Jing Liu
University of California, Los Angeles
Abstract: Abstract: This paper examines the forecasting and valuation roles of foreign currency translation gains and losses (TGL) that arise when multinational firms consolidate financial statements across borders. Under standard assumptions, such as no arbitrage and that foreign accounting can be characterized as a convex combination of mark-to-market accounting and permanent-earnings accounting, the paper articulates the transitory nature of TGL. It shows that TGL can be decomposed into two components. One component is transitory, and it satisfies three conditions for transitory earnings articulated in Ohlson (1999): 1) it is value-irrelevant after controlling for book value; 2) it is unpredictable; and 3) it is irrelevant in forecasting future comprehensive incomes. The other component is part of core earnings and aggregates with translated foreign earnings without loss of value relevant information. Because the two components are negatively correlated and tend to offset each other, the combined effect is that TGL maps into value with a weight between zero and one. This analysis thus provides theoretical support for the GAAP treatment of TGL as a “dirty surplus” line item, in which it bypasses the income statement and enters equity directly.
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