Academic journal article Academy of Accounting and Financial Studies Journal

The Value Relevance of Foreign Translation Adjustment: Case of Indonesia

Academic journal article Academy of Accounting and Financial Studies Journal

The Value Relevance of Foreign Translation Adjustment: Case of Indonesia

Article excerpt

INTRODUCTION

As a consequence of globalization, the increasing number of multinational companies has had an impact on financial reporting that will be the basis by which investors evaluate a company's performance. Multinational companies with significant overseas operations are exposed to exchange rate changes as the financial statements of foreign subsidiaries denominated in foreign currency are translated to the reporting currency of the parent company. Given the recent emphasis on valuation and economic interpretability of the statement of financial position, foreign currency translation has become a topic of interest for many users of financial statements. The concern regarding this issue, however, is exaggerated as the degree of internationalization of many firms continues to increase. Internationalization and the need for sound foreign currency translation method are expected to increase as additional foreign markets open to corporations throughout the world (Ziebart & Choi, 1998).

According to the Indonesia Financial Accounting Standards (PSAK 10 (1994) Transactions in Foreign Currencies and PSAK 11 (1994) Translation of Financial Statements in Foreign Currencies), if the business activities abroad are considered as a foreign entity and the functional currency differs from the reporting currency, the firm should employ a translation method. From an accounting perspective, the positive translation effect due to currency appreciation of a subsidiary will add the comprehensive income in the equity, thus have a positive impact on increasing the company's value. However, Louis (2003) proves the opposite effect between an accounting perspective and an economic perspective. According to the economic perspective, the appreciation causes the price of domestic products to become relatively more expensive than foreign products. Accordingly, in order to sustain, the domestic firm must lower its price. The decrease in the selling price cannot necessarily be followed by a decline in the prices of inputs, especially labor costs, as the company is bound by employment contracts and labor unions. Overall, from an economic perspective, wage rigidity and lower selling prices will reduce corporate profit margins, thus resulting in a decrease in the value of the company.

This study examines the effect of foreign translation adjustments on firm value. Specifically, this study tests the opposite effect of the accounting treatment with economic conditions on foreign translation adjustments as found by Louis (2003). Similar study in Indonesia has been conducted by Purba (2009) but she does not limit her samples to manufacturing firms due to limited observations during her study period. Our research employs a sample of manufacturing firms listed on the Indonesia Stock Exchange that are assumed to be most affected by the exposure of foreign assets and liabilities. The manufacturing sector was also selected for this study because the total cost of production inputs is rigid, especially the labor costs, which comprise a significant amount of the total production costs.

The results of our study confirm Louis (2003) finding that the foreign translation adjustment has value relevance and is negatively associated with stock returns using both raw return and market adjusted return. This negative association is mainly caused by the rigidity of wages, especially in firms that are high labor intensive. Accordingly, this implies that although positive translation adjustment increase comprehensive income and equity, it causes a decrease in the value of the company. Foreign translation adjustment is a balancing effect because of the differences in recording based on the subsidiary's functional currency and reporting based on the currency of the parent company. Standard setters should consider appropriate treatment in the recording of foreign currency translation that better reflects the actual economic conditions. …

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