Are Financial Statements Meaningful under Exchange Rate Fluctuations? : Financial Analysis*

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IntroductionSince the events of 1969 to 1973 that led to the current period of floating exchange rates, translated financial statements denominated in foreign currency has been an accounting problem of considerable economic importance. In December 1973, the Financial Accounting Standards Board (FASB) issued Statements of Financial Accounting Standards (SFAS)1, which moved the Accounting profession from a position of laissez-faire to requirement that extensive disclosures of a company's translation practices be made. In 1975, the FASB adopted SFAS 8 which required a single translation method. In December 1981, the FASB adopted a new standard for foreign currency translation, SFAS 52. The method of SFAS 52 combines conventional, historical costbased asset measurement in me foreign currency with translation at the current rate and deferral of translation gains and losses.This study evaluates SFAS 52 and several alternative translation standards. Evaluation requires a conception of attributes considered desirable. Unfortunately, different attributes are considered desirable by different interested parties, and the accounting profession is faced with a theoretical and practical problem in selecting evaluation criteria - the problem of social choice. The social choice problem has not been resolved in the accounting literature. Demski considers attempts to use qualitative characteristics, such as relevance and verifiability, in the establishment of accounting standards21 - His 'Impossibility Theorem' shows that, with certain assumptions regarding users of financial statements, qualitative characteristics may not be used to develop an optimal normative theory of accounting.The FASB must, however, set accounting standards and has chosen in Statement of Financial Accounting Concepts (SFAC) No. 2 to profess that qualitative characteristics will be used for the purpose of standard establishment3. Cushing has noted that relaxation of the limiting assumption of heterogeneous users invalidates Demski's proof of the Impossibility Theorem4. This paper follows the FASB in assuming that qualitative characteristics may be used to distinguish accounting alternatives. The criteria applied by the authors assume a financial statement user group with tastes within a prescribed realm of similarity. No absolute justification for the use of qualitative characteristics to establish accounting standards is, orean be, given - - The intention is rather to assume with the FASB concept statements that reliance on qualitative characteristics is reasonable, and to see where this reliance leads. Comparison of the conclusions reached in this study with the standard actually adopted may then provide insight into the relevance of FASB concept statements to standard establishment. It is in this spirit that the above rationale has been presented.Evaluation CriteriaSFAS 2 argues that comparability and representational faithfulness are desirable qualitative characteristics of financial statements5. The authors assume that translated financial statements of foreign subsidiaries should be comparable to the financial statements of domestic parents and other domestic corporations. This is clearly a desirable limitation to impose on translation methods if the conventional practice of consolidating the translated financial statements of a foreign subsidiary with those of its domesetc parent is to be continued. The financial interaction of a foreign subsidiary and its domestic parent is normally mediated by a currency exchange market. Comparison of the economic events described by translated and domestic financial statements requires an economic theory of that market. This paper describes and utilizes economic theories of currency exchange markets that are consistent with the available empirical evidence.Comparability of translated and domestic financial statements provides guidance for the formulation of a translation standard only if the economic events described by translated statements are essentially similar to economic events described by domestic statements. …