The Impact of the Functional Currency System in Korea on the Value Relevance of Foreign Translation Adjustments

This study examines whether the introduction of a functional currency system improves the value relevance of foreign translation adjustments in Korea. Companies" incomes and equities have been exposed too heavily on the changes of foreign exchange rates when these companies have transactions in foreign currencies or foreign operations. The adoption of the functional currency system is expected to minimize unexpected foreign translation adjustments from the fluctuation in foreign exchange rates and then improve the value relevance of foreign translation adjustments. We select Korean transportation and manufacturing companies which are usually highly affected by foreign currency exchange rates as a study sample. Using a return/earnings association approach, we find that the adoption of the functional currency system improves the value relevance of foreign translation adjustments for firms that designate foreign currency as a functional currency. After the adoption of the functional currency system, we do not find an incremental effect on the value relevance of foreign translation adjustments for firms that choose a local currency as a functional currency. However, for firms that choose foreign currency as a functional currency, an excessive effect from foreign exchange rates is alleviated thereby improving the value relevance of foreign translation adjustments.