HD28
.M414
Dewey
-7ss.*MST
ALFRED
P.
WORKING PAPER
SLOAN SCHOOL OF MANAGEMENT
PERFORMANCE MEASUREMENT OF FOREIGN OPERATIONS
UNDER FLOATING EXCHANGE RATES
David
WP 1393 - 83
J
Sharp
DECEMBER 1982
MASSACHUSETTS
INSTITUTE OF TECHNOLOGY
50 MEMORIAL DRIVE
CAMBRIDGE, MASSACHUSETTS 02139
r,-^
PERFORMANCE MEASUREMENT OF FOREICn OPERATIONS
UNDER FLOATING EXCHANGE RATES
David
WP 1393 - 83
J
Sharp
DECEMBER 1982
Massachusetts Institute of Technology
for the support and advice of my
like to record my thanks
would
advisers, Professors Donald Lessard and Richard Robinson; to Professor
and for the helpful comments of
the 'outside reader';
Brownell.
Peter
David Sherman and of my fellow students of International
Professor H.
I also record
Management; Bruce Kogut's advice was especially helpful.
Center for
the
of
Director
Bavishi,
my appreciation to Professor Vinod
University
of
Research,
Financial
Transnational Accounting and
facilities
and
processing
Connecticut,
for generously providing data
making data available for thii. study.
I
They
Working papers are a series of manuscripts in their draft form.
are not intended for circulation or distribution except as indicated by
or
For that reason, working papers may not be reproduced
the authors.
author.
the
of
consent
distributed without the written
I
....
FEB
f^Pnr
'^
i^oj
~n
"OBJECTIVES OF TRANSLATION
To provide information that is generally compatible with
the economic effects of a rate change on an enterprise's cash
flows and equity
a.
To present the consolidated
financial statements of an
enterprise in conformity with US generally accepted accounting
principles. ..."
b.
Statement of Financial Accounting Standards No. 52
Foreign Currency Translation, December 1981.
07452J-
INTRODUCTION
One of the problems facing the managers of
corporations
overseas
with
subsidiaries which distinguish them from their uninational colleagues is
that
proportion
large
a
corporate
of
different monetary jurisdictions;
earn
income
denominated
in
specifically,
published
For the purpose of
accounting
statements,
by the Securities and Exchange Commission (SEC)
required
devised
to
translate
these
statements into local currency (LC)
In December
1981,
foreign
currency
i.e.
US dollars.
,
(FAS 52),
which
Accounting for the Translation
replaced
of
an
Foreign
52:
earlier
Currency
as
rules have to
,
accounting
(FC)
the Financial Accounting Standards Board (FASB)
Statement of Financial Accounting Standards No.
Translation
subsidiaries
foreign
different currencies.
preparing consolidated quarterly
be
activity is undertaken within
Foreign
issued
Currency
statement
FAS
Transactions
8:
and
Foreign Currency Financial Statements.
FAS
8 had
previously
been issued in
1976
in
order
to
replace
variety
of
acceptable methods of accounting for foreign income with one
uniform standard.
The historic-rate translation method of FAS 8 treated
foreign income as if it had occurred in dollars.
all
the
It also
required
that
translation gains and losses be recorded in current income, thereby
producing net income figures which
i.
were as uncontrollably volatile as exchange rates
ii.
included large foreign currency gains and losses which bore
relationship
to
so-called
economic"
"real
effects
of
no
foreign
exchange movements.
As soon as the business community recognised the
reported
pressure
earnings,
effects
8
from "economic reality", but because managers had
the
income was different
little
(To be sure, submissions from the
business
community
couched in terms of the lack of credibility which FAS
the
accounting
the
profession,
and
the
were
profession (1).
We
will
unbiased income numbers which had
8
the
a
see
that FAS
8
interaction
FAS
community
generally produced
high variance, while FAS 52 produces
a
bias
created
of historic cost accounting rules and differential
inflation between domestic and overseas currencies.
of
had brought upon
unrealistic nature of net income
relatively stable income figures, but at the expense of
by
over
frequently
FAS 52 has therefore been welcomed by the business
figures.)
and
control
of unpredictable exchange rates on reported earnings.
effect
huge
on
was brought to bear on FASB to revise the
not so much, one suspects, because FAS
standard;
FAS 8
of
The
avowed
intent
to represent economic reality is likely to endow translated
52
dollar income figures with high credibility, and lead to their increased
use as a basis for management performance.
FAS 52 from
a
For this reason, we evaluate
performance measurement and control perspective.
out that the bias in net income is potentially large,
control systems are already
external
accounting
largely
requirements,
based
on
decisions
.and
It
since internal
translation
concerning
rules
for
resource
allocation across national boundaries may be made incorrectly after
adoption of FAS 52.
turns
the
This paper is in four main
understanding
current
sections.
of
first,
the
In
behavior of foreign exchange rates.
the
show that exchange rates, inflation and interest rates
linked
exchange
foreign
in
review
we
markets.
of
this,
literature on the accounting treatment of foreign exchange is
and
generally
found
is
not
be
to
consistent
with
We
inseparably
are
light
the
In
the
the
reviewed,
economic
the
literature.
The second section critically examines the practice
operations
foreign
as
required
accounting principles (GAAP).
basis
performance
for
by
We do
measurement,
accounting
by
developing
(ROD prepared
cost (HC) convention of US GAAP and FAS 52.
FAS
We
8.
show
would remove this bias.
different
significantly
The short run
to
This bias was
effects
from those of FAS
not
present
8,
of
FAS 52,
while
not
are found to misrepresent
Again, we find that
an
appropriate
possible if accounting statements are inflation-adjusted.
is
The requirement of GAAP to state
nominal
under the historic
that an inflation-adjusted accounting standard
foreign exchange gains and losses.
treatment
long-run
of
in foreign exchange markets, and are found to cause a bias
to net income and return on investment
under
normative
a
against which FAS 52 is compared.
The long-run effects of FAS 52 are examined in the context
expectations
for
and US generally accepted
FAS 52
this
of
value,
inconsistent
monetary
assets
and
liabilities
at
not discounted net present value, is shown also to lead
treatment
of
otherwise
identical
transactions
in
different currencies.
In the third
section, we test whether
control
systems
in
use
in
US
designed
are
multinationals
such
in
encourage
they
that
way
a
non-optimal decisions, and whether managers are aware of this.
that
reward
corporations
systems
in
encourage
potentially
find
high number of multinational
disturbingly
a
We
but
behavior,
non-optimal
there
appears to be some awareness of the problem.
the
discusses
section
The final
need
objective
more
for
reported
accounts, and the importance of the role of the accounting profession in
setting such standards.
FAS
8
was
historic-cost oriented standard;
a
by translating at historic
exchange rates, foreign accounting statements were
dollar
statements
produced
all-current translation
inseparable
from
under
method
of
the
three
with
historic cost convention.
FAS 52,
however,
US
The
conceptually
is
inflation-adjusted accounting, and cannot be expected
to produce sensible information otherwise..
including
consistent
of
committee
the
FAS 52 has
few
critics,
of seven who drafted it.
(FAS 52,
a
Their criticism (that FAS 52 is an unacceptably large
departure
from the HC principles of GAAP) it seems to me, is misguided;
it should
p. 15).
be
directed
instead at the much greater problem of the relevance of US
GAAP, and specifically historic cost accounting.
THE ECONOMIC EMVIROHMENT OF INTERNATIONAL ACCOUNTING - A REVIEW
*
In this section,
rates
in
a
we review the literature on the
floating-rate
world
such
as
has
behavior
been
the
of
exchange
case since
Smithsonian parities were abandoned in
1973.
following
the
find
V/e
fundamental relationships:
In the long
i.
run, purchasing pov;er parity (a goods market model)
and the International Fisher Effect together suggest
between
differential
inflation,
relationships
interest rates, and
diffrential
exchange rate movements.
ii.
In
the short run, exchange rates behave like financial
assets
an efficient market, with the result that expectations play the
in
dominant role in determining short-run exchange rate movements.
It would
seem reasonable then that accounting rules for translating into
dollars economic activity which is measured in foreign
built
be
on
foundation
a
which
recognises
currency
should
fundamental
these
relationships.
An exchange rate is simply the price of foreign
local
currency.
Like
any
other
hand,
the
in
terms
of
price, it is determined in a market
which may be more or less free of controls and
one
currency
imperfections.
On
the
exchange rates of centrally planned economies are fixed
entirely by government fiat, while on the other, exchange rates
between
the US dollar and, for example, major European currencies are determined
in
large,
well-organised markets free from controls, in which publicly
available information
correspond
(2).
closely
rapidly
is
to
a
disseminated,
and
which
therefore
semi-strong form efficient securities market
We consider here only the efficient-market case, tnough we mention
briefly the important implications of inefficiency.
Purchasing Power Parity (PPP) has enjoyed
a
long and successful
Briefly, PPP states that
as the long-run determinant of exchange rates.
exchange
tend to move in such a way that the relative purchasing
rates
power of all currencies is unchanged;
movements
v;ill
term
was
The
subsequent
(1976).
might
that is,
exchange
nominal
rate
be in proportion to relative inflation.
first
coined
literature
is
by
Cassel
summarised
in
(1915),
Balassa
tend
exactly
(1964)
and Officer
exchange
rates
towards PPP (owing to relative differences in
productivity in traded and non-traded sectors
technologically-advanced
voluminous
the
and
They also point out that there are reasons why
not
history
and
between
the
high-income
Such
low-income countries, for example).
reservations notwithstanding, this paper takes Krugman's (1978) point of
view:
"Few international economists would deny that
parity holds in some sufficiently long run..."
The analysis that follows is based on the view that
'ideal'
situation,
and
that
deviations
aberrations which, although they are
rates,
nevertheless
distort
from
obviously
translated
rates,
power
PPP
represents
PPP
are
short-term
accounting
statements are translated at actual exchange
purchasing
an
temporary
equilibrium
statements, since
and
not
at
some
hypothetical rate based on ex post differential inflation.
What are these short-term deviations?
Krugman's next sentence:
"But most [international economistsj would probably be skeptical of
any assertion that PPP holds in the short run."
Since the ending of Smithsonian
rates
have
highly
been
parities
February
in
exchange
1973,
volatile, and more or less unpredictable.
that respect, they behave, not as prices of goods and services,
prices
exchange
manner,
but
as
The primary determinant of price movements
of financial assets.
essentially
is therefore expectations, and as information arrives in
random
In
should
rates
also
move in
a
random manner.
a
rates
exchange
Giddy and Dufey (1975)
showed
between
major currencies was not significantly different
from
a
number
a
of
that
random walk or martingale.
demonstrating
importance
the
of
behavior
the
Frenkel
(1981)
information (i.e.
of
took
movements
exchange
in interest rates
movements
unanticipated
and
He showed
news).
that a strong relationship existed between unanticipated
further
this
(
a
rate
variable
which was expected to capture the effect of 'news' very quickly).
Dornbusch (1980)
elegantly
proposes
explains
an
that
the
asset
model
exchange
of
exchange
the
immediately
rate
which
high volatility of exchange rates arises
because changed expectations about future interest rates
cause
rates
to
overshoot
and
the
inflation
long-run
equilibrium rate, and only slowly to return to it.
However, there also
exists
exchange
the
rate
and
a
strong
relationship
betv;een
forward rate in the short run;
between these rates is determined
by
the
powerful
the
spot
tne difference
covered
arbitrage
differential risk-free interest rates in different
transaction
between
currencies.
The forward rate thus always represents that exchange
rate
which
can
guaranteed
be
hedging
by
in forward markets.
forward rate an unbiased predictor of the spot rate?
above
assumed
that
But is the
Giddy
Dufey
and
and found that this submartingale model of
it was,
exchange rate behavior was also statistically significant, and in
that
martingale
the
submartingale
and
models
fact,
virtually
produced
identical results.
It
is not clear that the forv/ard rate is an unbiased
spot
future
Hodrick
Henriksson
by
have
(1980)
inefficiency
flows
market
security
with
theoretical reasons why such
reviewed
a
and
exchange
(i.e.
movements
risk premium should exist
Lessard
demonstrated
and
existence
market
efficiency.
to outperform the market.
A
rather
the
validity
pragmatic
Levich (1981,
Lessard (1982) have both found that some
outperform
market
either
of
or a small risk premium, but in common with all studies of
efficiency is whether, ex post, so-called experts
able
thoroughly
is
Empirically, Hansen and
(1982).
the
were
rates)
literature on
The
(3).
this type, it is not possible to test separately
model
the
rate, since holders of FC financial assets would require a
risk premium if the expected cash
correlated
of
predictor
at
of
market
of
test
the
forecasting
were
1982), and Henriksson and
forecasters
can
consistently
market over the period studied for some currencies, but
the
by and large, the major currency markets are indeed at
least
weak-form
efficient most of the time.
The link between
International
the
Fisher
long-run
Effect
and
(IFE),
the
short-run
which
is
made
via
the
states that the difference
between the current spot rate and the expected value of the future
spot
10
equals the difference in interest rates.
rate
Giddy (1977) showed that
less
this relationship held quite well for one-year interest rates, but
so for very short-term rates.
states
that
nominal
the
Furthermore, the (domestic) Fisher Effect
rate
interest
of
interest plus the rate of inflation.
for
the
dollar,
US
expectations
short
well.
If
term
capital
the real rate of
equals
Fama (1975) showed that, at
least
interest rates incorporate inflation
markets
are
integrated,
perfectly
expected real interest rates should be equal for all currencies.
To summarise so far, we see a relationship between
rates and interest rates.
to
follow
FPP,
adjustments
but
in
In the long run,
the
expectations
in
short
are
run,
exchange rate movements tend
they are highly volatile as
simultaneously
incorporated
rates, and forv;ard and spot exchange rates.
interest
exchange
inflation,
the absence of
In
deviations from PPP, expected real interest rates in all currencies
equal.
future
Forward
spot
rates
rates,
into
are
are probably the best estimates of the expected
albeit
poor
ones.
interest
covered
Finally,
arbitrage ensures that the difference in nominal riskless interest rates
is
exactly reflected in the difference between the forward and the spot
rate.
V
The literature on the application
of
international
two
operations
is
of
financial background have concentrated
this
theory
types.
on
the
to
Those
accounting
for
who write from a
relevance
hedging;
of
Logue and Oldfield (1977) for example clearly view hedging as
a
zero-NPV
transaction, and therefore irrelevant as far as the value of the firm is
concerned,
though
they
also take the view that accounting performance
11
Giddy (1976)
(at that tine under FAS 8) did not matter.
clarifies
the
distinction between hedging and speculation, but he does not discuss the
accounting
misleading
treatment
of
discuss the appropriate measure of exposure;
article
insightful
but
descriptive
Other financial writers
hedging.
Dufey (1972)
points
out
of
accounting
exposure,
for
since
none
a
existed
brief
a
of
importance
the
cash-flow exposure but was unable to relate this to
in
standard
specific
at that time.
Few
writers have specifically examined the impact of accounting practice
foreign income measurement.
analysis
clearest
Fredrikson's (1968) must surely rank as the
the confusion created by accounting practice for
of
foreign exchange transaction losses, in spite of the fact
had
no
standard to which to refer;
accounting
on
subsequent developments in
the
theory
of
that
he
too
nor was he able to use
accounting
inflation.
for
Aliber and Stickney (1973) present an empirical analysis of the validity
of
PPP
and
International
the
incorporate their
findings
accounting (again,
a
into
Fisher
Effect,
specific
were not able to
implications
for
reported
standard did not exist at the time).
Those writing from an accounting perspective on
frequently
but
emphasised
the
the
other
have
hand,
effect of exchange rate movements without
a
complete
consideration
Contrary
to most of the polemic generated by FAS 8, Mueller (1976) took
the view that FAS
he
also
standard.
8
recognised
of
the
behavior
of
those
exchange
rates.
was no better or worse than any other standard,
that
the
but
real need was for an inflation-adjusted
Shank (1976) pointed out that one result of
FAS 3
would
be
that reported earnings would be more volatile than had formerly been the
case
(though
Rodriguez
(1977) was unable to verify this empirically).
12
Shank's view was confirmed when the parity of
subsequently
wildly against other (especially European) currencies.
fluctuated
Curran
example
for
dollar
the
accounting
(1981)
treatment
Alleman
and
The
(1932).)
inconsistent
transaction gains and losses, and the similar
of
which
treatment of the results of the translation process (both of
discussed
below)
Folks
Evans,
(1974),
inflation
and
Jilling
and
(1978),
The interrelationship of exchange
discussed
been
has
are
divert many writers' attention from the
to
Choi and Bavishi (1982),
Czechowicz,
rates
continue
Prindl
issues;
real
(See
in
of
terms
the
but
without
reference to exchange rate behavior, by Lorensen and Rosenfield
(197^),
"restate-translate
translate-restate
vs.
controversy",
while Choi (1977) recognises that under an inflation-adjusted accounting
standard,
the
issue
is
trivial;
which indeed it is, but only if PPP
holds.
v
This
paper
seeks
multinational
to
present
accounting
comprehensive
a
practice
in
relevant accounting rules and principles
the
US.
critique
We
now
of
current
examine the
.
ACCOUNTING FOR THE RESULTS OF FOREIGN SUBSIDIARIES
1 .
Background
Annual audited accounts are published by corporations in order to convey
information to shareholders;
and
accountability.
the main reasons for this are
Audited
statements
are
the
means
stewardship
by
which
13
shareholders are assured that directors (and by implication,
employees)
performing
are
fiduciary
their
duties
correctly.
objective is to disclose specific information prescribed by
defined set of rules, US GAAP, which originally evolved in
the need arose.
the
consistency
and
accounting
these three and
a
problems
compromise
of
between
fourth principle, that of relevance, but the advent of
accounting
multinational
objectivity,
rules:
There have always been
conservatism.
one-country
Three well-known fundamental principles lie behind
financial
formal
strictly
a
a
The
had to be adapted to a multinational environment as
have
but
context,
other
all
has
made
the problem acute.
specific statement (which purports
In
addition to
be
consistent
GAAP,
FAS 52 is
with
the more general guidelines of GAAP) of how to account for foreign
operations.
become
a
Since 1971,
international
the
to
environment
economic
has
stable, less predictable and arguably less well understood
less
while multinational corporations have spread their operations throughout
the world.
wonder,
Small
then,
accounting
that
multinational
for
operations has experienced such growing pains.
A further problem confounding the
operations
is
that
measurement
the same corporation.
maximise
dividend
between
issues,
at the
same
time,
repatriation,
and
subsidiaries
foreign
within
or
parent
to
cannot
lightly
be
autonomous
completely
or
system,
objectives
consolidate
share, with no immediate expectation of dividends
serious
of
A subsidiary may be part of a tightly-controlled,
worldwide
integrated
self-sufficient;
results
the strategic view of overseas subsidiaries varies
from one corporation to another, and even
highly
of
at
might
be
and
to
and build market
all.
These
are
dismissed, but they are also
14
applicable to large diversified domestic
here
focussed
is
specifically
corporations.
attention
Our
those problems which are currency-
on
related, and multinational in content.
A study of accounting-based control systems for use in
overseas
with
raises
operations
two problems which do not have exact
counterparts in the purely domestic case.
the
corporations
US
which
The first problem,
is
subject of detailed discussion in this paper, is that the reporting
system should correctly identify a cost item both by nature (an
"foreign
labelled
exchange
loss"
should exclusively be the result of
unforeseen exchange rate movements, for example) and by
which
issue:
expense
in its simplest form raises the centralisation
/
responsibility
,
decentralisation
function
if exposure management is to be a centralised treasury
- the most common and most efficient organisation - then the speculative
component
(unforeseen)
of
foreign
exchange
gain
loss has to be
or
attributed to the treasury function, whose responsibility it is to hedge
the company's overall foreign currency exposure against such
losses.
(It
is
true
that
the
treasury may also be responsible for
taking speculative positions where they have
access
exchange gain or loss, meanwhile, should
operating
better
imperfect or controlled markets.)
to,
management,
so
into
conventional
accounting
knowledge
or
The expected component of
attributed
be
of,
to
subsidiary
that they are motivated to incorporate those
operating
expectations
unforeseen
decisions.
As
will
be
seen,
the
treatment of foreign exchange gains and losses
does not enable this important distinction between the expected and
unexpected gain or loss to be made.
the
15
briefly
The second problem is more subtle, and is discussed only
here.
The fact that exchange rates and relative prices (among other variables)
do
(i.e.
a
that the standard against which performance is judged
means
change
changed
be
also
should
budget)
An appropriate control system then
changes in the business environment.
is
one
measures
which
given
standard,
against
actual
uncontrollable
reflect
to
particular
a
uncontrollable state of the world.
Suppose
These two problems can be illustrated by an example.
currency
of
foreign
the
subsidiary depreciates by more than would be
required to maintain purchasing power parity.
movement
plausible
entirely
is
announced
government
unemployment
increase
and
output.
Such
result
A
the subsidiary.
to
control of the
subsidiary
in
this
paper.
rates have moved in
overseas
(and,
for
an
A
to
certainly
will
income,
even
to
reduce
be
is that
1
attributed
the
way,
in
lower
subsidiary
fully
result
These are the
result of problem
unexpected
the
if
incorporates local inflation into its prices.
discuss
elected
The currency depreciation, outside the
manager,
operating
dollar
translated
newly
problem
of
likely
exchange gains or losses may arise which are
incorrectly
a
policy
monetary
rate
exchange
an
example,
for
if,
expansionary
an
the
that
2
issues
we
is that since exchange
competitiveness
of
the
matter, domestic) operations has changed, so
that
that the assumptions upon which the budget was based have become invalid
(Lessard
(1982)).
anticipated
correctly,
Control
systems
then
should
not
only
separate
and surprise elements of exchange losses, and allocate them
but
should
'over-depreciation'
of
also
recognise
foreign
that
currency
as
(in
a
result
this
of
exanple)
the
,
the
)
16
subsidiary has
operating
overseas
standard
.
more
become
competitive
manager
should
world
in
judged
be
markets,
against
and
the
revised
a
(U
Even though published accounting information does not claim to represent
a
true picture of the economic performance of
the two are closely related.
prepared
under
a
nevertheless
entity,
an
Furthermore, the accounting information is
well-understood set of professional rules.
natural then that published accounts
should
have
only
It is
widespread
acquired
credibility, and that managers - the stewards of the shareholders assets
rightly
should
be concerned that the only objective (and published)
measure of their performance appear as favorable as possible.
It can be
argued that they can develop their own separate
the
economic
performance
measures
of
true
for internal use, or that they at least use local
currency accounts for evaluation purposes.
Research by Czechowicz, Choi
and Bavishi (1982) does not support this view;
US dollar perspective,
a
translated under published-accounting rules, is most commonly used (5).
An accounting standard for financial reporting
could
their
which defined rules
were
that
fixed
assets
GAAP.
The
1975,
FASB
which
had
values
and
essential
features
of
and inventories were translated at the
exchange rate on the date of their acquisition
asset
In
objective to measure foreign subsidiary activity as if it had
been conducted in dollars under US
FAS 8
8
operations
overseas
be based on one of several conflicting objectives.
issued the controversial Statement No.
as
of
depreciation on
a
(thereby
showing
those
constant basis, just as they would
have been in the US under GAAP), while liabilities and current
monetary
17
and
expenses
average rate for the period.
appropriate
FAS
of
resulting
Revenues
rate).
(the current
aspect
at the exchange rate on the balance sheet date
translated
were
assets
8
that
was
this translation
from
(
8
an
figure
balancing
"plug"
infelicitously known as
gain or loss) be included in consolidated net income.
FAS
at
By far the most controversial
inevitable
the
translated
were
a
translation
The
results
of
US
financed
by
translation were that
i.
for a typical subsidiary located outside
equity
and
dollar,
a
foreign
the
debt, whose currency devalued relative to the
large "translation gain" arose, and conversely, when
dollar weakened,
a
the
loss arose.
this gain or loss, recorded within net income, could swamp all
ii.
operating
other
income
and
thereby
seriously
distort
the
measurement of the true income of the entity.
iii.
actually
although the extent to which these gains and losses
corresponded
to
real
economic
gains
exchange rate movements was unclear to
and
many
losses
arising
from
they
were
managers,
nevertheless concerned about them, and were tempted to take hedging
positions in order to reduce the volatility of reported earnings.
iv.
because depreciation and cost of goods sold were translated at
the historic rate, they appear exactly as if they had been
in
the
US.
located
These expense items were therefore understated by the
same amount that an identical US expense would
have
been;
i.e.,
.
18
foreign
translated
rather than foreign, inflation.
US,
A
income statements were biased by the effect of
relevant
second,
regrettably
but
show
we
(as
later)
less
controversial, item within consolidated net income is "transaction gains
This arises when
or loss".
is
monetary FC-denominated asset or liability
a
created in LC books at one date, and is extinguished at
after the exchange rate has changed.
later date
a
between
The difference
the
book
or asset (valued at the spot rate at the date of creation) and the
debt
amount of LC needed to extinguish it at the spot rate
settlement
is
treated
as
a
on
date
the
of
gain or loss in the current
transaction
period
In December
required
1981, FAS 8 was replaced with FAS 52.
year, but may be introduced earlier
(and
into the 1981 accounts).
it
many
firms
have
chosen
to
information
provide
economic effects of
equity,
while
a
generally
rate change on
an
to
The purpose of FAS 52 is very
objective
different from that of its predecessor, since its stated main
is
is
all published statements starting with the 1983 financial
for
incorporate
standard
The new
compatible
with
enterprise's
expected
the
cash
flows
and
presenting consolidated statements in conformity with US
GAAP (p. 3)
The mechanics of FAS 52 may be summarised as follows.
liabilities
are translated at the current rate.
including depreciation, are translated at an
for
the
period,
assets
All
and
Revenues and expenses,
appropriate
average
but the "plug" number is taken directly to
a
rate
reserve.
19
and so does not form part of the period's net income.
gains and losses is unchanged from FAS
transaction
of the treatment of gains and losses arising from
hedging
of
range
8,
a
The treatment
of
except in respect
carefully
defined
transactions, which may be deferred instead of being
reported in income.
An additional feature of FAS 52 is that translation
is to be made
dollars
into
this
subsidiary;
from
functional
"functional
the
currency
currency"
the
of
simply the currency of the
is
primary economic environment in which the entity operates
which
(p. 25),
typically, but not necessarily, the currency of the country in which
is
the subsidiary is located.
records
accounting
It should be noted
kept in
are
a
in
passing
that
v;here
currency which is not the functional
currency, the translation is in two stages:
i.
remeasurement from the currency of the books to the
functional
currency
ii.
translation from the functional currency to the US dollar.
The remeasurement process
practice
currency
is
based
historic
on
similar to the former FAS
very
into dollars)
is
and
,
the
it
follows
dollar,
8
therefore
exchange
rates
(in
requirements for translation
that
where
the
functional
and subsidiary books are maintained in local
currency, FAS 52 accounting results are substantially identical to those
which would have been produced under FAS
This
paper
difference
is
not
concerned
with
8.
the
theoretical
issues
of
the
between accounting and economic measures of income, nor with
.
20
manner
the arguments over the most appropriate
should be modified in order to show "current cost" or "current
accounts
income.
net
purchasing power"
The
problem
the discussion which follows is that rate which
run
indicator
which
of
of
the rate of inflation implied in
to use is also sidestepped;
inflation
long
conventional
which
by
satisfies
PPP
in
the
We will accept that accounts prepared under GAAP in the
(6).
absence of inflation represent an "unbiased" measure of net income (even
though we know that the principle of conservatism will in fact generally
lower than the reported income figure)
As used
cost'
accounting
refers
to
the
tangible assets are recorded at the time of
whereby
method
accounting
'historic
paper,
this
in
acquisition at cost, and expensed (either as
depreciation
cost
or
of
goods sold) without any adjustment being made for the fact that:
- the purchasing power of the numeraire (currency)
of
the
it
is
expense
has been reduced by inflation
- the replacement cost of the asset at
differs
from
the
cost
at
the
acquisition
time
(for
whatever
expensed
reason;
inflation is only one of many possible reasons)
V
The
two
adjustments
restatement
inflation
accounting
of
which
above
historic
are
represent
cost
presently
standard FAS 33 (7).
the
accounting
used
in
two
approaches
statements
the
to
experimental
to
adjust
the
for
inflation
Two separate adjustments to net income
are required to be shown in footnotes;
a
general price level adjustment
21
(GPLA) based on the CPI, and
price indices of the firms'
I
a
current cost adjustment
income to be overstated.
for
inflation
(i.e.
inflation
an
In this paper,
this bias can be completely removed by
adjustment
GPLA
causes
adjustment
I
take the view that
comprehensive
appropriate,
any
or CCA), though in general, of
course, these two methods will produce different
However,
on
specific assets.
will show below that the absence of
operating
based
(CCA)
adjusted
income.
net
since the long run movement of exchange rates reflects changes
in relative purchasing power,
the
it is
GPLA
(rather
than
the
CCA)
adjustment of FAS 33 which is conceptually more consistent with expected
long run exchange rate movements.
Before
v;e
measures,
discuss
it
the
accounting
useful
is
treatment
of
specific
performance
set out two desiderata of any performance
to
measure to be used across currencies:
First, the
currency,
measure
that
is,
should
the
be
unbiased
measure
with
respect
to
functional
should not consistently overstate or
understate performance in any one currency.
Second, the measure, when applied to
reasonable
a
foreign subsidiary, should
be
a
measure of economic performance, that is, the application of
FAS 52 and GAAP to the measurement of foreign performance should produce
an indicator which is no worse a misrepresentation of
and
the
economic
reality
results of managerial decisions than the corresponding measure
of domestic activity.
22
The
two
variables
economic
performance
the
are
rate
potentially
which
of
inflation
the
and
reported
distort
exchange rate.
No
discussion of accounting for foreign operations can make any sense until
three basic facts are addressed:
i.
in the
long
run,
nominal
relative purchasing power, i.e.
ii.
iii.
exchange
rate
movements
reflect
inflation
historic cost accounting assumes that inflation does not exist
in the short run, exchange
rates
highly
are
volatile
and
deviate substantially from PPP (8).
The bias to reported net income caused by
inflation
can
be
separated
into three elements:
i.
Costs (in particular, depreciation and cost of goods sold)
revenues
and
in the same income statement are not measured in the same
numeraire (units of purchasing power)
ii.
Non-interest-bearing assets and
liabilities
(i.e.,
monetary
working capital) lose purchasing power, and therefore create
or loss which is not captured by the accounts
iii.
Interest-bearing monetary assets
same
effect,
expense.
(The
though
this
accounting
may
be
treatment
offset
is
gain
show
the
.
liabilities
and
a
by interest income or
nevertheless
incorrect.
23
since
of so-called interest expense is effectively repayment
most
of capital, and interest income the maintenance of capital.
Vie
The
now separately examine the consequences of the first two items.
reason
the omission of the third is not that it is inconsequsntial
for
(indeed, the effect of debt on real taxes paid has arguably the greatest
impact on real corporate performance)
are
made
invariably
measures.
effects are not incorporated into subsidiary performance
any
effects
financing
case,
decisions
financing
corporate level, and therefore financing
the
at
but because
,
separable
easily
are
In
operating
from
performance, and amenable to independent analysis.
In
section
belov/,
2
depreciation
and
examine
we
cost
goods
of
sold
income
(9).
section
In
accounting
misunderstood
numbers
transaction
and
translation
demonstrate
the
inconsistency
accounting
treatment
appropriate one.
multinational
return
activity
to
a-
of
GAAP
tv.'o
foreign
hypothetical
its
accounts
other
in
that
activities,
In the course of this,
cost
historic
and
complexity
US
located
level,
country's
functional currency for the purposes of FAS 52.
a
we
the
in
a
diversity
and
more
of
we concentrate on the
corporation
in
and
maligned and
working capital, and suggest
tractable
a
those
to
"losses" (10).
investment
on
comprising
self-contained corporate entities, one located
reporting in dollars, the
preparing
unique
monetary
of
examine
we
In order to reduce the
comparative results of
identical,
3,
of
mismeasurement
the two most commonly used
on
measures of foreign subsidiary performance:
net
of
effect
the
foreign
currency,
two
in the US and
country,
which
is
and
its
24
2.
The Measurement of Operating Performance
As is well known, KC accounting overstates net income because:
1.
relative
depreciation expense is understated
the
to
current
cost of the asset
ii.
replacement
cost of goods sold is understated relative to the
cost at the time of sale.
Return on investment is further overstated
in
only
not
that
is
the
is
not
numerator overstated, but the denominator is understated:
i.
book value of fixed assets is at lower historic cost
inventories are understated relative to current cost.
ii.
The really troublesome feature of
HC
accounting
that
is
it
possible to predict the amount of this inflation bias on net income from
the
HC accounting statements;
^0% inflation might result in net income
being overstated by 5% in one firm and 50^ in another;
the age of individual assets of each firm.
a
reduction of 50? is
typical, and in some cases, net income has been reduced to
1979.
It
on
Empirically, the adjustments
shown in the published footnotes have been large;
The experimental inflation accounting
depends
it
standard
FAS 33
a
was
loss.
issued
in
requires that the effects of inflation on net income be shown
25
in the footnotes
FAS 33
of the annual reports.
is still experimental;
An
important
point
accountants and analysts are only slowly
beginning to understand the significance of the adjustments.
that
facts
The
they are controversial, experimental, reduce profit substantially,
that two published versions of an inflation adjustment
(GPLA
CCA)
and
very different adjusted net income, and that they are only
produce
can
that
is
footnotes all conspire to render the credibility
inflation-adjusted
of
accounts very low.
We now examine
scenarios
number of inflation/exchange rate
a
which
in
our simple two-country corporation might prepare its accounts, and their
impact on reported earnings.
1:
PPP HOLDS AT ALL TIMES, WITH HC ACCOUNTING IN BOTH COUNTRIES
Under the historic cost principles of
inflation
causes
income
be
to
GAAP
overstated
incorporated
the
in
accounting statements, and the greater the inflation,
distortion.
However,
the
movement
foreign
of the
currency
greater
the
Consider the
extreme
the
case
inflation is positive, while domestic inflation is zero.
Domestic HC accounts are unbiased, while foreign profits in the
overstated, and this overstatement is present to
translated
FAS 52,
of the exchange rates may in some
cases partially compensate for this effect.
where
into
accounts,
because
the
a
are
reduced extent in the
translation accurately reflects the
reduced purchasing power of the foreign profits, but
for the HC-induced distortion.
LC
cannot
compensate
26
In general,
it can be shown
(Appendix A) that for all positive values of
inflation, foreign HC income translated
exchange
rate
is
using
overstated
unambiguously
appropriate
an
relative
measured in end-of-period purchasing power, but may
to
average
real income
understated
be
or
overstated relative to the US HC accounts.
For identical entities, the HC results can be summarised:
^f < ^d
^f > ^d
Foreign Income
overstated
Foreign Income
understated
where I. is foreign inflation, and
I,
is domestic
(i.e.
US)
inflation.
Thus in those countries where inflation is greater than that of
(but
highly
not
inflationary,
appear to do better than
versa.
It
should
be
their
noted
see
US
scenario 3), foreign subsidiaries
identical
that
the
this
US
counterparts,
result
does
not
and
vice
hold if
a
comparison is being made between non-similar entities.
2:
AS
ABOVE, BUT PPP HOLDS ONLY IN THE LONG RUN
1
This is the real world situation at present, where
still the "accepted principle".
bias
is
costs
are
All we can say now is that the expected
as stated above, but that actual reported performance may turn
out to be understated or overstated, depending on
rates
historic
prevailing during the period.
the
actual
exchange
Furthermore, since actual exchange
rates are typically very volatile, the variance around the expected bias
27
will be large.
determine
Worse
whether
still,
it
is
not
even
possible
ex
post
to
net income is over- or understated without knowledge
of its sensitivity to inflation adjustments.
For identical entities, the HC results can be summarised:
^f
<
^d
.
28
at controlling the rate)
,
we can look forward to
a
reported
net
income
figure which is unbiased, but very unpredictable indeed.
At the present time, FASB is preparing an amendment to its standard
inflation
accounting,
FAS 52 (10).
currency
the present standard is incompatible with
therefore appropriate to examine the implications of
It is
an accounting standard
foreign
since
which
integrates
interrelated
the
translation and worldwide inflation,
the problems facing the design and implementation
vjill
4:
of
of
in the hope that
such
a
standard
AND WORLDWIDE ACCOUNTS ARE INFLATION ADJUSTED
The results can be stated easily.
results
the
asset/equity
translated
remain
values,
at
Performance
measures
through
translation.
unbiased
restated
to
adjust
for
translated
accounts
are
therefore
inflation,
local
Furthermore,
terms.
the
accounts,
distinction
accounting
standard
produces
needed)
just
and
as
easily
(in
the
B)
.
Foreign
be
and
in
between
made.
absolute
highly
Finally,
unbiased results regardless of
whether inflation is higher in the US or overseas;
handled
addition,
unbiased, both for the purposes of
inflationary economies and others does not need to
an
In
the current exchange rate, are exactly equivalent to the
measuring performance relative to domestic
economic
unbiased,
are
domestic assets restated for domestic inflation (Appendix
such
issues
eventually be overcome.
PPP HOLDS AT ALL TIMES,
and
for
unlikely
indeed deflation
is
event that this should be
29
5:
AS No.
4,
BUT PPP HOLDS ONLY IN THE LONG RUN
This situation corresponds to the real world with accounting
which
recognise
the
reality
of
inflation.
principles
Since both domestic and
foreign accounts are unbiased, all that matters is whether
movement
of
the exchange rate has compensated for relative loss of purchasing power.
This is readily ascertained simply by comparing the average differential
inflation
with the average change in exchange rates used to restate and
translate the foreign currency accounts.
These are the only possibilities:
Appreciation
<
30
result of the movement in exchange rates, the value of the firm measured
in dollars is reduced.
Accounting identifies two types of such loss:
Transaction losses
i.
liabilities
or
assets
recorded in the books
currency
which arise for
,
denominated
are
at
example
time
the
in
contractual
when
foreign currency,
a
acquisition
of
domestic
in
the spot exchange rate, and subsequently extinguished
at
at a different rate.
ii.
Translation adjustments
,
which arise only in the consolidation
since net income is translated
process;
at
exchange
average
an
rate, all assets and liabilities at the current rate, and equity is
at a historic rate, a
translated
the dollar balance sheet balance;
known as
a
loss, while a cr.
'plug'
number is required to make
if the plug
is
dr.,
a
gains
related
and
losses.
of
a
is
This
assets.
(though in
unlikely
that
a
is
arise
from
a
and
lower
(under FAS 52) as
firm
the
changed
has
cannot
be
are
value
dollar
a
translation
yet
it
suffered any economic loss which has
Second, real operating gains
competitiveness
are
losses are typically buried within changes in gross
volumes,
losses
and
reserve, not through the income statement),
reduced shareholders' equity.
which
recorded
foreign
An example of this occurs
foreign currency depreciates, resulting in
fixed
'loss'
gains
First,
generated which may have no economic meaning.
when
is
is a gain(ll).
There are two general problems with the accounting treatment of
currency
it
determined
accurately.
and
losses
not identified;
margins
Also
and
excluded
such
sales
are
31
off-balance-sheet
obligations
not
losses
which
recognised
arise
from
fixed
liabilities
as
contractual
FC
under
GAAP
order
(e.g.
backlog, contracts).
Transaction losses are misleading because the objectivity requirement of
HC accounting requires monetary assets and liabilities to be
historic
cost.
dollar
A
receivable
due,
say,
recorded at its nominal, not discounted, value.
effect of inflation is invisible.
Since the actual number
asset
FC
recorded at the spot rate on the transaction date.
loss
defined
is
between
the
rate
on
gain
be
The exchange gain or
No
distinction
is
actual amount received and the expected amount to be
the transaction date)
the
or
appropriate
If the FC amount is booked at
.
the forward rate on the transaction date, however, then
FC-related
liability
or
received (which is the contracted amount translated at
forward
contracted,
the difference between this and the dollar amount
as
subsequently received at the later settlement date.
made
number
Not so with the foreign currency
GAAP require that the nominal
receivable.
at
three months is
in
of dollars subsequently received is the same as the
the
valued
the
accounting
loss includes only the unexpected component, while
the expected component would automatically be included where it
belongs
- in operating margins.
\.
The problem arises because GAAP do
purchasing
power
of
monetary
inflation between currencies
reflected
in
is
not
assets
recognise
and
expected
the
change
liabilities.
(in
the
long
the
in
Differential
run)
to
be
the movement of exchange rates, and is thereby recognised
by the accounting system not as an inflationary gain or loss, but
as
a
32
exchange loss.
foreign
behavior,
In practice,
though,
currency
movements
short-run
and
v/e
must consider short-run
determined
are
by
not
expected inflation, but by interest rates (even though, according to the
Fisher
Effect, these are determined by expected inflation in any case).
A strict interpretation of the expected
foreign exchange loss is that it
is the foregone differential interest income on the foreign
an
interest
from
paradoxically
be
nominal
receivable
in
uncertainty
with
currency
a
Let it
hedging does not reduce foreign exchange gains and
rather it guarantees that the gain or loss
value defined above.
the
a
is the reduced loss of
lower nominal (but the same real) interest rate.
a
clearly:
stated
losses;
holding
gain
exchange
foreign
expected
Likewise,
receivable.
v/ill
be the expected
The expected loss is unchanged by hedging;
around
which
loss
that
is
it
is
by appropriate
reduced
hedging, and of course increased by inappropriate hedging.
In perfect markets, hedging involves only trivial transaction costs
the apparent cost that appears in the accounting system as
real terms);
a
exchange transactions loss was actually incurred at the time
foreign
the decision was made to grant credit in
presumably
domestic
(in
marketing
a
operating
inflation
into
cost (Fredrikson)
management
foreign
a
and
is
So in just the same way as
.
incorporate
should
currency,
expected
domestic
pricing decisions such that the desired real revenue is
actually achieved at the
time
of
final
payment,
should
so
foreign
management incorporate expectations about foreign inflation (or strictly
foregone
speaking,
interest).
incorporate the total amount
measure
of
subsidiary
of
It
is
therefore
transaction
gains
inappropriate
and
management operating performance.
losses
in
to
a
The expected
33
part of the gain or loss is
marketing expense resulting strictly
a
from
foregone interest (but implicitly the loss of purchasing power for which
nominal
the
interest
when
a
only
and are rightfully the responsibility of
,
follows that any decision not to
It also
the treasury function.
hedge,
hedge, is always speculation against the collective
selectively
to
and should be
,
they are truly speculative (or the
position is unhedged;
result of unforeseen exposure)
or
compensation)
been
Unforeseen gains and losses on the other hand
identified as such.
arise
have
would
information of the foreign exchange market;
unfortunately, GAAP do
not
managers to separate the effects of prudence from the effects of
enable
speculation.
To be consistent, it follows that domestic receivables and payables, and
the corresponding revenue and expense items, should also
to
reflect
be
discounted
loss of purchasing power of the receivable between the
the
date of recognition of the revenue and the subsequent collection of
receivable.
payment
Since
delay
incorporated
normal
(i.e.,
into
to
the
purchasing
terms
of
pov/er
trade)
a
reduction
marketing
in
treasury
function.
value
Any
additional collection
function)
of
control
receivable
(in
any
currency)
is separated
component (based on interest rates and forward exchange
expected
collection
sale,
the
department
This suggests an internal control system in
.
which the inflationary loss in purchasing power resulting
accounts
been
have
should
the
delay, however, is the responsibility of the credit
(the
during the expected
price in the first place, the foregone interest
the
for this period is correctly
attributable
of
loss
the
the
period)
from
holding
into an expected
rates
for
the
and residual gains and losses which arise
3M
from undue delays in collection and
unhedged
unexpected
consider
the
movements
in
where
an
exchange rates and interest rates.
At this point, it is appropriate to
market
exchange
situation
not semi-strong efficient, either because the firm
is
has better information than the foreign exchange market, the
.is
thin, or government restrictions on the mobility of capital create
very
arbitrage opportunities for corporations which have
in
market
place
exploit
to
and
undertake
such
In
function
treasury
reasonable that the
situation
them.
However, without the separation of
measurement
of
success
the
expected component of
a
of
situation,
a
might
transactions
transaction
speculative
and
loss of purchasing power
which
NPV.
returns,
speculation is misleading.
gain
arises
the
of
positive
expected
loss
or
accounting, since it is simply
inflation-adjusted
is entirely
it
advantage
take
with
expected
such
infrastructure
the
from
a
has
a
The
place
in
part of the gain or
holding
net
a
monetary
position.
Translation losses are more obviously
misunderstood.
frequently
monetary assets in
so;
it
is
a
a
A
firm
misleading,
only
holds
and
therefore
non interest- bearing
period of inflation because it cannot
necessary part of doing business.
less
avoid
doing
Conversely, monetary
liabilities are held to the greatest extent practicable in order to gain
purchasing power (or tax advantages).
assets
usually
in
order
to
But the firm
holds
non-monetary
derive cash flows from their future use.
This is equally true of inventory and fixed assets.
(An exception would
be where an asset is held for speculative reasons;
its
nominal
value
35
would
expected to increase faster than the rate of inflation).
be
true currency-related gain
related
loss
or
assets
such
to
is
The
not
determined at all by their cost as shown in the accounts, but instead by
the
dollar
present
net
are
flows
costs
competitors'
(whether
structure
cash
Such
generate.
expected to
of the future cash flows that they are
value
function
a
prices
and
of
market
sensitive to
are
exchange rate movements, for example), and are more correctly designated
operating exposure of
of
analysis
a
business
sensitivity
the
debt)
operating
exposure.
is
rule
sheet
balance
so-called
against
any
So
.
unit
of
is
its
translation
accounting perspective,
definition)
it is impossible to state whether the
In general,
"operating exposure".
exposure
Likewise,
an
(from
an
of
assets
long
by
is
which encourages the netting of
(essentially
defined
above
equals
the
assets
non-monetary
"non-monetary-
asset"
true inventory exposure is really incorporated in
the exposure of the expected sales revenue to
any
without
revenues
and
exposure
short
meaningless in general, and can only make sense if the
exposure
inventory;
or
costs
thumb
of
long
measure
of
generated
be
from
that
inventory exposure which incorporates the
cost of inventory (or the cost of any other fixed asset for that matter)
is
simply
falling
foul
of
the
well-
Inventory and fixed assets are sunk costs;
a
value
for
reality than the book value of
Disclosure
"sunk
cost
fallacy".
to be sure, we have to state
them for accounting purposes, but we must not be led into
thinking that the book value of
^.
known
.
a
a
foreign asset has
domestic one.
any
more
economic
36
Operating exposure can only be very approximately measured, both ex ante
(the financial perspective)
Balance
sheets
also
and ex post
have
"translation plug number".
to
balance,
sheet.
In
in
a
reserves
the
of
section
it
would
the
reasonable
seem
currency-by-currency statement of operating exposure;
to
even a
qualitative footnote that exposure was long, short, or immaterial
be
a
the interests of better management decision-making
(not to mention adequacy of disclosure)
require
be
always
will
there
so
However, it is misleading to label it "gain"
or "loss", and its correct place is
balance
perspective).
accounting
(the
would
an enormous step in the direction of better shareholder information.
Shank and Shamis (1979) have suggested that transaction gains and losses
be disaggregated
disaggregation
by
currency,
major
between
distinguish
would
but
a
more
additional
useful
expected
unexpected
and
amounts, ideally with the expected portion reported along with
income
loss.
and
expense,
The remainder,
as
interest
part of the monetary/purchasing power gain or
which
is
exchange movements, then is truly
the
a
result
of
unexpected
unhedged,
foreign exchange loss.
In
the fully
hedged firm, its value would be zero (hedges of operating exposure would
be netted (but disclosed) against the corresponding revenue items);
actual value truly is the ex post cost or gain of speculation.
THE RESEARCH
1.
Introduction
The purpose of this study is to verify;
its
37
i.
multinational
that
shareholder
maximising
systems
control
rather
wealth,
with
consistent
are
than accounting profit or
some other measure of managers' utility;
ii.
that
they
if
inconsistent,
are
managers
this
perceive
inconsistency;
that
iii.
if
with it;
dissatisfied
inconsistency,
this
perceive
managers
they
are
alternatively they are satisfied with their
performance measures and are therefore unlikely to change them.
Managers maximise shareholders' wealth by undertaking
once-for-all decision;
by
rather, it is an on-going process
retention and new capital injection.
profit
expectation
uncertain
of
their
behalf
Now foreign investment is not simply
transactions.
non-negative-NPV
on
future
flows
cash
of
a
expansion
To the extent that the
is
colored
by
actual
experience of similar cash flows from existing investments, unprofitable
investments
may
be
undertaken
those
in
countries
where
performance is biased upwards relative to the US or other
and
profitable
ones
rejected
where
m.easured
At the very least performance
downwards.
dysfunctional.
A
performance
evaluation
subsidiaries,
performence
evaluation
system
measured
systems
is biased
will
be
should therefore be
unbiased.
This study uses data which was originally collected in
practice
of
corporations.
overseas
performance
evaluation
in
a
study
of
the
large multinational
We investigate the appropriateness of control systems (as
38
describe
the respondents
relative
implications of the change from FAS
measurement,
dysfunctionality
firms'
their
of
individual awareness of the
to FAS 52 on operating performance
8
respondents
whether
finally,
and
approach
normative
the
to
We also test respondents'
above.
described
them)
were
systems
control
of
the
they
have
aware
where
(perhaps unknowingly) reported its potential existence.
2.
Sample and Methodology
This study uses data collected in
a
postal questionnaire survey of large
multinational corporations, supplemented with
1980.
interviews,
some
during
The survey was carried out for Business International Corporation
I
have
used the raw survey data at the Center for Transnational Accounting
and
by
I.
Czechowicz,
below.
University
Research,
Financial
Three
companies;
eighty-eight
sources
of
Bavishi.
(292)
form
the
For this study,
of Connecticut, to test the hypotheses
questionnaires
hundred
from US multinationals
potential
Choi and V.
F.
were
sent
to
US
sample
under
investigation.
Since
non-response bias are not known, the results may
distribution of the sample studied here is given below:
Fortune rank (summer 1980)
1-100
201
non-US
were returned, of which the sixty-four
not be generalisable to all large multinational corporations.
101
and
- 200
- 300
unknown
Number in sample
30
21
12
1
The
size
^Q
was
sample
The
diversified
widely
some
with
industries,
among
Fifty-six of
preponderance towards the chemical industry (seven firms).
the sixty-four individual respondents were Manager/Director of Financial
Planning
or
Analysis, CFO. Financial Controller, Assistant Controller
and
title;
similar
six
rest
the
of
had
general
international
responsibility.
3.
Hypotheses and Results
The control systems of the sixty-four large
sample studied here are HC oriented.
inflation
adjustment
while
respondents
was
US
multinationals
in
the
Only one respondent stated that an
made to the measure of overseas performance,
were
not
calculated at all, and 28 respondents did not answer the question.
This
is
35
not
inconsistent
that
stated
adjustments
inflation
answers to another question in which it was
with
valuation,
stated that HC was used in 51 firms for fixed asset
firms
inventory
for
valuation
for
the
denominator in SOA and similar indicators.
the
caution
which
must
be
purposes
It
does
and
44
of calculating the
however
illustrate
exercised in drawing conclusions from any
questionnaire- based data of this nature.
At the time of the survey, FA3 8 was the required
standard,
accounting
but the first draft of what was later to become FAS 52 had recently been
issued.
(The major difference between this draft and the final version
of FAS 52 was that the first version contained no provision
inflationary
economies.)
to FAS 8 accounting rules;
for
highly
Answers to the questionnaire therefore relate
however, it should be recalled that
uo
FAS
i.
8
accounts are prepared under the historic cost convention,
and therefore incorporate
same
the
underlying
of
bias
any
HC
accounts
arising
The inflation bias in foreign reported income is that
11.
from US inflation, not foreign inflation
higher
much
The variance of reported earnings was typically
iii.
than under FAS 52, and no exchange-related gains or losses could be
deferred.
One of the few things that could be said in favour
since it preserved
foreign
a
accounts
aside,
bias
the
net
due
income
was
Under
item?
of
depreciation
liability,
FAS
foreign
8,
dollar
to
inflation
8
in
Translation
sold.
goods
respect of
gains
it
the
is
debt.
Since
gain
"translation
What of the
this
is
a
monetary
nominal
correspondingly
visible of course)
by
the
high
.
In
depend
if foreign inflation is greater than in the US,
foreign subsidiaries would show in the
the
or
purchasing power parity considerations would lead us
strict
relative inflation;
(while
and
result of the appreciation or
to the conclusion that the perceived expected gain or loss would
on
that
was
unbiased relative to historic cost net
Income of the domestic corporation.
loss"
FAS
dollar perspective, it also preserved in translated
depreciation expense and cost of
losses
of
high
long
interest
term
a
translation
gain
expense would be much less
practice though the PPP effect would
be
masked
volatility of the actual exchange rate, so that virtually
none of the trend would be visible.
m
HYPOTHESIS Ka)
A firm may use a performance evaluation system which
faults and advantages)
,
or it may use any other method
appropriate
for
We have seen that FAS 8 produced unbiased
own particular business.
its
the
on
for external reporting (with its embedded
required
method
translation
based
is
while
(though highly variable income figures,
FAS 52
income
will
be
We have no a priori reason to expect managers whose firms have
biased.
'home-grown'
translation methods to make changes to them as
result
a
of
the introduction of FAS 52 (unless perhaps accounting numbers per se are
a
management
objective)
.
The
real
is that those performance
issue
evaluation systems which are based on external translation methods
have
be changed;
to
not just because the external method has changed,
but because the new translation
historic
cost
rules,
will
produces
method
biased
income
under
and historic cost income is invariably the basis
for performance evaluation.
HYPOTHESIS 1(a):
internal
for
Firms which used
a
FAS
8
basis
translating
for
reporting should anticipate altering that basis upon
implementation of FAS 52.
Respondents were asked whether the translation method used for
internal
evaluation differed from that used for external reporting by the parent.
Another
question asked whether the proposed changes to FAS
any affect on how the company evaluates or plans
operations.
in Table
1
to
8
evaluate
would have
overseas
The analysis of the 59 responses to the questions is shown
below:
42
External and internal
translation methods are
the same
different
Would affect
performance
evaluation
The proposed
change to
FAS 8
Would have
little effect
19
(44%)
7
(44?)
24
(56%)
9
(56?)
43 (73?)
16
(27?)
on perf. evaln.
Total
TABLE
59
1
We note first that as many as 43 (73%) of the
respondents
stated
that
their
firms used the same method of translation for internal evaluation
as FAS
8
that
as
change.
required for external reporting.
more
Of
concern
though
many as 56% of those 43 respondents did not perceive
Coincidentally, among those other
alternative
translation
firms
which
a need
is
to
developed
had
measures, the same proportion expected to make
changes upon implementation of FAS 52.
This is perhaps less
than
the most likely candidate for an
at
first
might
alternative method
historic
for
appear,
would
be
since
the
substitution
the translation of inventory,
of
surprising
current
rate
for
(though we have no means of
verifying this), which would also need to be changed under FAS 52.
It could be argued
survey,
that the proposed FAS 52 had
only recently been made public.
,
at
the
First,
the
companies
'of
the
Hence, the respondents may not
have had time to to consider thoroughly its implications.
observations.
time
in
the
We
make
two
sample were some of the
largest and presumably most sophisticated anywhere.
We are entitled
to
13
expect
the
respondents
proposals.
Second, FAS
was almost
universally
earnings.
This
alone
least
at
8 had
to
have
conversant with the
been
been in effect four years at the time, and
disliked
its
for
highly
impact
erratic
on
should have been sufficient encouragement for
a
multinational to modify internal evaluation systems had they so wished.
HYPOTHESES Kb) and (c)
A
control
fictitious
system
should
discourage
inappropriate
hedging
for
the
hedging
it
should
perspective
at
therefore
not
create
exposures by local managers (since an
of
exposure at the local level might disappear
the corporate level)
,
in
the
overall
portfolio
The inclusion of translation and
transaction gains and losses in managers' evaluation encourages them
hedge
such
a
loss.
In addition,
currency gains and losses.
the
a
true measure of
However, even though we have no
information
inclusion of cash flow exposure into performance measurement
(since no questions were asked on this subject), we can state
inclusion
to
we have already noted the fallacy of
accounting measures of transaction gains and losses as
about
of
exposure (since this would increase the variance of earnings
while incurring transaction costs);
incentives
the
of
that
the
transaction and translation gains and losses, as measured
by GAAP rules, is dysfunctional.
HYPOTHESES Kb) and 1(c):
gains
Transaction
(b)
and
translation
(c)
and losses are not included in the performance evaluation of
the overseas subsidiary manager.
4M
Respondents were asked whether transaction
were
losses
incorporated
unit;
transaction losses were
here,
since
there
is
an
separated
intercompany
into
2 below.
Translation
gains/losses
Transaction
gains/losses
35(55%)
24(385^)
TABLE 2
Source: Czechowicz, Choi, and Bavishi, page
components
accounting
foreign
of
incorporate
numbers
exchange
loss.
expected gain or loss is typically
component.
categories.
hedging
The
percentages
expected
exists
It
small
We see, therefore, that
decisions
(excluded
The number of firms which include such
gains and losses is shown in Table
these
and
responsibility for them) and
of
ambiguity
gains/losses with third parties.
Both
gains
performance measure of the overseas
the
in
translation
and
in
a
the
large
expected
and
unexpected
will be recalled that the
relative
are
166,
to
the
therefore
potential
zero
for
unexpected
in
both
inappropriate
proportion of the respondents'
companies.
HYPOTHESIS 2(a)
The second issue is whether managers perceive the inadequacy of existing
control systems in respect of
foreign
therefore the need to change them.
A
exchange
risk
management,
and
fundamental issue is that the true
45
exposure
of
firm is not a function of the accounting system which
the
The change from FAS
measures it.
to FA3 52 should therefore affect in
8
no way the concern that managers may have for foreign exchange gains and
losses.
Managers recognise that the change from FAS
HYPOTHESIS 2(a):
8
to
FAS 52 will have no impact on the exposure of the firm.
Respondents
were
replacement
of
asked
FAS
8
would
gains and losses unnecessary.
that
this
indicating
more kindly,
make
thought
that
proposed
the
management concern over translation
Thirteen
(20!^)
of the respondents
agreed
the case, (Czechowicz, Choi and Bavishi, p. 167) thereby
was
a
they
whether
lack of understanding of the nature of exposure, or perhaps
a
concern for accounting numbers.
HYPOTHESES 2(b) and 2(c)
It was stated earlier that there are indeed sound pragmatic reasons
managers
should
show
concern
what
for
economic fundamentals of the business.
av/are
of
the
is published, as well as the
However, if managers
and
truly
are
misleading nature of such accounting measures, then they
should recognise that the inclusion of accounting measures
gains
why
losses
into
measured
of
currency
performance should lead to increased
incidence of overseas managers making decisions not in the
interest
of
the firm's shareholders.
HYPOTHESES 2(b) and
(c):
In
those
corporations
where
foreign
H6
exchange
gains
and
arising
losses
from
translation (c) are included in managers'
respondents
report
will
transactions
performance
(b)
and
evaluation,
higher incidence of decisions taken by
a
overseas managers which are not in the best interest of the firm as
whole.
a
they
Respondents were asked v/hether
had
found
that
performance
the
evaluation system encouraged overseas managers to take action not in the
best
interest of the company as
action
v;ere
increase
action.
they
a
whole.
disposal of
cited in the question, viz.
reported
Table
thought
3
ROI
,
and
taking
Two specific examples of such
expensive
useful
the
control
decisions by subsidiary managers.
system
did
to
or unnecessary hedging
below shows the number of respondents who
that
assets
encourage
stated
that
inappropriate
M7
even when the possible outcome (i.e.
unnecessary
hedging)
pointed
is
out in the question.
HYPOTHESES 3(a) and 3(b)
The binary (yes/no) nature of the answer to the question above leaves no
of
room for judgement by the respondent on the overall suitability
control system.
A further question asked
for a rating, on
a
the
three point
scale, of the performance evaluation system.
HYPOTHESES 3(a) and
foreign
exchange
(b):
Respondents
transaction
(a)
and
from
companies
translation
(b)
losses are included in performance evaluation sliould show
which
in
gains and
lower
a
level of satisfaction with the performance evaluation system.
Respondents were asked to express on
three-point scale
a
overall
their
satisfaction with the way the system evaluated overseas managers.
the
alternatives were "very satisfied"
,
"moderately satisfied" and "not
satisfied", the problem of the small numbers in Table
As
an
approximate measure of the satisfaction level
3
may be
-1
for each "very satisfied" response,
for "not satisfied".
a
an
value
for "moderately satisfied" and
However, owing to the unreliability of the data
(in particular, non-response bias),
significance would have any meaning.
below.
avoided.
in each column,
index of satisfaction for the group was calculated by assigning
+1
Since
I
do not think that
a
formal test of
The results are shown in
Table
1
48
49
50
on
question the validity of any data such as these which are based
aggregation
of
subsidiary activity, when in practice subsidiaries
all
process
probably
product by product and subsidiary by
interesting
the
of
most
aggregation
the
and products may be so diverse that
causes
the
subsidiary data to be lost.
generally
HC-oriented,
and
systems
control
that
towards the requirements of the FASB
and
the
are
internationally
operating
We have seen that large US corporations
SEC,
are largely geared
requirements may be inconsistent with economic reality.
such
though
even
As many as half
of the large multinationals have adopted FAS 52 for their 1931 accounts,
This rapturous welcome is
two years before they were required to do so.
less
a
reflection
of the merits of FAS 52, but rather
demerits of its predecessor FAS
FAS 52 is
a
a
result of the
8.
current-cost oriented approach
to
translation,
and
in
a
world of reasonably stable exchange rates moving in response to PPP, and
with
an
sitandard
reasons.
inflation-adjusted
achieved
which
First,
its
an
all-current
incorporates
in
the
use
movement of the
volatile
in
the
exchange
short
balance sheets.
incorporates
two
objectives.
It
fails
for
a
two
rate
for
translation
automatically
long run the expected inflation adjustment in the
(that on the date of the
foreign
stated
standard, it would indeed be
are prepared under the HC convention, while
accounts
of
the
accounting
rate.
Second,
exchange
are
rates
highly
run, and in effect, a somewhat arbitrary value
financial
year
end)
An exchange rate used
elements:
the
differential
is
used
to
translate
for translation actually
inflation
since
the
51
previous
statements,
and
random
a
element which causes income to be
understated or overstated relative to that change in relative purchasing
We have shown that only with inflation-adjusted accounts will it
power.
be possible to identify the direction of that bias.
With
accounts
unpredictable
prepared
under
distortion
of
reward
performance
nations
across
resources
unlikely
are
A change of emphasis is needed
economically consistent manner.
maintain
integrity
the
of
accounts
published
from
an
must
Reported accounts
achieved
in
auditing
adjusted
be
for
inflation.
an
the
the
impeccably
is
actually
but
in
to
misleading.
This
been
has
many other countries, and in spite of the complexity of the
issues, it should also be
accounts
perspective,
in
spawned
has
"supplementary statements" which shed more light on what
objective
'an
The necessity
accounting profession from objectivity towards relevance.
to
is
commonly used performance
managers
income,
allocate
and
most
there
As long as an inflation-adjusted standard
reported
into
convention,
HC
two
the
measures, net income and ROI.
is not incorporated
the
in
US
the
possible
For
too.
prepare
to
the
objective,
verifiable
to be credible, the
adjustments
accounts themselves, not footnotes, must be changed.
As
long
as
HC
remains
the
basis
of
reported
accounts,
and
the
alternative inflation-adjusted net income remains only in the footnotes,
it
will
lack
credibility
not
only
among
its
importantly among the managers of the firm, those
resources
and
are
rewarded
on
the
readers,
who
but
allocate
basis of the results.
most
scarce
Inflation
adjusted accounting will never achieve respectability, nor managers make
52
efficient decisions, until the financial press, securities analysts
shareholders
use
inflation-adjusted information as
and historic cost statements are
relegated
matter of course,
a
obscurity
the
to
and
of
the
footnotes.
This study has
reported
shown
numbers.
once
again
that
managers
are
It is right that they should be so.
function of audited accounts would be failing
if
they
concerned
with
The stewardship
otherwise.
did
But the role of the public accounting profession, and the rules it makes
for
the preparation of audited accounts, is not limited to the sense of
prevention
of
defalcation
of
assets;
those
rules
also
decision-makers in the allocation of shareholders' resources.
function
surely
rightfully
the
strongest
be
part
case
a
duty
opportunity.
That this
of the definition of good stewardship is
that
inflation-adjusted annual accounts.
has
guide
can
be
made
for
relevant,
The accounting profession therefore
to implement inflation-adjusted accounting at the earliest
53
FOOTNOTES
1.
See for example, the comments of
of
any
the
accounting
8'
'big
firms.
2.
hypothesis,
Under the efficient market
cannot
prices
market,
semi-strong form
available
efficient
information,
predicted
be
in
a
from
prices
market,
and
in
a
past
efficient
v;eak-form
performance,
incorporate
all
in
a
publicly
strong-form efficient market, prices
incorporate all information.
3.
The problem here is that a
defined
with
respect
(systematic)
risk
premium
to a particular securities market.
that could be the US market,
a
has
be
to
Conceptually
consumption-weighted market, or even
the
world market.
M,
This contingency approach in
a
budgeting context is
of the 'flexible budgeting' technique.
a
function
of
volume
sold,
generalisation
a
Budgeted revenues and costs
which
in
turn
is
a
function
(uncontrollable) relative price movements of inputs and outputs
by deviations from purchasing power parity.
are
of
created
For the firm dealing with
a
highly differentiated product in one country, the latter effect could be
small.
even)
However, for any firm, (not necessarily with overseas operations
dealing
in
a
more price-sensitive, internationally competitive
environment, the relative prices of currencies has
considerable
impact
51
on expected profitability.
A contingent budget in such circumstances is
very appropriate basis for
a
5.
study
The
by
a
control system.
Czechowicz
et
found
these
results
for
US
Macharzina
and
A.
or Current Purchasing Power Accounts?
An
al.
multinationals:
Currency perspective
6.
Budgeting
ROI
US dollar
55?
an
local currency
both currencies
3^%
13%
^5%
For
discussion
a
Coenenberg,
of
Current
'
this
Cost
issue,
see
K.
Internationally-based Assessment
of
Reporting
International Journal of Accounting 15
Spring 1981.
7.
Changing
and
FAS 33:
Prices'
FASB
Statement
33
on
Financial
.
Financial Reporting and Changing
Prices,
September
1979,
and its proposed am.endments vis a vis FAS 52 incorporated in an Exposure
Draft of December 1981.
8.
It
is therefore quite remarkable that FASB should suggest
in
their
proposed amendment to FAS 33 that where an index of foreign inflation is
not
available,
and opposite
purchasing
an alternative may be "to assume that there is a direct
relationship
power of
a
between
(a)
the
change
in
the
relative
functional currency and the US dollar and (b) the
55
change in the exchange rate for those currencies" i.e.
that
holds
PPP
the short run, thereby imparting the volatility of exchange rates to
in
relative inflation.
The Czechowicz et al
9.
a
number
study ascertained the relative importance
.
of measures of performance on
score was 1.5 for budget net income
score
was
for
1.8
scale of
a
actual,
vs.
1
to 4.
the
of
The highest
second
highest
(The next most important measure, return on
ROI.
sales, scored 2.2).
Of course, there could equally well be gains;
10.
be
no
doubt
that
the
concern
of
managers
'gain'
12.
for
a
a
cr.
to
maximise
translation adjustment
simplicity, we use the term 'loss'
for
,
can
gains.
or Bobbins and Stobaugh (1973) p. 120.
Although FAS 52 correctly calls this
11.
loss
31
there
other than professional
currency dealers is to minimise losses rather than
See Rodriguez (1979) p.
however,
for a dr.
,
not
adjustment and
adjustment.
FASB recognised the problem of inefficient decision-making in their
introduction to FAS 33.
However, they probably underestimate the extent
of the credibility embedded in HC statements.
56
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and C.
Stickney, 1975.
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FAS 52,"
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B.
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A
Cassel G.
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Choi,
F.,
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Curran J., 1981.
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Bavishi,
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1982.
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,
Dornbusch, R.,
York.
Open Economy Macroeconomics
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Dufey, G., 1972.
"Corporate Finance and
Financial Management
(Summer):
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Basic Books Inc., New
Exchange
Rate
Variations,"
1
Evans, T. W.
Folks and M.
Jilling, 1978.
The Impact of Statement of
Financial Accounting Standards No.
on
the Foreign Exchange Risk
8
Management Practices of American Multinationals:
Impact
An Economic
Study Financial Accounting Standards Board, Stamford, Conn.
,
,
Fama, E., 1975.
"Short-term Interest Rates as Predictors of Inflation,"
American Economic Review 65 (August):
208-221.
Financial Accounting
Currency Translation
Frankel
,
'News':
(August):
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Statement
Standards Board:
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No.
52:
Foreign
"Flexible Exchange Rates, Prices, and the Role of
(1981).
Lessons from the
1970's,"
Journal of Political Economy 89
665-705.
J.,
Fredrikson, E.
"On the Measurement of Foreign
1968.
of Accounting Research 6 (August):
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,
Income,"
Journal
Giddy, I., and G.
Dufey, 1975.
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Giddy, I., 1976.
Hedging," Euromoney (December) 96-100.
"Exchange Risk:
Giddy, I., 1977.
(Summer):
23-33.
to
Make
Whose View?"
of
Habit
a
F inancial
Forward
Management
6
"Forward Exchange Rates as Optimal
Hodrick, 1980.
Hansen, L.
and R.
Spot
Rates:
an Econometric Analysis," Journal of
Predictors of Future
829-853.
Political Economy 88 (October):
,
"The Efficiency of the Forward
Lessard, 1982.
and D.
Henriksson, R.
Conditional Non-parametric Test of Forecasting
A
Exchange Market:
Ability," Working Paper SSM-WP-1 337-82 H.I.T., Cambridge, Mass.
,
.
"Purchasing
1978.
Evidence,"
the
at
Krugman,
P.,
Another Look
(August):
Power
Parity and Exchange Rates:
Journal of International Economics 8
379-407.
"Measuring the Performance of Operations Subject
1982.
Lessard, D.
(mimeo) MIT, Cambridge, Mass.
Movements"
Exchange Rate
,
"How to Compare Chance with
Levich, R., 1981.
61-68.
Euromoney (August):
Expertise,"
Forecasting
Foreign
"Evaluating the Performance of Professional
Levich, R., 1982.
Exchange Forecasters: An Updated Report," Euromoney (August):
Logue, D., and G.
Exchange
Foreign
16-22.
(Summer)
to
"Managing Foreign Assets v^;hen
Oldfield,
1977.
Markets are Efficient," Financial Management 6
:
"Management Information
Rosenfield,
1974.
and P.
Lorensen, L.
Accountancy
of
138 (December)
Journal
Foreign Inflation,"
,
and
"Translating Foreign Currency Financial Statements:
Mueller, G., 1976.
Accounting Points of View," Proceedings, Annual i-leeting of the Academy
Mev; York.
of International Business
,
Exchange
Parity Theory of
"The Purchasing Power
Officer, L.
1976.
1-60.
Rates:
A Review Article," liF Staff Papers 23 (March):
,
"Managing Exchange Exposure
Prindl, A., 1974.
23-27.
Euromoney (March):
Stobaugh,
and
R.
Robbins, S.
New York.
Basic
Books,
Enterprise
,
1973.
Money
in
Floating
a
in
the
World,"
Multinational
,
What has it
"FASB No.
8:
Rodriguez, R., 1977.
40-47.
Financial Analysts Journal 33 (March-April):
Foreign Exchange Management in US
Rodriguez, R.
1979.
Heath and Co., Lexington, Mass.
C.
,
D.
Done
for
Us?,"
Multinationals
,
58
"FASB Statement 8 Resolved Foreign Currency Accounting
Shank, J,, 1976,
55-61.
- Or did it?"
Financial Analysts Journal 32 (July-August):
and
J.,
Shank,
A
Adjustments:
59-65.
(April):
"Reporting
1979.
Shamis,
Journal
Perspective,"
Disclosure
G.
Currency
Foreign
of Accountancy 147
APPENDIX A
Consider an overseas company v.'ith a depreciation expense D units of
local currency, with book value of assets A at thj start of the
accounting period when the spot exchange rate is S (direct quote, the
identical U3 company therefore has an
dollar price of FC)
The
Assume also that cost of goods
identical depreciation expense $ D.S
value except for the lag induced by the
sold maintains its real
inventory valuation process, and all other revenues and expenses
maintain their real value.
.
.
1.
GPLA Inflation Adjustments
Translation of revenues and expenses takes place temporally, i.e.
foreign income (revenue less expense) is recognised in dollars at the
same time that GAAP recognise the local income in local currency.
The current cost
For simplicity, consider the case of linear inflation.
inflation to date.
at the time the expense is recorded has to reflect
The pattern of depreciation expense therefore approximates to
D(l + I)
Clearly, if the average inflation factor which appears to have been
applied to the HC inflation expense D is (1 + i)
this is half of the
overall inflation (1 + I) during the period.
,
At the end of the accounting period, all expenses are required
be
to
stated
in
terms of period-end purchasing power.
The depreciation
expense must be stated in purchasing power after inflation I, and
is
therefore D(1 + I). We may derive the relationship between (1 + i) and
(1 +1) in two ways:
Exact method:
restate each sub-poriod's expense and sum them
Suppose we divide the accounting period into a large number (n) of short
sub-periods.
Let inflation to date in sub-period j be i.,
and
the
HC
depreciation expense for sub-period j be d (where
d. = D).
Tlie
depreciation expense as recorded in each sub-period is therefore
d (1 + iJ in terms of sub-period j purchasing power.
At the end of the
accounting period, each has to be restated to end of period purchasing
power by a factor corresponding to the inflation I - i which took place
between the sub-period and the end of the accounting period, i.e., the
restated expense is
.
.
)
d
d.(1
(Note.
=
+ I
this
inflation.
(1
+
)(1
i
+ T
-
i
)
which approximates to d.(1 + I) if I, i. << 1.
derivation does not require the assumption of linear
- i.)
+ li.
Approximate method:
use
average
rates
of
inflation
for
whole
the
period.
The HC depreciation expense D for the period had been adjusted by an
average inflation factor (1 + i) applied to the whole period expense:
This can be restated to
the expense appears therefore as D(1 + i)
end-of-year purchasing power by adjusting again by the same factor
adjusted
The
(1 + i)
expense
is
therefore
=
Since I = 2i and if i << 1, then
D(1 + i)(1 + i)
D(1 + 2i + i ).
this restated expense is D(1 + I) as before.
.
.
Translation
2.
Let I be the domestic, i.e.
US, inflation rate, and I„ be the
foreign
inflation rate. Then i, and i- are the corresponding apparent inflation
rates defined
in
above applicable to revenues and expenses in the
domestic and foreign unit respectively.
1
In the absence of
inflation,
the
translated depreciation expense =
which is by definition numerically equal to the depreciation
expense of the US entity.
$
DS
If PPP holds and there is foreign inflation but no
domestic
inflation,
the average exchange rate is S /(I + i^)
Under foreign HC accounting,
the depreciation expense is D, but is translated to $ D.S /(I + i„).
.
o
f
Since the corresponding domestic expense is $ D.S
the
effect of
translation process is to understate the expense by a factor 1/(1 +
and therefore to overstate foreign income.
the
,
i
),
In the general case of inflation in both countries, the average exchange
rate applicable to the translation of revenue items is
3^(1 ^ i^)/(1 . ip
so that the translated expense becomes
$ D.S (1 + ij)/(1 + if)
which would typically, but erroneously be compared to the
domestic item $ DS
thereby
o
corresponding
.
'
understating foreign income relative to US HC income if i,>i
d
f
overstating foreign income relative to US HC income if i,<i
d
f
Consider now the case where full inflation adjustments are incorporated.
The inflation adjustment is in two parts:
i.
Recording the expense at the time it is incurred at the then-current
purchasing power.
ii.
Restating the expense at the end of the year into units of year-end
.
purchasing power.
The implication behind using an average exchange rate for translation of
foreign inco:ne is that at the time the foreign revenue is recognised, it
in
At
this point
is measured after adjusting for foreign inflation.
it
is
implicitly recognised as dollar revenue, so that on any
time,
subsequent date, that dollar-denominated revenue should be restated to
reflect the changed purchasing power of its dollar numeraire.
Consider first the simpler case where the only inflation
The current cost expense in foreign currency is
D(1
+
is
overseas.
i^),
which translated at the average exchange rate S /(I + i.) becomes
o
1
which is exactly analogous to the US expense. Since there is no
$ D.S
domestic inflation, this is also the expense in year-end purchasing
power
,
In the more general
S
case, the average exchange rate, as before, is
+ ij)/(1
+ if).
The foreign inflation-adjusted expense is D(1 + i„)
which translates to
D.S
which is once again exactly the same as the domestic
(1 + i,),
$
d
o.
depreciation expense.
(1
,
'
,
,
.
The adjustment factor to convert expenses to year-end purchasing
is (1 + ij)
so in year-end purchasing power, this becomes
which equals $ D.S (1 + I,),
$ D.S (1 + i.)
power
,
o
o
d
d
Thus HC alv/ays understates the expense and overstates income relative to
real income, since
(1 + i,)/(1 + i^) < (1 + I.) for all i, and i^ > 0.
d
f
d
d
f
Finally, since the direction of adjustment for COGS is the same as the
depreciation, but to a lesser degree, analogous reasoning and a similar
result applies.
APPENDIX
B
Using the terminology of Appendix A, the book value of foreign assets at
in
dollars $A.S
and
the start of the year in local currency is A,
Excluding the current year depreciation charge, the book value restated
for local inflation at the end of the year is A(l + I„).
The end of year exchange rate (PPP holds) is
S (1 + I.)/(1 + If.)
which gives a translated book value
$ A(1 + I ) X S (1 + Id)/(1 + If.) = $ A.S^CI + I^)
which is the restated book value of the corresponding
year-end US purchasing power.
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