hypothesis will be tested in the paper: There is a statistically significant correlation between the level of an enterprise's transaction exposure to foreign exchange risk and the level of currency hedging application.

Having defined the problem, the subject and the research objectives, and having set the research hypotheses, we have provided a detailed presentation of the literature on foreign currency accounting. Understanding these complex theoretical and methodological aspects enables us to become familiar with the practical cases of both foreign individual and multinational enterprises (MNEs) as well as to have them compared with the practice of local entities. This survey of representative enterprises in our country, which are faced with foreign currency transactions and currency hedging, makes it possible to generate some relevant empirical findings on the key issues of foreign currency accounting contents translation and the possibilities of the implementation of international achievements in having them resolved. In the research process, a wide range of methodological procedures and techniques allowing the verification of the hypotheses are used. Finally, the main results of the theoretical and empirical research into the accounting implications of foreign currency translation and currency hedging will be the understanding of interactivity in these areas, the promotion of the international convergence of foreign currency accounting regulations and the analytical interpretation of the effects of application of different foreign currency transaction translation methods on a company's financial position and yield.

In accordance with the determined objectives, the goals and the initial hypothesis, and after considering the accounting aspects of foreign currency translation, accounting for transactions in foreign currency will be discussed in the paper. Then, an enterprise's transaction exposure to foreign currency risk will be discussed, followed by the consideration of the exposure of an enterprise's transaction to foreign currency risk. The last part of the paper will focus on the financial hedging of foreign currency transactions. In addition, instead of the initial integrative review of the previous research, a sequential review of the literature will be used in each part of the paper.

THE ACCOUNTING ASPECTS OF FOREIGN CURRENCY TRANSLATION

The specific meaning of the foreign currency translation syntagm is emphasized in the economic literature. In the accounting context, foreign currency translation is a process of expressing financial data presented in one currency into another one using appropriate exchange rates. Additionally, historical, current or average rates can be used in the process of the monetary expression of the change in the foreign- currency denominated amount against the domestic currency equivalent.

While conversion implies a real, physical exchange of one currency for another, accountants use foreign currency translation in order to fulfill the condition of financial data currency homogeneity. As English- speaking accountants have taken this term from linguists, the term translation is incorrectly interpreted and used by non-accountants. (Nobes & Parker, 2010, 412).

Generally, the reasons for translating foreign- currency denominated financial data should be viewed in the context of the expansion of international business, financial and investment activities, an increase in the number of multinational groups, the frequency of fluctuations in exchange rates and the growing importance of financial reporting on the transparency of the inter-currency fluctuations effects on a company's financial position and profitability. Adequately translated financial data not only eliminate the information asymmetry between domestic and foreign users of accounting contents, but they are also a conditio sine qua non for the international group financial statements consolidation and segment reporting. In a number of situations, the necessity for accounting data translation arises both at the level of individual firms and the level of international groups. The problem of foreign currency transactions translation occurs in recording them in the book of accounts and in the preparation of financial statements of individual companies. The importance of translation, as a process of reformulating the information content of financial statements denominated in one currency into another, becomes particularly apparent in preparing MNEs` consolidated financial statements. There are other reasons causing a need for foreign currency translation, among which reporting on the results of independent activities abroad, reporting on the international activities of foreign subsidiaries and branches as well as their managers are emphasized.

Although at first glance the importance of the foreign currency translation issue has declined in the Euro zone due to the demonetization of the national currencies of the majority of the European Union member states, the undeniable significance of this accounting area could undoubtedly be confirmed by the following arguments:

* The Member States of the European Union, alongside intergroup economic communications taking place in a single currency, continue to perform their business, financial and investment activities outside the Euro zone;

* As some countries (e.g. the United Kingdom, Denmark and those to have recently acquired the status of a European Union member state) have not carried out the demonetization of their national currencies in the Euro, there is still currency heterogeneity in the European Union; moreover, the intergroup economic relations between all the member states are not performed on the basis of a single currency; in other words, the EU is characterized by a multicurrency environment.

An illustrative explanation of the undisputed importance of foreign currency translation clearly reveals the generally accepted F. Choi's assertion, which says "foreign currency translation choices are at the core of the fundamental concepts underlying the present financial reporting" (Choi, 1997, 13.2). The leading authors in the international accounting area highlight the fact that foreign currency translation and corresponding currency hedging are the most complex and the most controversial aspects of international financial reporting. A number of studies dedicated to the exploration of the relative importance of specific problems in the international accounting area have been pointing out their priority for a long time. In this regard, the author H. P. Troberg (1987, 318) gives a numeric argument of this statement, noting that "of the top ten individual problems of the 88 ones evaluated by international accounting experts, there are five related to currency translation". T. Doupnik and H. Perera (2007, VI) cite the results of the two different surveys conducted by business executives indicating that the most important topics to be considered in an international accounting course are those related to foreign currency accounting.

The relevant literature points out that there is a problem in understanding foreign currency translation because of frequent fluctuations in exchange rates, which increase the number of exchange rates used in the translation process. The argumentation for this assertion is metaphorically confirmed by F. Choi and G. Meek (2008, 204), who notes that "if foreign exchange rates were relatively stable, the currency translation process would be no more difficult than translating inches and feet into their metric equivalents."

Faced with a lack of fixed exchange rates, accountants deal with two issues:

* Which type of exchange rate (historical or current) should be used to translate assets and liabilities denominated in a foreign currency?

* How should gains or losses arising from changes in exchange rates be treated in the accounting context?

As the applied exchange rate determines the value of the assets and liabilities of a company and influences its result, the first question should be paid maximum attention to. Another problem is related to the presentation, i.e. descriptive determination and financial reporting on the positioning of the translation effects, or as Flower (Nobes & Parker, 2010, 415) qualifies it as translation differences. The financial statement disposition of these translation differences affects many important financial indicators, such as net income, total assets, equity, debt ratio, return on equity, etc.

The accounting aspects of foreign currency translation involve the processing of the following key issues, namely:

* Foreign currency transaction translation and

* Foreign currency financial statements translation.

Although the issues relating to the treatment of foreign currency transactions and their currency hedging are methodologically complex, they are mainly uniformly interpreted in the relevant accounting literature. When the translation of foreign subsidiaries' financial statements denominated in a foreign currency are concerned, there are a number of controversies, mainly arising from different interpretations of the following conceptual issues: (a) the choice of exchange rates to restate amounts denominated in one currency into another, and (b) financial reporting on the positioning of translation effects. Depending on the exchange rates applied in the translation of financial statements of foreign subsidiaries into a single currency equivalent, a number of methods are differentiated, such as the current rate method, the current/non-current method, the monetary/ nonmonetary method and the temporal method. Using different methods of financial statements translation has resulted in a wide range of translation results, different amounts of net assets as well as different translation exposures to foreign exchange risk.

Given the thematic orientation of this paper, the accounting implications of foreign currency transactions translation and a consecutive transaction exposure to foreign exchange risk are predominantly important to further be considered. Pursuing a holistic consideration of the relevant accounting implications of the effects of changes in exchange rates on foreign currency transactions, the key aspects of transaction exposure hedging will be considered. A focus on transaction exposure does not mean that the presence of the other types of foreign exchange risk should be sidelined. Simply, a detailed consideration of them is beyond the scope of this paper.

ACCOUNTING TREATMENT OF FOREIGN CURRENCY TRANSACTIONS

Accountants are faced with the problem of foreign currency transactions translation in the context of their recording in the books of accounts as well as in preparing a set of financial statements at the level of individual companies. In fact, it is those transactions that involve a settlement, i.e. debt collection or the payment of liabilities in a foreign currency. In addition to this, it is necessary that a strict distinction should be made between transactions in a foreign currency, on the one hand, and foreign trade, i.e. import-export transactions, on the other. Actually, in any international transaction, there is only one party to be faced with the problem of accounting for them in a foreign currency because a payment is usually specified in a single currency. Consequently, only the party who is settling a liability or a receivable in a currency other than its national currency faces foreign currency transactions. Beside sales activities, transactions in foreign currencies mainly include borrowing or lending money as well as a dividend payment (Roberts et al, 2008, 181). R. Baker et al. (2005, 542), similarly specified transactions in foreign currency:

* "Purchases or sales of goods or services (imports or exports), the prices of which are stated in foreign currencies;

* Loans payable or receivable in a foreign currency;

* A purchase or sale of foreign currency forward exchange contracts;

* A purchase or sale of foreign currency units."

Accountants have assumed a unique attitude that the initial bookkeeping records of foreign currency transactions should be based on an effective exchange rate on the transaction date. Because of a potential utilization of a credit conditions during exchange-rate fluctuations, the unrealized part of the transaction, (the outstanding obligation and/or outstanding receivables in a foreign currency) should be adjusted in the balance sheet at a date before the payment date. However, if an amount of a settled transaction is different from a previously recorded one, accountants are faced with the problem of the treatment of the identified difference, i.e. gains and losses on foreign currency transactions. In this regard, the two aspects were differentiated, namely: a single-transaction perspective and a two transaction perspective (Choi & Meek, 2008, 209).

According to the first view, the real and the monetary part of a foreign currency transaction are treated as parts of ? single business event. The liability payment or accounts receivable collection in foreign currencies are considered to be an indispensable and inseparable part of a purchase or sale transaction, respectively. According to the single-transaction perspective, the effect of changes in foreign exchange rates at selling goods on credit to foreign customers are recorded on foreign currency accounts receivable and sales revenue. As the Sales account is closed at the end of the prior period, the negative effects of the changes in foreign exchange at the beginning of the period are included in the Retained earnings account. Therefore, this perspective could be remarked as to the effects of changes in exchange rates being masked by adjusting the Sales account, or the Retained earnings in respect of credit payment terms.

According to the other view, foreign currency transactions are decomposed into a real and monetary segment, and a purchase or sale of goods, on the one hand, and the settlement of the obligation or the collection of a receivable, on the other, are separately treated. In other words, according to this perspective, exports and the correspondent collection are treated as two separate transactions. Since the management make two decisions on the sale of a product in an international market and also offer credit terms of payment to a foreign buyer, the effects of both of these decisions are stated separately in the income statement. The difference between the amount initially recorded on the transaction date and the amount by which the same is finally regulated (settled) is treated as a gain or a loss on a foreign currency transaction (transaction gains or losses). In other words, according to this view, initially recorded sales are not adjusted, but the effects of changes in exchange rates on foreign currency receivables are reported on as foreign exchange gains or losses.

Comparing these perspectives, it could be concluded that they both have an influence on a company's profitability in the same way. These perspectives differ in that, under the single transaction perspective, the amount of sales is adjusted for changes in exchange rates, and the effects of the more transparent of the two transaction perspectives are included in an exchange loss or gain.

While considering the effects of fluctuations in exchange rates in the context of the accounting treatment of foreign currency transactions, it is important to deal with the problem of the lack of a single, standardized method of the translation of the monetary part of a foreign currency transaction. In this regard, accountants have taken the view that the translation of the real part of a foreign currency transaction should be based on historical, i.e. transaction rates. On the contrary, there are three modalities of translation pointed out for the translation of monetary assets (receivables) and liabilities denominated in foreign currencies by Flower (Nobes & Parker, 2010, 417):

"(1) at the historical rate. With this method, the home currency amount of these items is left unchanged and no translation gain or loss is reported.

(2) at the closing rate. Translation at the balance sheet rate gives the current value of these items in terms of the home currency, i.e. the amount of money that would be received on the balance sheet date if the monetary asset were converted into the home currency (mutatis mutandis for liabilities). When the closing rate is different from the historical rate, a translation difference arises, which is generally taken as a gain or a loss in the income statement;

(3) at the lower (higher) value of the historical rate and the closing rate for assets (liabilities). When this method is used, assets are stated at the lower of two possible values and liabilities at the higher one. The closing rate is only used if it gives rise to a loss on translation, which is charged to the income statement."

Since the first method can lead to an overestimation of monetary assets and an understatement of liabilities to their current values, it can be concluded that it is in direct contradiction to the principle of prudence. Therefore, the question of the argumentation and validity of such an approach is rightfully raised. Unlike this method, in the accounting literature, we can find well-founded arguments emphasizing the application of the second and third approaches.

According to the translation effects of the monetary part of foreign currency transactions (transaction gains and losses), the second method, which is based on the accrual principle, should be assigned to the accounting period in which a change in an exchange rate occurs rather than the period of cash and its equivalents collection or payment.

Both the regulatory authorities in the U.S. and the UK and those in other countries with the Anglo- Saxon style of accounting assume the attitude to the accounting allocation of gains or losses on foreign currency transactions translation since these translation differences are due to changes in exchange rates, which have just occurred during that accounting interval. Thus, both American Statement No. 52, Foreign Currency Translation (published in 1981), which is marked as ASC 830, officially became part of the ?ccounting ?tandards ?odification by the decision reached by the Financial Accounting Standard Board - FASB (September 2009) and, under the same name, British Statement 20 generally follows the method based on the accrual principle. A similar approach is represented in the International Accounting Standard 21 (IAS 21), Accounting for the Effects of Changes in Foreign Exchange Rates.

The third method is based on the principle of prudence. In the context of foreign currency transactions, this principle is effected by the restatement of monetary assets and liabilities at the historical or the current exchange rate resulting in a lower value of assets and a higher value of liabilities. Because of a possibility of exchange rates moving in the opposite direction in the future, which may neutralize the positive effects of the current period, "cautious (prudent)" accountants are not ready to show gains on the translation of the monetary part transaction in the current period, but rather have them disposed in the period in which foreign currency receivables or liabilities will undoubtedly be settled.

Unlike the majority of the EU countries whose national policies advocate the application of the current rate in the translation of monetary assets, a more conservative approach is favored in Germany and France, which translates monetary assets at a lower historical or the current exchange rate while foreign currency liabilities are translated at a higher historical or the current exchange rate. Therefore, it is evident that this method can be used in those countries that favor or, better said give priority to the principle of prudence (Germany and France).

Summarizing the discussion on the pragmatic value of these methods, Flower (Nobes & Parker, 2010, 419) notes that the best solution is the one based on a compromising treatment of both methods and states that "monetary assets and liabilities should be valued at the closing rate, whereas the transfer of a gain to the income statement should be deferred until the foreign currency asset/liability has been realized."

On the basis of an original empirical research conducted in 2010, while performing doctoral dissertation work, the accounting implications of foreign currency transactions translation as well as the analysis of the applied, existing, practice of currency risk management in representative enterprises in RS were assessed.

Beside the problem of the accounting treatment of foreign currency transactions, comments on the current accounting regulations in the field of international business were investigated, with a special emphasis on the consistency of the application of IAS 21.

In accounting for foreign currency transactions in Serbian enterprises, the majority of the surveyed respondents pointed out the problem of their inconsistent financial reporting presentation after the publication of the Ordinance on Changes and Amendments of the Regulation of the Chart of Accounts and Content of Accounts for Companies, Cooperatives, Legal Entities and Entrepreneurs ("The Official Gazette of RS", No. 9/2009). In fact, due to a large amount of the stated (recorded) foreign exchange losses to be reported as an expense in the income statement of companies in RS, by allowing their transfer to accruals, the Regulation has enabled the reposition of the effects of changes in exchange rates from the income statement to the balance sheet. Not only has it challenged the periodical comparability of a company's financial position and its profitability but it has also challenged the application of the part of the IAS 21 related to foreign currency transactions.

Accruals of the effects of exchange rate differences have for many years affected the financial position and profitability of a large number of companies in RS. We should keep it in mind that the transfer of the effects of deferred foreign exchange differences to the income and expenses of the accounting period will affect the financial statements in the years to come.

COMPANY'S TRANSACTION EXPOSURE TO FOREIGN EXCH ANGE R I SK

The internationalization of the economic activity associated with rising cross-currency instability directs a globally-oriented company to a higher perception of the exposure to foreign exchange risk and currency hedging. As S. Saudagaran (2004, 59) emphasized the fact that an exposure to foreign currency risk is a "measure of the potential of a firm's profitability, its cash flow and market value to change due to a change in exchange rates." In addition to this, the general concept of exposure to foreign exchange risk is not considered as monolithic in the literature, but is rather decomposed into the transaction, translation and economic segments (Demirag & Goddard, 1994: Dhanani, 2003; Menon & Viswanathan, 2005; Kim & Kim, 2006; Madura & Fox, 2011). A. Shapiro (2006) classifies foreign currency exposures into the transaction, operation and translation components. In this case, it is an economic exposure in a broader sense including the transaction and operating components. Although these alternative types of exposure reflect foreign exchange risk from various perspectives, with a considerable degree of congruency between them, it is necessary that they be identified separately. Not only do these types of exposure to foreign exchange risk affect the existing and prospective company's financial position and its profitability in a different way but they also entail the use of different hedging strategies.

The essential determinants of the transaction, translation and operating exposure are illustrated in Table 1. On that basis, and because of an overlap between these types of exposure to foreign exchange risk, it can be said not to draw a clear demarcation line between them.

Due to the impact of fluctuations in exchange rates on foreign currency transactions, enterprises are facing transaction exposure to exchange-rate risk, which, upon the regulation (settlement) of these transactions' monetary part, effected directly to both flows cash and profitability. Since these transactions result in a future foreign-currency cash inflows and outflows, changes in exchange rates from the period of their initial recording to the period of their settlement will cause a change in the amount of the inflow or outflow of local-currency cash. Transaction exposure refers to a potential change in the value of the outstanding receivables and payables stated in a foreign currency due to a possibility of exchange rate fluctuations during the period from contract signing to its completion. As the short-term component of economic exposure in the broadest sense, transaction exposure arises from a wide range of transactions exclusively settled in a foreign currency. This type of foreign currency risk exposure is present when the cash flows of certain foreign currency transactions are affected by changes in exchange rates and it "stems from an unprotected cash flow" (Nobes & Parker, 2010, 571).

Although it was pointed out that transaction exposure is part of economic exposure in a broader sense, it is usually "lumped in together" with translation exposure. "In reality, transaction exposure overlaps with both accounting and operating exposures" (Shapiro, 2006, 338). The individual components of transaction exposures (assets and liabilities denominated in a foreign currency) for their inclusion in the balance sheet are also the segment of translation exposure. On the other hand, some elements of transaction exposure, such as, for example, forecasted foreign currency purchase/sales contracts are not a balance sheet item. Consequently, they are not part of the company's translation but an operating exposure.

Upon the collection of foreign currency receivables, the amount received and converted into a local currency would be reduced in the case of foreign currency devaluation. If receivables exposed to foreign exchange risk exceed exposed liabilities, foreign currency depreciation would lead to negative and the appreciation of the exchange rate would lead to foreign exchange gains. On the other hand, if the amount of exposed foreign currency liabilities exceeds the amount of receivables, the depreciation of a foreign currency would result in foreign exchange gains. In contrast, the appreciation of the exchange rate would produce a difference. I. Demirag and S. Goddard (1994, 95) decompose transactional exposure into closed and open. While closed transaction exposure is associated with the already completed foreign currency transactions at the exchange rate different from the rate used in the initial valuation of foreign receivables or foreign obligations, open exposure is related to other outstanding foreign currency transactions.

Dynamically speaking, transaction exposure can be divided into (Saudagaran 2004, 60):

* "Quotation exposure, from the time the seller quotes a price to the time when the buyer orders the goods;

* Backlog exposure, from the moment an order is placed to the point of shipment (and invoicing);

* Billing exposure, referring to a lag between the point of shipping to the payment of the invoice."

Although all of these components of transaction exposure could be quantified, only the measure mentioned the last, i.e. the degree of billing exposure to foreign currency risk, is relevant for financial reporting.

The importance of identifying a degree of transaction exposure arises from the fact that it is an objectively conditioned exposure to foreign currency risk due to unregulated foreign receivables and/ or foreign liabilities that have already been established, and will be settled after a change in exchange rates. Numerous empirical studies confirm the highest relative importance of transaction exposure to foreign exchange risk, both in terms of attention given to this type of exposure in practice and in terms of financial managers' hedging preferences. A survey of 125 U.S. multinational companies, conducted by Malindretos and Tsanacas (according to Kim & Kim 2006, 236), disclosed that almost 2/3 of the surveyed financial managers rank transaction exposure as the most important. 26 percent of the surveyed financial managers consider economic exposure as the most important. A survey revealed that only 13 percent of the respondents consider translation exposure as the most important type of exposure. The review has also concluded 65 percent of the companies' hedge transactions are exposed to foreign exchange risk, while only 26 percent of the financial managers from the observed sample implemented translation exposure hedging currency risk. The interviewed managers pay little attention from translation and operating exposure to foreign exchange risk because they believe that these types are not important and have no relevance that belongs to the transaction type of exposure. The relative importance of different types of foreign exchange exposure is shown in Table 2.

For the purpose of the research, the intensity of use and changes in the application of certain types of currency exposure hedging in Serbia, the author addressed the questionnaire to over 60 companies (Bogi?evi?, 2011, 278-303). The questionnaire was answered by 35 enterprises, and more than 15 companies excused themselves for their inability to respond to the questions due to the problems of their insufficient knowledge. From the aspect of the activity, 19 of the surveyed units (i.e. 54.29%) are industrial enterprises, and the 16 of them (i.e. 45.71%) belong to the trading enterprises category. The twenty-five respondents are part of the group which consolidated financial statements are made for. Financial institutions are not included in the research, but exclusively companies. The respondents were asked to indicate the intensity of the use of certain types of currency risk hedging, where some replies were offered, such as "no use", "sporadic use" and "regular use". As it can be seen from Table 3, the majority of the companies (82.86%) sporadically or continuously applied the hedging of transaction type exposure to currency risk and were followed by the companies that regularly or sporadically applied the hedging of translation type of currency risk (51.43%). Only 17.14% of the respondents implemented the hedging of operating exposure to foreign exchange risk. As for changes in the application, there is an evident increasing tendency in all the types of currency risk hedging.

Both accounting data on uncollected foreign receivables and outstanding foreign liabilities, aggregate or individual by countries, operations and currencies are used in order to determine transaction exposure. For the purpose of identifying transaction exposure, accountants use multicurrency reporting forms, which include information on outstanding foreign liabilities and uncollected receivables by currency. A report on multicurrency transaction exposure contains data that do not occur in official financial reports, which can lead to positive and negative exchange rate differences, such as foreign currency forward contracts and contracted future sales and purchases. On the other hand, this report does not include items not directly associated with foreign currency transactions (e.g. cash). The following report of a multicurrency transactional exposure (Table 4) reveals the effects of changes in exchange rates on the accounting data of the Philippine branch in terms of changes in the value of the peso to the Australian dollar, the Indonesian rupee and the U.S. dollar (Choi & Meek, 2008, 435).

Thereby, the first numerical column, containing the transaction data noted and settled in pesos, is not in the focus. It is evident that the devaluation of the Philippine currency against the Australian dollar and the U.S. dollar due to the positive net exposure in both currencies resulted in gains on a foreign currency transaction. At the same time, the devaluation of the peso relative to the Indonesian rupiah caused transaction losses owing to negative in that currency. Based on the illustrated example, which - aggregately observed - reflects the absence of transaction exposure, the importance of the currency- decomposed presentation of transaction exposure to foreign exchange risk can be argued. Despite the undeniable importance of the presentation of a multi- currency transaction exposure, the research conducted in Serbia accounted for an extremely unsatisfactory situation. In particular, 80% of the total number of the respondents negatively answered to the following question: Do you prepare a report on country- and currency-specific multi-currency transaction exposure to foreign exchange risk?

In order to hedge against transaction exposure, enterprises can use a number of operating techniques (e.g. exposure netting, payment adjustment), which is primarily used to protect the operating type of exposure to foreign currency risk. As the protection of transaction exposure to foreign exchange risk is primarily operationalized by using foreign currency financial derivatives, the key aspects of foreign currency transaction financial hedging will be presented further in the paper.

THE FINANCIAL HEDGING OF TRANSACTION EXPOSURE

Essentially, the financial hedging of foreign currency transaction (Figure 1) assumes:

* The existence of foreign exchange risk,

* The existence of the hedged item (the position effected by currency risk) and

* The use of a hedging instrument to protect against foreign exchange risk.

Daily currency fluctuations and an increased integration of the world economy are the main reasons why business subjects consider foreign exchange risk as the most important type of risk. Authors F. Choi and G. Meek (Choi & Meek, 2008, 428) use the following facts to explain the focusing of the business community on currency risk: "(1) foreign exchange risk is one of the most common forms of the risk encountered by multinational firms, (2) influential financial executives state that foreign exchange risk is one of the most difficult external risks that financial managers must cope with, and (3) risk management concepts and associated accounting treatments for foreign exchange risk parallel those for interest rate, commodity, and equity price risks." Because of the foreign exchange risk they encounter in carrying out their activities, business subjects take a number of hedging measures primarily focused on the protection of both transaction and operating exposures. Hedging is a process of protecting an entity from its exposure to risk by acquiring or creating instruments representing an offset to a certain type of risk. Accordingly, currency hedging is a connection of gains and losses on currency derivatives (hedging instruments) with losses or gains on the items that are the object of currency hedging. Companies enter into hedging arrangements in order to minimize the adverse effects of changes in exchange rates on cash flow and net profit. Currency hedge accounting is a specific accounting treatment which, after the establishment of hedges, enables the equalization of changes in the value of both hedging items and currency hedging instruments in the same period. The goal of currency hedge accounting is to "assure that the financial statements of entities engaged in hedging activities reflect the results of those activities" (Bierman et al, 1991, 6). Hedge accounting is also seen as a means linking the effects of the hedging components, i.e. hedged items, with hedging instruments on financial statements, thus allowing the reflection of the effectiveness of hedging relationships in financial statements. The failure of hedge accounting to show hedging activities in financial statements is metaphorically identified with a map not presenting relevant geographic features (Bierman et al, 1991, 6).

A hedged item which exposes an entity to foreign exchange risk can be a recognized asset or payable, firm commitments/unrecognized receivables or a liability and anticipated transactions expressed in foreign currencies. First of all, companies come across currency risk in selling goods on credit in the international market. In order to protect themselves against the adverse effects of changes in foreign exchange rates in collecting foreign currency receivables, companies often use currency derivatives, among which currency forwards and currency options the most predominantly used ones. The use of currency forwards will be illustrated by the example of a domestic company's import transactions. This company needs to purchase goods on credit abroad to be paid in foreign currency. Due to possible changes in the exchange rate of foreign currencies, as well as the use of payment credit conditions on the settlement of the purchase transaction, i.e. a foreign currency payable, the domestic company is said to be exposed to foreign currency risk. In order to eliminate or reduce the risk, the company can use a currency forward contract. Under this agreement, the company will receive an appropriate amount of the foreign currency on some future date at the exchange rate which the parties agreed upon today. As the result of these derivative transactions, an adverse movement in the exchange rate of the domestic and foreign currencies, which resulted in increased liabilities to the foreign supplier, is neutralized by the positive change in the currency forward contracts. While the company has made a loss on the purchase transaction, it has made a gain on the foreign exchange forward transaction. In other words, the loss on the purchase transaction is reversed by the counter derivative transaction. A currency option, giving the holder the right but not an obligation, provides a flexible hedging possibility for foreign currency trading in the future.

Companies engaged in activities denominated in foreign currencies are often included in hedging arrangements after the receipt of a non-cancellable sales order or making out of such a non-cancellable purchase order. A non-cancellable order with a specified price in a foreign currency and the date of delivery is known as a firm transaction, i.e. a firm receivable/payable in a foreign currency. Currency derivatives could be used for the hedging of firm transactions. Some companies regularly encounter foreign currency transactions that can reliably be predicted. Under such circumstances, even in the event of failure to sign a contract on future purchases, the company is exposed to currency risk. Currency derivatives can be used to protect these anticipated transactions denominated in foreign currencies.

Derivatives that companies want to use for hedge accounting must be structured for fair value hedge or the cash flow protection. For the purposes of the protection of the recognized assets and liabilities, as well as foreign currency firm transactions, the company must make a choice between these two types of determinations. On the contrary, the protection of an anticipated transaction can only be qualified as cash flow hedges. Different accounting procedures are applied for these two types of hedging. Generally speaking, while gains and losses on the fair value hedges are recognized immediately in the net profit, gains and losses on cash flow hedges are included within Other Comprehensive Income (Fraser & Ormiston, 2013, 132).

Companies have widely and ever-increasingly been using derivatives to protect against currency risk and. The increasing tendency of using these protective creations of financial engineering in modern developed economies for the purpose of protecting against currency risk is explained by its simple application, flexibility, low transaction costs as well as a real opportunity to reduce or neutralize the effect of this type of risk. The increasing use of currency derivatives allows a more flexible approach in the composing of currency-sensitive assets and liabilities.

By exploring foreign exchange risk management practices in non-financial companies, a large number of authors have found a positive correlation between the level of the foreign exchange risk exposure of the company and the level of the financial derivatives use (Doupnik & Evans, 1986; De Ceuster et al, 2000; Menon & Viswanathan, 2005). Due to an impossibility of presenting the detailed results of the conducted original empirical research of the current state of the accounting practices of the foreign currency translation and currency hedging in the companies in the cities of Western Serbia (Dmitrovi? Saponja et al, 2011), only fragmentary data relevant for testing the initial hypotheses will be displayed:

There was a statistically significant correlation between the level of the enterprise's transaction exposure to foreign exchange risk and the level of currency hedging applications.

This hypothesis is directly related to the answers to the questions as to how transaction exposure and hedging varied (moved) in the responding companies in Western Serbia in the period of 2006-2010.

To the first question of how the level of transaction exposure varied in their companies during that period, 14.29% enterprises out of the total number of the enterprises responded that the scope "fell", 5.71% said that it "remained the same" and 80.00% of them said that it "increased".

To the second question related to the movement of the degree of the currency hedging application in their companies during the observed period, 5.71% of the companies out of the total number of the enterprises responded that the degree of the currency derivatives application "fell", 28.57% said that it "remained unchanged", 62.86% said that it "increased", and 2.86% of respondents provided no answer to the question.

We tested the correlation between the level of transactional exposure and the degree of the implementation of currency hedging. In order to identify the level of a quantitative congruency between the variable X-rated answer to the first question, and variable Y-rated answer to the second question, the simple linear correlation coefficient Rxy= 0,725026 was identified.

The analysis of the statistical significance of the linear dependence and independence of variables, evaluated by R, was carried out by the procedure of defining and testing the null and alternative hypotheses.

The null hypothesis H0 : r = 0 means: a simple linear correlation coefficient of the population was statistically indistinguishable from zero, i.e. there is no linear correlation of the observed variables.

An alternative hypothesis H0 : r ? 0 means: a simple linear correlation coefficient was statistically significantly different from zero, i.e. there is a linear correlation of the observed variables.

Testing hypotheses for the samples with the number of elementary units greater than 30 was carried out by using the standardized normal distribution.

The test statistic is ...

The risk of error ?=0,05.

The test is a two-way test. The theoretical value z?/2 = 1,96.

The signing procedure is a standard procedure for the z-test.

As 35 respondents forwarded questionnaire, in this case n=35.

As n > 30, ...

As |z| >z?/2 and p < 0,05, the alternative hypothesis is accepted, which means that there is a statistically significant linear correlation between the level of transaction exposure and the degree of the implementation of currency hedging. Thus, the assertion of the initial hypotheses has been proved.

CONCLUSION

The ambitious research framework of the accounting implications of the translation and hedging of foreign currency transactions has opened a number of theoretical-methodological and application issues. The complexity, importance and topicality of the discussed matter implied in the introduction have been supported by highlighting the key aspects of the accounting treatment of foreign currency transactions and their hedging.

Any transaction whose terms of settlement are stated in foreign currencies could be dually observed and decomposed into two closely related parts: the monetary and the real parts. There is a widely- accepted attitude that the translation of the transaction non-monetary part or the real assets should be based on historical exchange rates. However, when it comes to the translation of monetary assets (receivables) and liabilities, no unified attitude is adopted because of the conflict between the accrual principle and the principle of prudence.

Due to the impact of the foreign exchange rate fluctuations on foreign currency transactions, companies are faced with transaction exposure to currency risk, which upon the regulation of the transaction monetary part influences a company's flows, both cash flows and profitability flows. In particular, transaction exposure arises due to changes in the exchange rate between the time of the origin of foreign liabilities/receivables and the period of its regulation, i.e. the payment or collection, respectively. In other words, if the foreign exchange rate changes between the period of the foreign currency transaction origin and the period of its final settlement, changes in the value of corresponding foreign currency cash flows will lead to either positive or negative exchange rate differences. The importance of identifying the level of transaction exposure arises from the fact that it is an objectively conditioned exposure to foreign currency risk due to the unsettled foreign currency receivables and/or foreign currency payables that have already been established, and will be settled there has been a change in exchange rates. The justified aspiration of a company to protect itself from the effects of transaction risk is primarily operationalized by using currency derivatives, among which the most common ones are currency forwards and currency options.

The interactivity of foreign currency translation and hedging are highlighted by the theoretical consideration, and the key hypothesis has been asserted by the conducted empirical research. Besides, the empirical research has confirmed that Serbian companies are poorly acquainted not only with the accounting implications of foreign currency translation but with the possibilities of using financial derivatives for protection against currency risk, too. In this regard, companies in RS are advised to undergo staff training, i.e. to provide training to accountants and financial personnel who are not sufficiently familiar with the issues of the accounting treatment of the effects of changes in exchange rates and the use of currency derivatives. By engaging individual experts, scientific or educational institutions, they should be working on promoting the application of new theoretical and methodological knowledge in foreign currency accounting. Banks and other financial institutions in RS are recommended to better inform their existing and potential clients about the possibilities of the application of financial derivatives as well as to provide consulting services to companies in the practical use of currency hedging.

Apart from emphasizing the importance of the application of currency derivatives in the future, the relevant contribution of this paper is reflected in its pointing out a requirement for the implementation of the verified international achievement in the foreign currency accounting area in enterprises in RS. As an active participation in global operating, financial and investment flows assume the international convergence of the national foreign currency accounting regulations, large and small and medium enterprises in RS should, apart from offered possibilities, , consistently follow the guidelines of IAS 21.

Having in mind the effect of the Ordinance on Changes of and Amendments to the Regulation of the Chart of Accounts and Content of Accounts for Companies, Cooperatives, Legal Entities and Entrepreneurs at both the level of the treatment of foreign currency transactions and the level of currency hedging application, a future research should be focused on an analysis of the impact of the foreign currency accounting regulation on the degree of foreign currency transaction hedging. In order to exceed the main limitation of the conducted research reflected in the insufficient size of the sample, a future research should cover a great number of enterprises. It would be useful to explore remarks to the actual accounting regulation in the foreign currency business area, with a particular review of the non-consistent application of IAS 21.

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Received on 5th July 2013, after revision, accepted for publication on 26th August 2013