|
...sector, translation adjustment associated with a loss of value instead of an increase in value. This result stems from the fact that, for firms in the manufacturing sector, the accounting rules governing foreign currency translations generally produce results opposite to the economic effects of exchange rate changes.
I. INTRODUCTION
Proponents of comprehensive income maintain that comprehensive income "identifies all (recognized) sources of value created in one number as a measure of value added" (cf. AAA FASC 1997). 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. After discussing the effects of currency fluctuations on firm value from the perspective of current economic theories, I test whether and how the foreign currency translation adjustment is actually related to changes in value in the manufacturing sector. In doing so, I take the accounting process generating the translation adjustment as a given and analyze the adjustment in view of generally accepted economic theories.
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.
The remainder of the paper is organized as follows. The next section analyzes the accounting and the economic effects of foreign currency fluctuations on firm value. Section III provides a review of existing studies on the foreign translation adjustment. Section IV describes the research design. The results are reported in Section V. The study concludes in Section IV.
II. ANALYSIS OF THE ACCOUNTING AND THE ECONOMIC EFFECTS OF FOREIGN CURRENCY FLUCTUATIONS
The Accounting Effect of Foreign Currency Fluctuations
In October 1975, the FASB issued SFAS No. 8, Accounting for the Translation of Foreign Currency Transactions and Foreign Currency Financial Statements, following the collapse of the fixed exchange rate regime. (1) SFAS No. 8 was severely criticized for treating the foreign exchange gain or loss as a component of net income. In December 1981, the FASB responded by issuing SFAS No. 52, Accounting for Foreign Currency Translation, which supersedes SFAS No. 8. The new pronouncement requires the use of the current rate method and the exclusion of translation adjustments from income when a foreign subsidiary uses a foreign currency as its functional currency. (2) The temporal rate method is still required by SFAS No. 52 in the case where the U.S. dollar is deemed the functional currency of the subsidiary and in the case where the subsidiary is located in an hyperinflationary economy. The initial decision as to which currency is the functional currency rests with the parent company.
In general, appreciation (depreciation) of the local currency results in an increase (decrease) in the book value of net assets under the current rate method and a positive (negative) foreign translation adjustment, suggesting an increase (decrease) in firm value. (3) The accounting argument for a positive association between foreign currency fluctuations and firm value focuses on the assets alone, without regard to the role of these assets in the production process. However, the effects of currency fluctuations on the value of a foreign subsidiary's plant and equipment are not clear. When the assets of a foreign subsidiary are imported into the host country or built by U.S. firms, as is usually the case, they are not quoted in the local currencies and, thus, their values in U.S. dollars are not much affected by fluctuations of the local currencies. Even if the assets are bought in the host country, because they are production inputs and not speculative assets, a depreciation (appreciation) of the local currency should, if anything, benefit (hurt) a going concern because the replacement costs of the assets are lower (higher). (4) White et al. (1998, 859) illustrate the effect of the current rate method on the book value of assets as follows:
Assume that a company builds two identical factories, at identical initial costs, one in the United States and one in Country G, where it has a subsidiary. Assume also that the currency of Country G appreciates relative to the dollar, rising 50% over the next five years. If the currency of Country G is the functional currency for that subsidiary, the "cost" of the factory in that country will be 50% higher than the cost of the U.S. plant. Presumably, the rise in Country G's currency is due to a lower rate of inflation. But the inflation rate does not change the asset's historical cost. The higher carrying amount of the factory in Country G (and the higher depreciation expense as well) is not logical. It is equally absurd for a factory in a country whose currency depreciates against the dollar to decline steadily in carrying amount. Yet this is the consequence of the application of the all-current rate method.
The Economic Effect of Foreign Currency Fluctuations
From an economic standpoint, fluctuations in exchange rates affect the value of a foreign subsidiary primarily due to the effects of exchange rates on production costs in U.S. dollars. When the local currency depreciates, production costs fall. Similarly, when the local currency appreciates, production costs rise. (5)
Depending on the degree of integration between a foreign subsidiary and its parent, the subsidiary can be classified as either an integrated foreign operation (IFO) or a self-sustained foreign operation (SSFO). An IFO tends to incur production costs in the host country, but generate revenues in the U.S. Hence, when the foreign currency depreciates, an IFO benefits because it becomes cheaper to produce in the host country due to the increase in the relative purchasing power of the U.S. dollar. (6) However, under the current rate method, depreciation of the local currency implies an adjustment loss rather than a gain because net assets are translated at a lower rate. Thus, the postulate that the translation adjustment is a source of value added clearly does not hold for an IFO if management treats it as an independent operation and uses the currency of the country where the subsidiary is located as the functional currency. (7)
The main issue arises, however, in the case of an SSFO. An SSFO tends to borrow, repay, and sell in foreign currencies. A weaker local currency would result in not only lower production costs, but also lower revenues when translated into U.S. dollars. Thus, at first glance, it may appear that currency fluctuation should not have a material effect on the economic value of an SSFO. The revenue effect should counterbalance the cost effect. However, because input prices are stickier than output prices, (8) appreciation of the local currency negatively affects the value of an SSFO even if the operations of the subsidiary are indeed self-sustained. (9)
Appreciation of the local currency makes it harder to sell in an open market because foreign goods become relatively cheaper (see Aggarwal 1981). (10) To remain competitive, the firm may have to reduce sales price. Labor costs will also be higher; however, as I have explained above, labor costs cannot be adjusted as easily as sales prices. Therefore, appreciation of the local currency is likely to result in decreasing profit margins and greater competition with foreign firms leading to a decline in the value of the firm. Similarly, depreciation of the local currency is likely to result in increasing margins and less competition with foreign firms leading to an increase in the value of the firm. In general, as long as the local markets are not closed, a manufacturing firm is better off operating in a weak foreign currency environment, no matter where it sells its goods. In an internationally competitive market, the world market determines real output prices, while, because of barriers to the free movement of labor, local markets determine real wages.
One objective of SFAS No. 52, as stated by the FASB, is "to provide information that is generally compatible with expected economic effects of a rate change." (11) However, McClenahen and Whenmouth (1988) note that, "The weaker dollar has lowered the prices on U.S. goods shipped to world markets, leading to increased sales for U.S. exporters. U.S. firms manufacturing abroad, however, are forced to pay more dollars to meet foreign currency payrolls, resulting in less profits to be brought back to the U.S." Because the local currencies appreciate, the offshore subsidiaries report positive translation adjustments. However, U.S. manufacturers operating in the countries where the local currencies appreciated are hurt. The following example by White et al. (1998, 861) further illustrates the point:
Consider ... a British manufacturing subsidiary whose output is sold entirely in Great Britain and whose costs are incurred entirely in pounds sterling. If the value of the pound sterling rises, imports will enter, taking market share from the British subsidiary. The result is likely to be lower sales, lower earnings (price cutting...
NOTE: All illustrations and photos
have been removed from this article.
More articles from Accounting Review
The implications of using stock-split adjusted I/B/E/S data in empiric..., October 01, 2003
Control in a teamwork environment--the impact of social ties on the ef..., October 01, 2003
Looking for additional articles?
Search our database of over 3 million articles.
Looking for more in-depth information on this industry?
Search our complete database of Industry & Market reports by text, subject, publication
name or publication date.
About Goliath
Whether you're looking for sales prospects, competitive information, company
analysis or best practices in managing your organization,
Goliath can help you meet your business needs.
Our extensive business information databases empower business
professionals with both the breadth and depth of credible,
authoritative information they need to support their business
goals. Whether it be strategic planning, sales prospecting,
company research or defining management best practices -
Goliath is your leading source for accurate information.
|
