The Value Relevance of the Foreign Translation Adjustment
Posted: 24 Apr 2003
Proponents of comprehensive income maintain that comprehensive income "identifies all (recognized) sources of value created in one number as a measure of value added." In this study, I present an economic analysis of one of the major components of comprehensive income, the foreign translation adjustment. The analysis suggests that, in general, the translation adjustment is not a source of value added for firms in the manufacturing sector because the accounting rules governing foreign currency translations generally produce results opposite to the economic effects of exchange rate changes. Consistent with existing economic theories, I find that, on average, a positive translation adjustment is associated with a loss of value instead of a creation of value. I also find that the negative association between the translation adjustment and change in value is largely attributable to those firms that are the most labor-intensive. Because such firms are likely to have the most rigid (or "sticky") input factor prices, economic theories predict that they should be the most affected by currency fluctuations. The study raises questions about an accounting income computation that recognizes a positive translation adjustment as an increase in income.
Keywords: comprehensive income, foreign translation adjustment, foreign exchange, international accounting, value relevance, multinational firms
JEL Classification: M41, M44, M47, G12, F31, F20
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