Comparative Information Content of Return on Assets Based Alternative Translation Methods

There is a massive foreign currency translation literature, but virtually no empirical research exists that describes differences in information content of translated financial statements when different translation methodologies are applied. This study examines return on total assets across translation methodologies with the assumption that differences in information content are reflected in differences in rank orderings of companies. The greatest differences in rank orderings were observed between the methodologies of SFAS #8 and SFAS #52 whereas the current-noncurrent and the current rate methods rank companies similarly. Differences in information signals across translation methodologies are often enormous and are highly firm specific. Introduction and Purpose It is clear that there is nothing close to a worldwide consensus as to which exchange rates ought to be used to translate various accounts from a foreign subsidiary’s currency to U.S. dollars prior to consolidation. An examination of the accounting practices of fifty countries a decade ago reveals that seven countries used the current-noncurrent method (CNM), ten used the monetary-nonmonetary method (MNM), eleven used the temporal rate method (TRM), and twenty-two a current rate method (CRM), (Choi and Mueller 1992). Three other countries (U.S., U.K., and Canada) used CRM or TRM, depending on the circumstances. In more recent years, translation practice in a number of countries has been influenced by the International Accounting Standards Board pronouncements and U.S. GAAP. Many multinational companies, domiciled in various countries, use TRM for non-integrated companies and CRM for companies more closely integrated with the parent company, (Holt, 2003). This study examines a single financial ratio, return on total assets, and suggests that differences in information content between translation methodologies are reflected in differences in rank orderings of companies based on return on assets numbers. The purpose of this paper is to determine (1) if different translation methodologies materially affect the comparative rankings, and hence comparative information content, of companies in terms of return on total assets, and (2) if some methodologies appear to be informationally similar in terms of return on total assets. The lack of understanding of the effects of alternative translation methods is not surprising once surrounding circumstances are considered. Companies use one translation method at a time, some methods have not been used for many years, some feasible methods have never been used, and except for the translation gain or loss, the effects of translation are buried in the consolidated accounts. Untangling these effects for a reasonable number of firms presents a discouraging task. Moreover, obtaining the further temporally referenced item-by-item data required to construct comparable results under alternative methods for research purposes would task the patience of the most cooperative of firms. For these reasons, no broadly comparative and temporally sustained study, involving reasonably large samples of real firm data, appears to be available. This study seeks to begin to fill this vacuum of empirical insight into the reporting consequences of alternative translation methods to the extent that these obstacles can be overcome. The present study overcomes these difficulties with a unique methodology described below. Southwest Business and Economics Journal/2003-2004 10 Literature Review There exists a massive foreign currency translation literature, spanning several decades, which consists largely of theory and opinions about how translation should or should not be done. Yet, little empirical research has been done to describe differences in information content of translated financial statements when different translation methodologies are applied. The translation policy choices for GAAP, in the U.S. as well as in other countries, have always been made with virtually no empirical knowledge of just what happens to consolidated financial statements when foreign accounts are translated by different methodologies. The foreign currency translation literature can be divided into four general categories: (1) studies which are surveys of management perceptions and studies of changes in management behavior, (2) studies of the impact of alternative translation methods on financial statements, (3) market studies, and (4) studies which reveal preferences for translation methods by studying events such as early adoption of SFAS #52 and lobbying. Among the category (1) studies, Rodriguez (1980) surveyed 70 U.S. MNCs and found that managements were non-speculative, defensive with respect to exchange rate variations, and reluctant to report translation losses. As a result, they were willing to pay a hedging cost higher than the average exchange depreciation. Houston (1986) found that managements decreased their financial exposure hedging when adopting SFAS #52. A number of studies reflect managements’ displeasure with currency translation rules. Examples are Choi et al.’s (1979) survey, Stanley and Block (1979a and 1979b) and Cooper et al. (1978). Among the category (2) studies are Aggarwal (1978), Biel (1976), Teck (1976), Porter (1983), and Selling and Sorter (1983), all of which criticize accounting rules for currency translation. Aggarwal (1978) and Reckers (1978) expressed the opinion that SFAS #8 resulted in financial statements that, in one way or another, did not reflect economic reality. In a simulation study, Rupp (1982) concluded that the temporal method of SFAS #8 was extremely sensitive to the proportion of debt in the capital structure. Among the category (3) studies, Griffin and Castanias (1987) observed that managers were motivated to enter the currency futures markets to reduce the fluctuations in reported translation gains and losses. This behavior, while functional for managers, can be dysfunctional to the company since currency futures trading is costly. Bryant and Shank (1977) expected that such dysfunctional behavior would result in significant adverse market reaction. Shank et al. (1980) and Ziebart and Kim (1987) did observe various market reactions to currency translation methods. A conclusion to be drawn from category (3) studies is that accounting method does often result in an adverse market effect, although such effects are partially the result of managers’ changes in behavior based on changes in accounting method. Collins and Salatka (1993) concluded that including the foreign currency adjustment in reported earnings, as required by SFAS #8 (TRM), produced noise which reduces the quality of earnings, but Soo and Soo (1994) found that the market reflected no difference between including the adjustment in earnings as required by SFAS #8 and excluding it from earnings as required by SFAS #52 (CRM). Bartov (1997) found that the SFAS #52 requirements caused reported earnings to be more relevant for market valuation than SFAS #8. Among the category (4) studies, Griffin (1983), Ayres (1986), Berg (1987), Kelly (1985), and others indicate that large companies with low management ownership are more likely to lobby for or against a proposed change in currency translation rules than smaller companies with higher management ownership. Furthermore, managements do change their behavior based on managements’ perceptions of how different currency translation rules may affect financial statements. During the period that the massive literature was being written, standard-setting bodies in the United States have required, at different times, four different translation methodologies. First, the current-noncurrent method (CNC) was required; then the monetary-nonmonetary (MNM) method advocated by Hepworth (1956) and required by APB Opinion No. 6 in 1965; then the temporal rate method (TRM) developed by Lorensen (1972) and required in 1975 by SFAS #8; and most recently the current rate method of SFAS #52 (1981). But even this newest standard is criticized widely (for example, Beaver and Wolfson, 1982). Clearly there is no closure on the foreign currency translation and consolidation problem in the United States, let alone worldwide. Comparative Information Content of Return on Assets Based on Alternative Translation