Beaver1982 PDF

Accounting Research Center, Booth School of Business, University of Chicago
Foreign Currency Translation and Changing Prices in Perfect and Complete Markets
Author(s): William H. Beaver and Mark A. Wolfson
Source: Journal of Accounting Research, Vol. 20, No. 2, Part II (Autumn, 1982), pp. 528-
550
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Journal of Accounting Research
Vol. 20 No. 2 Pt. II Autumn 1982
Printed in U.S.A.
Foreign Currency Translation and

Changing Prices in Perfect and
Complete Markets
WILLIAM H. BEAVER AND MARK A. WOLFSON*
1. Introduction
Our purpose is to explore some properties of the major methods of

foreign currency translation under the assumptions of perfect and com-
plete markets. In doing so, we identify a set of sufficient conditions under
which the various methods possess properties claimed by their advocates.
Moreover, the role played by the controversial and elusive translation
gain or loss becomes clearly defined. Neither the properties of the various
methods nor the role of the translation gain or loss are obvious, notwith-
standing the considerable debate during the recent attempt to resolve
the issue in the policy domain.'
In order to interpret the disclosures under the various methods of
translation, it is necessary to make an assumption about the economic
forces that induce changes in the exchange rates. The perspective we
adopt is that changes in exchange rates are driven solely by differential
rates of inflation among the respective countries. Given this assumption,
we analyze the properties of three accounting models-translation
methods: historical cost accounting with foreign-denominated subsidiary
financial statements translated at historical rates of exchange, compre-
* Professor and Associate Professor, Stanford University. This research is supported by

the Stanford Program in Professional Accounting, major contributors to which are: Arthur
Andersen & Co.; Arthur Young and Company; Coopers & Lybrand; Deloitte, Haskins and
Sells; Ernst and Whinney; and Peat, Marwick, Mitchell & Co. The helpful comments of R.
Dukes, G. Foster, N. Gonedes, and B. Jacquillat are gratefully acknowledged. [Accepted for
publication July 1982.]
' Consider discussions in the popular financial literature regarding the interpretation of
disclosures under FAS No. 52: Foreign Currency Translation (FASB [December 1981])
(e.g., Seidler and McConnell [1982]).
528
Copyright (, Institute of Professional Accounting 1983
CURRENCY TRANSLATION AND CHANGING PRICES 529
hensive market value accounting with translation at current rates of

exchange, and historical cost accounting with translation at the current
exchange rate (hereafter the H/H, C/C, and H/C methods, respectively).
Our analysis derives some properties of these three methods and precisely
defines the role of the translation gain or loss.
In particular, the analysis focuses on two potential properties of each
foreign currency translation method: economic interpretability and sym-
metry. Economic interpretability is defined as: (a) the book values
reported on the balance sheet are equal to the present values of the
future cash flows of the assets, liabilities, and net worth of the firm; and
(b) the reported return on investment (net income divided by beginning-
of-the-year assets) is equal to the nominal rate of return on investment,
denominated in terms of the domestic currency. Symmetry is defined as:
two economically equivalent investments (e.g., one foreign, one domestic)
produce the same financial statement numbers when the investments are
translated into a common currency.2
The notion of economic interpretability has received considerable
attention in the accounting literature, while symmetry has not. However,
Nobes [1980] has interpreted FAS No. 8 as follows: "Each transaction of
the foreign subsidiary should have the same effect as if it had been a
transaction of the parent" (Nobes [1980, p. 425]). In other words, the
intent of FAS No. 8 is to provide a translation algorithm which yields
financial statement numbers equivalent to what would have been re-
ported had economically identical transactions been undertaken domes-
tically (i.e., symmetry). If the accounting basis for that domestic trans-
action is historical cost, then symmetry would effectively preserve his-
torical cost in the translation procedures. We interpret the desire for
symmetry as wanting to avoid an "apples and oranges" mixture of
accounting methods to account for transactions of a given type. If
"deficiencies" are perceived in the resulting numbers, they are due to the
basis of accounting (e.g., historical cost) and not to the translation
methods per se.
The basic findings of our analysis are twofold: (1) With respect to the
three major methods, (a) the C/C method possesses both economic
interpretability and symmetry; (b) the H/H method possesses symmetry
but not economic interpretability; and (c) the H/C method possesses
neither property, except in trivial cases. (2) The inclusion of the transla-
tion gain or loss is necessary in order for a given method to achieve either
economic interpretability or symmetry. Negatively stated, net income,
prior to the inclusion of the gain or loss, does not, in general, possess
2 A precise definition of economically equivalent investments is provided later after some

notation has been introduced. The generic term investment is used throughout. However,
we show that the conclusions apply with equal force to liabilities, assets, or net assets (i.e.,
net worth).
530 JOURNAL OF ACCOUNTING RESEARCH, AUTUMN 1982, PT. II
either property. As discussed more fully in section 1.2, this has not been
well understood in the accounting literature.
In order to conduct our analysis, we assume the well-defined setting of
perfect and complete markets among and within all countries. In doing
so, we recognize that these conditions may be stronger than needed.3
Moreover, we acknowledge a major conundrum in assuming the existence
of a monetary unit in a world of perfect and complete markets.4 However,
given the current state of the art in accounting for foreign currency
translation, there are some compelling reasons for adopting this perspec-
tive: (1) Much of the discussion of the relative merits of the various
translation methods effectively assumes that markets are perfect and
complete. That is, we shall show that perfect and complete markets are
a sufficient condition for the various methods to have the properties their
advocates claim they have. (2) Perfect and complete markets may provide
a reasonable description of the markets for at least some currencies.5 (3)
An analysis of a simple, well-defined setting can be a prerequisite to
dealing with more complicated, albeit more realistic, settings of imperfect
and incomplete markets. For example, there is no reason to believe that
difficulties of interpretation which can arise even in this simple setting
will disappear when a more complex, ill-defined setting is introduced.
The analysis consists of three sections. Sections 2 and 3 deal with
foreign currency translation for monetary and nonmonetary investments,
respectively. Section 4 discusses empirical implications of the analysis.
The paper closes with a discussion of the implications of relaxing the
assumptions of perfect and complete markets (section 5).
2. Foreign Currency Translation of Monetary

Investments
Section 2.1 provides the notation, assumptions, and relationships that

are used throughout the analysis. In section 2.2 we consider the simple,
3 A weaker set of assumptions would also be sufficient (e.g., spanning). What is important
is that there be nothing "unique" about foreign assets or claims relative to domestic assets,
insofar as state contingent payoffs denominated in terms of a common numeraire are
concerned.
4 In such a world, there would be zero demand for money and contracts would be written
directly in terms of commodities. This conundrum is not distinctive to our analysis of
foreign currency but is prevalent throughout the international economics and finance
literature. Moreover, it is similar to analyses in the finance literature which assume
securities markets are sufficiently complete to imply prices for primitive claims (see Grauer
and Litzenberger [1979], among others).
5 In some nominal sense, markets cannot literally be perfect or complete. Otherwise, it
would be difficult to explain the existence of some (costly) aspects of our institutional
framework (e.g., the existence of money and forward contracts in foreign currencies).
However, the mere existence of this set of contracting opportunities may permit the same
allocations that would be attainable in markets that were literally perfect and complete
(e.g., see Arrow [1963], among others). Hence, perfect and complete markets may provide
a "reasonable approximation" for such markets. See section 4 below.
special case of a single-period monetary investment under certainty,

where the flavor of our analysis is transparent. Section 2.3 and the
remainder of the analysis treat the more general setting of uncertainty,
in which certainty becomes a special case.
2.1 NOTATION, ASSUMPTIONS, AND BASIC RELATIONSHIPS
The notation, assumptions, and basic relationships are listed in Appen-

dix A. The notation is straightforward, with the possible exception of fRd,
the ex post nominal return on a foreign investment denominated in terms
of the domestic currency. The motivation for fRd becomes apparent in
section 2.3, where uncertainty is introduced. Inflation rates if and id are
assumed to be well defined. Prices of all goods and services in a given
country changing at the same rate would be a sufficient condition.
The major assumption is Al, perfect and complete markets, some of
whose implications are: (1) Market values are well defined, and everyone
prefers plans which maximize the market value of the firm (this requires
only the weakest of assumptions about individuals' preferences). (2)
Entry values (e.g., replacement cost) equal exit values (e.g., liquidation
value) equal values in use (e.g., present value of future cash flows). (3)
Valuation of assets and other multiperiod claims admit to a simple
characterization, namely, the present value of future cash flows. (4) To
preclude arbitrage profit opportunities, the exchange rate movements
over time must be solely a function of differential inflation rates between
pairs of countries (i.e. = = +i)

Assumptions A2-A4 are purely for convenience and simplicity of
presentation. There is no loss of generality here, since dropping them
would merely add complexity to the derivations with no commensurate
benefits in terms of added insights. A5 and A6 merely define what we
mean by a "classic" monetary investment and a "classic" nonmonetary
investment.
Relationships RI through R3 are tautologies that follow from the
definition of real and nominal rates of return. R4 is an equilibrium
condition.
2.2 FOREIGN CURRENCY TRANSLATION OF A MONETARY

INVESTMENT UNDER CERTAINTY
Initially, we consider the simplest possible case-a one-year monetary

investment under certainty. In this simplest of settings, the spirit of the
analysis is transparent and is helpful in understanding the more general
cases to follow.
Future prices and interest, inflation, and exchange rates are known
with certainty. Moreover, the real rate of return is the same in all
countries (i.e., rf = rd = r) for all types of investments. In fact, the
distinction between monetary and nonmonetary investments is trivial
here. There is no issue about how the investment will be recorded on the
532 W. H. BEAVER AND M. A. WOLFSON
books of the respective firms at the end of the year (t = 1), and hence we
draw no distinction between historical cost and market value accounting.
There is an initial investment of one unit (i.e., If = Id = 1) and the
nominal rate of return is Rf and Rd, respectively. Clearly, these invest-
ments are economically equivalent.6
Appendix B summarizes the financial statements reported assuming
the translation takes place at the current rate (i.e., at E1). In this setting,
(1) both economic interpretability and symmetry are obtained, and (2)
the incorporation of the translation gain or loss is essential to the
attainment of these properties.
The translated balance sheet amount is equal to that of the domestic
investment (i.e., 1 + Rd), which implies symmetry. Moreover, that
amount is equal to the market value of those assets or their present value
of the future cash flows (if reinvested), which implies economic inter-
pretability. The translated net income, after inclusion of the translation
gain or loss, is equal to that of the domestic investment and, in turn, is
equal to the nominal rate of return (Rd), which implies symmetry and
economic interpretability, respectively.
Taken separately, each component of net income (the translated inter-
est income and the translated gain or loss) has no obvious interpretation
or relationship to an identical domestic investment. However, when
combined, their sum is a net income number equal to Rd, the amount of
income that would be reported on a domestically equivalent asset. Hence,
the incorporation of the translation gain or loss is essential to attaining
symmetry and economic interpretability. This occurs because the changes
in exchange rates reflect the differences in nominal return due to differ-
ences in inflation rates. Merely translating interest income, even at the
current rate of exchange, is inadequate because this ignores the fully
anticipated change in the purchasing power of the principal (relative to
the domestic currency) which accounts for the Rf and Rd differential.
For example, if if exceeds id, there will be a larger, fully anticipated loss
in the purchasing power of the principal of the foreign investment. To
compensate investors for incurring this anticipated loss, equilibrium
requires that Rf be higher than Rd. Translating Rf at the current exchange
rate overstates net income because it includes only a portion of the effect
of the transaction. It records the added compensation for incurring the
loss on the principal, but neglects the loss itself. Net income, including
the translation loss, incorporates both the added compensation in interest
6 Two investments (e.g., domestic and foreign) are economically equivalent for the period
t- 1 to t if and only if CftEt = Cdt, Mft-iEt-i = Md,t-1, and MftEt = Mlt, where Ct (Cdt) is
the cash flow received on the foreign (domestic) investment at time t and Et is the exchange
rate at time t as defined in Appendix A. In other words, (1 + Rft)Et = (1 + Rdt) where
Rft(Rdt) is the nominal rate of return from t - 1 to t. From relationships R1-R4, it can be
shown that this implies the equality of real rates of return (i.e., rf = rd) for economically
equivalent investments. In equilibrium, all assets are economically equivalent in the case of
certainty.
income and the loss in relative purchasing power of the principal. The
net result is a correctly stated net income number (i.e., Rd is reported).
The role that the translation gain or loss plays in monetary items may
seem transparent and obvious. Surprisingly, the literature is ambiguous
on this point, often viewing it as a plug figure to make the financial
statements articulate. Consider Aliber and Stickney's [1975] discussion
of foreign currency translation in a perfect markets setting. In criticizing
FAS No. 8, they state: "Thus the current methodology for translating
foreign assets and liabilities into dollars assumes that the Purchasing
Power Parity theory [changes in relative prices equal experienced changes
in exchange rates] holds while the Fisher Effect [anticipated changes in
exchange rates equal relative differences in interest rates] does not.
Nonmonetary items are not considered exposed to exchange losses while
monetary items are exposed to such losses" [1975, p. 46].
Our analysis suggests that the translation gain or loss is required to
attain economic interpretability and symmetry, even when the Fisher
Effect is assumed to hold. In particular, relationships RI through R4
imply the Fisher Effect; and it is precisely because the Fisher Effect holds
that the incorporation of the translation gain or loss is required.
It is trivial to extend the analysis to monetary liabilities and to
multiperiod monetary items in a certainty setting.7 However, no further
insight would be provided. Instead, we now turn to the more general case
of uncertainty, and henceforth certainty is only treated as a special case.
2.3 FOREIGN CURRENCY TRANSLATION OF A MONETARY
INVESTMENT UNDER UNCERTAINTY
In contrast to the certainty setting considered in the preceding section,

actual inflation (exchange rates) may not equal expected inflation (ex-
change rates) in a world of uncertainty. As a result, inflation (exchange
rate) "risk" can arise due to unanticipated changes. In fact, in our model,
both are directly linked and represent the same source of uncertainty
regarding future inflation. In a setting of uncertain inflation, the distinc-
tion between monetary and nonmonetary assets is economically substan-
tive (in contrast to the certainty setting).
In this section, we consider "classic" monetary investments, while in
section 3 "classic" nonmonetary investments are analyzed. The monetary
investments are assumed to have certain nominal returns but uncertain
real returns because of inflation rate uncertainty. By contrast, the non-
monetary investments are assumed to be riskless in real terms (i.e., they
constitute a perfect hedge against unanticipated inflation), even though
their nominal returns are uncertain.
As defined earlier, economically equivalent investments have the same
7 Under certainty, it is easy to force historical cost book values for monetary investments
(and the related income) to coincide with market value numbers by selecting the appropriate
amortization schedule of any discount or premium (Beaver [1979]).
ex post real rates of return (i.e., rf = rd). For example, consider a foreign
investment whose ex post real rate of return is rf. [Rd represents the
nominal return of the foreign investment expressed in terms of the
domestic currency. An investor would be indifferent between a foreign
investment whose return is Rf and a domestic investment whose return
is fRd. Alternatively stated, [Rd is the nominal return on an economically
equivalent domestic investment, a quantity which figures prominently in
the analysis below.
In the case of multiperiod monetary investments, care must be exer-
cised regarding assumptions about end-of-period market values. In gen-
eral, the market value will not equal the book value under a predeter-
mined amortization schedule, because no such schedule is capable of
incorporating the unanticipated movements in market value. The key
feature of the uncertainty analysis is the richness of exchange rates in
reflecting unanticipated inflation. This richness permits foreign currency
translation methods to attain economic interpretability or symmetry,
even when uncertainty is introduced.
2.3.1. Single Period Monetary Investment. Our analysis in this section,
in which we consider a single-period monetary investment, represents the
uncertainty analogue to section 2.2. The initial investment is again one
unit (i.e., If = Id = 1), and the nominal returns Rf and Rd are known with
certainty. Appendix C summarizes the reported financial statement
amounts assuming translation at the current exchange rate.
As in the certainty case, the translated results, including the translation
gain or loss, exhibit both symmetry and economic interpretability. The
net income, after the translation gain or loss, is equal to fRd, the nominal
rate of return of the foreign investment (denominated in the domestic
currency), whose real rate of return is equal to rf. The translated net
income is equal to that attributable to a domestic investment if and only
if rf = rd (i.e., when the two investments are economically equivalent). In
other words, symmetry is also preserved.
As in the certainty case, the translated net income, prior to the
translation gain or loss, has no obvious interpretation.8 In contrast to the
certainty case, however, the translation gain or loss is not fully antici-
pated. As such, it is a partial reflection of the exchange rate uncertainty
and contains an unanticipated portion. If there is substantial uncertainty,
this could result in large unanticipated changes in earnings over time.
While many appear to view earnings volatility as "undesirable," it is a
natural reflection of the economic consequences of holding a foreign
monetary investment under conditions of exchange rate uncertainty.9
8 One exception is where iL = if, in which case there is no translation loss and since El
= Eo, the H/C method is equivalent to the H/H method. Hereafter, this is referred to as
the trivial case.
9 For example, one of the major claims made on behalf of FAS No. 52 is that net income
will be less volatile because of the exclusion of translation gains and losses (Seidler and
McConnell [1982]).
Under uncertainty, monetary items are exposed to (unanticipated)

changes in exchange rates, even if the Fisher Effect holds (see Grauer
and Litzenberger [1979] for further discussion). And, as we have indicated,
the inclusion of the translation gain or loss is essential if economic
interpretability and symmetry are to be achieved.
2.3.2. Multiperiod Monetary Investment. In the single-period analysis,
no distinction was drawn between results under historical cost and
current value accounting, since the distinction is not substantive. In the
case of a T-period monetary asset (T > 1), the market value of a claim at
time t (O < t < T) may not be equal to its book value as measured by
some predetermined amortization schedule based on historical cost. For
reasons of simplicity and without loss of generality, we assume that the
monetary investments are purchased at t = 0 at a par value of one unit.
Appendix D reports the results of three major translation methods for
the first period (i.e., from t = 0 to t = 1). No additional insight is to be
gained from extending our analysis to t = 2 and on through T. This
convention is retained for the analysis of nonmonetary investments as
well. The three translation methods are: (1) current (i.e., end of period)
market value accounting for the investments in the local currency-denom-
inated financial statements translated at the current exchange rate (the
C/C method), (2) historical cost accounting in the local currency trans-
lated at the historical exchange rate (the H/H method), and (3) historical
cost accounting translated at the current exchange rate (the H/C
method). It is our contention that all of the major translation methods
advocated are hybrids of these three methods.10
As in the earlier analyses, the two investments are assumed to have
the same initial investment of one unit at t = 0. The domestic and foreign
monetary investments possess cash flows known with certainty, equal to
Cd and Cf, respectively, for 0 < t < T, and equal to 1 + Cd and 1 + Cf for
t = T. With uncertain inflation and hence exchange rates, these invest-
ments in general do not represent economically equivalent investments.
There is no assurance that COEt = Cd or MftEt = Mdt for any 0 < t c T.
There is no reason to believe that either real or translated nominal rates
of return will be equal. The exact relationships are reported in Appendix
D. The nominal rate of return on the foreign investment, expressed in
terms of the domestic currency, is fRd, the nominal return on a domestic
investment whose real rate of return is equal to that of the foreign
investment, rf. fRd will not, in general, equal Rd.
The major findings of this analysis are: (1) the C/C method possesses
both economic interpretability and symmetry; (2) the H/H method
possesses symmetry but not economic interpretability; and (3) the H/C
W For example, in theory, the temporal method of FAS No. 8 is a hybrid of the C/C and
H/H methods. In practice, because of the treatment of long-term monetary assets and
liabilities, it is a hybrid of all three methods. The all-current method is a hybrid of the C/C
and H/C methods. The current-noncurrent and the monetary-nonmonetary methods are
hybrids of all three.
method possesses neither economic interpretability nor symmetry, with

the exception of the trivial case.
The first result is not surprising in this setting and requires little
elaboration. The balance sheet reports 1 + fRd, which is the market value
(present value) of the investment, denominated in the domestic economy
and will equal 1 + Rd if rf = rd (i.e., given economic equivalency).
Similarly, the net income, after the translation gain or loss, is fRd, which
is identical to the nominal return that would be reported by an econom-
ically equivalent investment. Alternatively stated, fRd will equal Rd if rf
= rd. Hence both economic interpretability and symmetry are preserved.
As in the previous cases, the inclusion of the translation gain or loss is
essential to the attainment of both properties.
With respect to the second result, the symmetry of the H/H method
may be somewhat more surprising. However, upon reflection, the sym-
metry property follows directly from the definition of economic equiva-
lency. Here there is no translation gain or loss, and translated net income
is CfEl, which equals Cd by definition if the investments are economically
equivalent in the first period. Symmetry is obtained by the common
omission of the capital gain component for both investments, but eco-
nomic interpretability is not achieved.
With the exception of the trivial case, the H/C method possesses
neither property. The balance sheet does not report the market value
(present value) of the investment, either in the local currency or in the
translated amount. Moreover, symmetry is also violated. In both cases,
the failure to obtain these properties arises from a translation at the
current rate of the initial amount of the investment recorded at historical
cost. Hence, even if CfEl = Cd, the resulting balance sheet amounts and
the net income after translation gain or loss are neither symmetric nor
economically interpretable. Obviously, net income, ignoring the transla-
tion gain or loss, is symmetric."
In the special case of certainty, it is trivial to establish a predetermined
amortization schedule such that the book value will equal the market
value of the investment. Here the C/C and H/C methods produce
identical results. In the more general setting of uncertainty, it is not
possible to establish such a predetermined schedule.
3. Analysis of Nonmonetary Investments
The analysis here is simpler than for the case of monetary investments,
because nonmonetary investments are defined to be riskless in real terms.
" This provides a potential rationale for opposition to FAS No. 8, which required long-
term monetary items to be translated at current rates. The failure to include translation
gains and losses in net income under FAS No. 52, which requires the all-current method,
could be similarly motivated, although direct charges to equity under FAS No. 52 still result
Two benchmark types of nonmonetary investments are considered: (1)

undeveloped land, natural resources, or inventory held for sale (i.e.,
capital gain is the only source of income) and (2) depreciable assets,
which accommodates arbitrary cash flow patterns.
3.1 UNDEVELOPED LAND, NATURAL RESOURCES, OR INVENTORY
HELD FOR SALE12
The key feature of this type of investment is the absence of cash flow
in the first period (i.e., Cd = Cf = 0). To induce individuals or firms to
hold such assets, the nominal return must be reflected in capital appre-
ciation. Assume that If = Id = 1. Moreover, rd = rf = r is known with
certainty.
Appendix E summarizes the results of the three major methods of
translation. The major conclusions of the analysis are the same as for the
monetary investments: (1) the C/C method possesses both economic
interpretability and symmetry; (2) the H/H method possesses symmetry
but not economic interpretability; and (3) the H/C method possesses
neither, with the exception of the trivial case.
As in the case of monetary investments, the properties of the C/C
method are hardly surprising. Both investments will report balance sheet
amounts equal to 1 + Rd, the market value (present value) of the
investment, and both report net income of Rd, the nominal rate of return.
Again, the inclusion of the translation gain or loss is critical to both
properties. The symmetry of the H/H method is obvious, since there are
no cash flows and capital gains are not recorded. As before, the common
omissions preserve symmetry but result in the lack of economic inter-
pretability.
3.2 DEPRECIABLE ASSETS
Consider two depreciable assets, identical in "real" terms, where one is

in the foreign economy and the other is in the domestic economy. More
precisely, these two assets have the property that for all t = 1, ...., T
Cft/Cdt = 7T ( , where Cft(CcIt) is the cash flow in period t for

sol I + Id,
the foreign (domestic) asset and T is the useful life of the assets. For
simplicity, and with no loss in generality, we take if and id to be constants,
in which case Cft/Cdt = + i) The market values at time t, Mft and
in balance sheet amounts that possess neither property. Moreover, since FAS No. 52 is a
hybrid method, translation gains and losses under C/C are accorded the same treatment as
those under H/C.
12 Prominent examples in this category include renewable resources (e.g., timber) or
assets which become more valuable with aging (e.g., certain beverages and tobacco). For
convenience, we shall refer to this class of assets as simply undeveloped land.
Mdt, will obey the following relationship:13
(1 + )
Mft = Mdt (1 + )
At t = 1, the relationship would simply be Mft = Md, (1 + if) Note that
the market values translated at the current exchange rates will always be
equal (i.e., MftEt = Mdt). This is to be expected since the assets are
equivalent in real terms in each period.
Appendix F summarizes the financial results reported under the various
methods for depreciable assets. The major findings of the analysis are:
(1) the C/C method possesses both economic interpretability and sym-
metry; (2) the H/H method preserves symmetry if and only if identical
depreciation methods are used;"4 and (3) the H/C method, in general,
possesses neither property.
In the special case of certainty, it is trivial to set up a predetermined
depreciation schedule so that the book value is equal to the market value
of the investment in their local currencies at each point in time. In this
special case, the H/C method becomes equivalent to the C/C method
and possesses its properties. In a similar vein, under certainty, it is also
trivial to set up a depreciation schedule for the foreign investment such
that the translated book value will be equal to its market value denomi-
nated in the domestic currency.15 In this case, the H/H method and the
C/C method produce equivalent results.
But in the more general setting of uncertainty, no predetermined
depreciation schedule can be set up to ensure the equality of book values
and market values. Hence, the major results above occur in the more
general case. And again, the inclusion of the translation gain or loss must
be incorporated in order to preserve the two properties of interest.16
13
(1 + jf)S
T cd. (1 + id) (1 + if)tT C'ds
s=t+l (1 + if)' t(1 + r)Wt (1 + id) t=t+I (1 + id) t(l + r)st
= (1 if) + Mi t
14 Depreciation methods are identical if and only if Dft/If = Ddt/Id for each t, where
Dft (Ddt) is the depreciation recorded at time t in the local currencies.
15 In this case, the book value of the asset denominated in the foreign currency will not
equal its market value. However, translating this "incorrect" amount by the historical,
rather than the current, exchange rate will produce a translated amount equal to the current
market value of the asset denominated in the domestic currency. Sometimes "two wrongs
do make a right." From the perspective of the income statement, the translated depreciation
amount will differ from that reported under the C/C method by exactly the amount of the
translation gain or loss (which is not reported under the H/H method). These two offsetting
differences produce the same net income under H/H as under the C/C method.
" As in the case of monetary investments, the H/C method possesses symmetry in net
income, excluding the gain or loss, for both developed and undeveloped land. However, this
property fails in the case of depreciable investments.
4. Empirical Implications
It is possible to extend the analysis to derive empirically testable

hypotheses. For example, under the C/C method, there would be perfect
correlation between the rate of return on equity reported in financial
statements and the investor rate of return defined in terms of dividends
and changes in the price of the common equity. Imperfect correlation
would generally result from excluding the translation gain or loss from
the net income calculation as called for in FAS No. 52.
Of course, the success of these correlations will depend partially on the
realism of our assumption of perfect and complete markets. In some
nominal sense, markets cannot be literally perfect or complete; otherwise,
it would be difficult to explain the existence of such (costly) aspects of
our institutional framework as forward contracts in foreign currency.
However, the existence of this rich set of state-contingent contracting
opportunities may, in fact, permit the same observations that would be
attainable in markets that were literally perfect and complete (e.g., see
Arrow [1963], among others). Hence, complex claims such as common
stock may behave as if they were priced in a perfect and complete
markets setting. As a result, perfect and complete markets may provide
a "reasonable approximation" of the setting which gives rise to the actual
behavior of these variables.17 At a minimum, the predictive ability of such
a model can provide a benchmark against which to compare the predictive
power of information-based models in an imperfect or incomplete markets
setting (i.e., models yet to be supplied).18
Another problem in attempting to extend the predictions of the model
to the empirical domain relates to the nature of the data (rather than the
nature of the markets). For example, the C/C method is generally not
the basis of reporting. Here, the reported data under some other method
can be viewed as containing "measurement error." A key feature of the
research design would involve the explicit recognition of such errors.
Some possibilities are to structure the data such that the properties of
measurement error would admit to a classic "errors-in-variables" treat-
ment, or to structure some portfolio procedure in order to "diversify"
away the measurement error.19 Another would be to employ sample
selection procedures to obtain firms for which the measurement error is
"small" (e.g., firms having the property that a large portion of their assets
and claims are effectively reported under a C/C method).
The structuring of the precise research design is a nontrivial task and
is beyond the scope of this paper. While it would be premature to presume
In a related vein, the model may be perceived to be more appropriate for some
currencies than others. The research design could reflect these priors.
18 This is not to say that the model would be appropriate for any phenomenon of interest
(e.g., explaining hedging behavior by corporate management). However, it may be helpful
for some phenomena of interest (e.g., security price behavior).
19 Careful thought is required here, because the "measurement error" may be both cross-
sectionally and cross-temporally correlated. In addition, its mean may differ from zero.
that a research design which will adequately overcome these difficulties

is feasible, it would be equally premature to dismiss out of hand the
potential predictive power of our analysis.
5. Concluding Remarks: Moving Toward More

Complicated and Realistic Economic Settings
In a world of perfect and complete markets, managers would not worry

about what sort of foreign exchange hedging positions they undertook.
Nor would the foreign currency composition of their monetary positions
be of any consequence (i.e., where a firm borrows or lends would be a
matter of indifference). A generalization of the Modigliani-Miller theorem
quickly demonstrates that such decisions are a matter of indifference to
shareholders, who could undo any of the firm's decisions along these two
dimensions to suit their own tastes and beliefs (see Feiger and Jacquillat
[1981]).
Although our assumption of perfect and complete markets may be at
variance with the way in which the world economy operates, this does
not imply that our analysis is of no interest. A thorough understanding
of the properties of translated foreign currency-denominated financial
statement numbers in a simple setting is a prerequisite to analysis in
more complicated settings. In this sense, it is important to distinguish
between sufficient versus necessary conditions. As indicated earlier, per-
fect and complete markets are sufficient, but they are probably not
necessary. Our analysis relies on two central features: (1) exchange rate
changes driven solely by inflation rate differentials, and (2) the concept
of economically equivalent assets. With respect to feature (2), a weaker
"spanning" condition may be enough, as suggested in note 3. Moreover,
we could take the condition we defined as economic equivalency and
apply it to any market setting. The problem, of course, is that the term-
economic equivalency-is no longer an appealing label to attach to such
a condition. Note, however, that the property of symmetry can be
examined under fairly weak conditions. The symmetry properties of the
C/C and H/H methods can be preserved under general conditions (i.e.,
the exchange rate condition holds and an appropriate label is placed on
the economic equivalency condition).20
Unfortunately, the next logical step of allowing for certain market
imperfections and incompleteness, potentially involves an enormous in-
crease in the complexity of the economic setting. To be sure, such steps
are essential if we hope to understand such empirical phenomena as shifts
in hedging behavior or changes in the mix of foreign-denominated debt
20 Still another route is to assume that product and factor markets are imperfect but that
foreign exchange and financial capital markets are perfect. This appears to be the spirit of
several analyses in the international finance and economics literature (see Flood [1982] for
references). This would not require the real rate of interest to be identical in any two
countries.
which may have accompanied the adoption of FAS No. 8 and which may
accompany any changes to FAS No. 8. For example, with the introduction
of certain market imperfections, purchasing power parity, which we have
relied on extensively in the previous sections, may no longer be expected
to hold (see Officer [1976] for a recent review of empirical evidence).2"
Differences in tax laws across countries may lead to preferences for
borrowing in one country over another. Differential tax treatment of
hedging-related gains and losses may also encourage or discourage hedg-
ing behavior (Chown and Finney [1977]). Differences in information due
to costly observation might very well render local financing of foreign
investments less costly when the investments serve as collateral for the
loans.
21 See Gjesdal [1981] for an analysis of foreign currency translation where deviations
from purchasing power parity are introduced exogenously.
REFERENCES
ALIBER, R., AND C. STICKNEY. "Accounting Measures of Foreign Exchange Exposure: The
Long and Short of It." The Accounting Review (January 1975): 44-57.
ARROW, K. "The Role of Securities in the Optimal Allocation of Risk-Bearing." Review of
Economic Studies (1963): 91-96.
BEAVER, W. "Accounting for Inflation in an Efficient Market." In The Impact of Inflation
on Accounting: A Global View. The International Journal of Accounting, pp. 21-42.
Urbana: University of Illinois, 1979.
, AND J. DEMSKI. "The Nature of Income Measurement." The Accounting Review
(January 1979).
CHOWN, J., AND M. FINNEY. Foreign Currency Debt Management. New York: J. F. Chown
and Co., 1977.
FEIGER, G., AND B. JACQUILLAT. International Finance. Boston: Allyn and Bacon, 1981.
FINANCIAL ACCOUNTING STANDARDS BOARD. Standard No. 52: Foreign Currency Trans-
lation. Stamford, Conn.: FASB, 1981.
FLOOD, E. "The Effect of Exchange Rate Changes on the Competitive Firm's Pricing and
Output." Working paper, Massachusetts Institute of Technology, 1982.
GJESDAL, F. "Valuation of Assets Denominated in Foreign Currencies." Working paper,
Norwegian School of Economics and Business Administration, 1981.
GRAUER, F., AND R. LITZENBERGER. "The Pricing of Commodity Futures Contracts,
Nominal Bonds, and Other Risky Assets under Commodity Price Uncertainty." Journal
of Finance (March 1979): 69-83.
JENSEN, M., AND W. MECKLING. "Theory of the Firm: Managerial Behavior, Agency Costs
and Ownership Structure." Journal of Financial Economics (October 1976): 305-60.
NOBES, C. "A Review of the Translation Debate." Accounting and Business Research
(Autumn 1980): 421-31.
OFFICER, L. "The Purchasing-Power-Parity Theory of Exchange Rates: A Review Article."
International Monetary Fund Staff Papers (March 1976): 1-60.
SEIDLER, L., AND P. MCCONNELL. "FASB Statement No. 52 on Foreign Currency Trans-
lation: A First Look." Financial Analyst Journal (January/February 1982): 18-20.
APPENDIX A
Summary of Notation, Assumptions, and Relationships
I. Notation
Et = the exchange rate at time t expressed as a ratio of one unit
of the domestic currency to one unit of the foreign currency
d = subscript denoting domestic
f = subscript denoting foreign
id (if) =ex post inflation rate in the domestic (foreign) economy
from t = 0 to t = 1
Id (If) =amount of initial investment in the domestic (foreign)
economy (i.e., at t = 0) denominated in the local currency
rd (rf) =ex post real rate of return on the domestic (foreign) in-
vestment from t = 0 to t = 1
Rd (Rf) = ex post nominal rate of return on the domestic (foreign)
investment from t = 0 to t = 1
f Rd = ex post nominal return from t = 0 to t = 1 on a domestic
investment whose ex post real return is equal to rf, the real
rate of return on foreign investment
Cd (Cf) = cash flow on domestic (foreign) investment at t = 1
Md (Mf) = end-of-period market value of domestic (foreign) invest-
ment (i.e., at t = 1)
Dd (Df) = historical cost depreciation on domestic (foreign) invest-
ment from t = 0 to t = 1
II. Assumptions
Al Markets are perfect and complete
A2 Without loss of generality, Eo = 1
A3 Without loss of generality, If = Id= 1
A4 Events, inflation, exchange rate changes, and cash flows occur at
discrete intervals t = O 1, . .. , T
A5 Monetary investments are "riskless" in nominal terms (i.e., Rf
and Rd are known with certainty at t = 0, although rf and rd may
be uncertain)
A6 Nonmonetary items are riskless in real terms (i.e., rf and rd are
known with certainty at t = 0, although Rf and Rd may be
uncertain)
III. Relationships
RI (1 + if)(1 + rf) 1 + Rf
R2 (1 + id)(1 + rd) I + Rd
R3 (I + id)(l + rf) I + fRd
R4* E1 = 1 + id
1 + if
* R4 is an equilibrium condition of the world assumed in Al. If R4 did not hold, arbitrage
profit opportunities would exist.
a + ~~~
n +Y+
; _ +
Q 1~~~~~~~~~~~~~~~
*QQ ++
+ + II-
n~~~~~~~~c cn
Ss ~ ~~~~~ H
s 219 - 0 S I +
0 n I
X 0
0 cn 0
i,~~~~~ H
d,. cn R4i<4
~~~~~ 0~~~~~c
H~~~~~~~~-
4,D
+ +
Can
.o+ + a. aA
>
0; 0 + + 2~
> C m ~+ + .> ,>O
0~~~~~~~~~~~~~~~~~~0 c
X = +~~~~~~~~~~~~~~~~
4-D ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ c-
0 41~
~~ -~~~-D
~ ~ ~ ~~~~E*~~~~cI~~~*
4-D Z5 4-D r2* ~~~~+
-~ + C
,~~~~~ .~~~~~~~ ~~~~ ~ ~ ~ ~ ~ ~~~c
i ? O
W ==Q
W t 0
W++
0 Q~~~~~~~-
t Q ~~~~~~11 11
-~ ~~~~ Q It
11 o rfli
o +
11 N +-
cn~
0
4-D~II
+ p-
o s
;T..4 ~ ~ ~ I I
z ~ c rn
;-49 g*
rA4:z
7:
rn 4 S p
Q cnQ 0
4-D ~ ~ - .
a) 4-~~~~~~w -Q4
4-D a) 0 )-~C cC
ccn
P 4 Q Z H
a)
a)
+~~~~~~~~
o; =
rm 4
o V
D -I
_, a . ~ a , 4,A t 'X
Pz 0 P EXE
o -
a)) +
+
'? " '--t1 II
so +
z - + +
so Zo
> ~~~ $'1-
X) -, C
g S Xo = r =0
= O = S U -O
a)
> >
ct
>~~~~~~ C t
,D ~ -q ~-q o o o o 4 ~ ~ o ~
o- Ei
o~~~~ ++
O~~~~C , ,-C~ c
cn~-
?5~~~~4- ?t ct t W
Q)o=EH?
- b 0cc :t4 b= ~3
0000 -: 0-Y S > : Q
; X H = = m ; X H = = m~~~~~~rj
?je ct ct)=Q
oQPE
_ +S
>>
Q , H
+~~~+
= * ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~a )
ao II +e 0
~~~-~~~~~'--~~~~~~~~~ + 7 -~~~~~~~~~~~-4 -
II cn c
So t~~~~~~~~~~~~~~~~~~~~~~c
a) L J ~ ~ ~ ~ ~ ~ ~ ~ ~c
4~~~~~~
4i ?- , - X 4 X E
a)~~~~~~~~~~~~~
>~~~~~~~~~~~~~
Q~~~~~~~c
-4-)
q .+
a C
+ +
X~~~~ I I
++~~~
.- +~~~~~~~~~~~~~~~~~~~~~~~~~
+|+ ~ ~~ + + a II _ ~~~
-- ++~~~~~~
++ ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~
.. 0
>
- 0~~~~~~~~~~~~~~~~~~~~c
< > = a Q A it a l ? X = a++

ct~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~i
a)~~~~~~~~~~~~~~4- >t
ct ct~~~~~~
ct 4-5 c 0 0 q ol .5
A -~~~~~~~ Q - -- C-
ct ct E-1
>
E--l~~.
0
c-q ~
ct~~~~~~~~~~~~~~~~~~
-qH
ctzOkc
E-1 E-4 ~ ~ ~ a s

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Accounting Research Center, Booth School of Business, University of Chicago

Wiley, Accounting Research Center, Booth School of Business, University of Chicago

Foreign Currency Translation and

WILLIAM H. BEAVER AND MARK A. WOLFSON*

Our purpose is to explore some properties of the major methods of

* Professor and Associate Professor, Stanford University. This research is supported by

Copyright (, Institute of Professional Accounting 1983

hensive market value accounting with translation at current rates of

2 A precise definition of economically equivalent investments is provided later after some

2. Foreign Currency Translation of Monetary

Section 2.1 provides the notation, assumptions, and relationships that

special case of a single-period monetary investment under certainty,

2.1 NOTATION, ASSUMPTIONS, AND BASIC RELATIONSHIPS

The notation, assumptions, and basic relationships are listed in Appen-

pairs of countries (i.e. = = +i)

2.2 FOREIGN CURRENCY TRANSLATION OF A MONETARY

Initially, we consider the simplest possible case-a one-year monetary

2.3 FOREIGN CURRENCY TRANSLATION OF A MONETARY

INVESTMENT UNDER UNCERTAINTY

In contrast to the certainty setting considered in the preceding section,

Under uncertainty, monetary items are exposed to (unanticipated)

method possesses neither economic interpretability nor symmetry, with

3. Analysis of Nonmonetary Investments

Two benchmark types of nonmonetary investments are considered: (1)

3.1 UNDEVELOPED LAND, NATURAL RESOURCES, OR INVENTORY

HELD FOR SALE12

3.2 DEPRECIABLE ASSETS

Consider two depreciable assets, identical in "real" terms, where one is

Cft/Cdt = 7T ( , where Cft(CcIt) is the cash flow in period t for

in which case Cft/Cdt = + i) The market values at time t, Mft and

Mdt, will obey the following relationship:13

At t = 1, the relationship would simply be Mft = Md, (1 + if) Note that

T cd. (1 + id) (1 + if)tT C'ds

s=t+l (1 + if)' t(1 + r)Wt (1 + id) t=t+I (1 + id) t(l + r)st

It is possible to extend the analysis to derive empirically testable

that a research design which will adequately overcome these difficulties

5. Concluding Remarks: Moving Toward More

In a world of perfect and complete markets, managers would not worry

Summary of Notation, Assumptions, and Relationships

> C m ~+ + .> ,>O

> ~~~ $'1-

< > = a Q A it a l ? X = a++

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