The Value Relevance of the Foreign Translation Adjustment

Abstract

Proponents of comprehensive income maintain that comprehensive income identifies all the sources of value-added in a firm. However, the economics of the foreign translation adjustment, which is a major component of comprehensive income, suggests that this is not necessarily the case. When a foreign currency appreciates, both the production costs and the revenues of U.S. manufacturers operating in the host country tend to increase. But, because input prices are stickier than output prices, in general, the cost effect dominates the revenue effect. Hence, U.S. producers get hurt when the currencies of their host countries appreciate. However, under the current rate method, the foreign currency appreciation implies an adjustment gain rather than a loss because net assets are translated at a higher rate. Consistent with the economic rationale, I find that the translation adjustment is negatively associated with firm value. This implies that the translation adjustment is value relevant, but not in the direction generally assumed.