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http://journals.sfu.ca/abr       ADVANCES IN BUSINESS RESEARCH 
2015, Volume 6, pages 65-78 

 

 

 65 

A Comparison of the Characteristics of Price Parity 
Constructs with Exchange Rates and the Potential 

Impact on Foreign Currency Translation 
 

Paul E. Holt 
Texas A&M University, Kingsville 

 

Characteristics of a constructed time series of price parity numbers were compared with the 
time series of exchange rates between twenty-two countries’ currencies and the United States 
dollar. These characteristics were analyzed to determine in which countries an accounting 
policy change from exchange rates to price parity for translation of foreign currency would 
result in greater information content of consolidated statements. The results of the study are 
consistent with the use of price parity for sixteen of the twenty-two countries studied, but not 
for translation of accounts between the Japanese yen and the United States dollar. 

 

Introduction 

 

Reported earnings variability is an indicator of the degree of risk associated with the earnings 
series. Material differences in variability of subsidiary earnings across translation methodologies do 
matter to assessment of earnings risk. Managers can be expected to prefer that their companies be 
perceived as less risky rather than more risky. Companies with significant foreign operations could 
therefore be expected to prefer translation methodologies that result in lower variability of translated 
subsidiary earnings which would result in lower variability of consolidated earnings. Further, 
accounting policy makers and analysts might prefer less variability if that variability could be ascribed 
to noise. 

In 1974, the Committee on International Accounting suggested the possibility that purchasing 
power parity (PPP) constructs might be appropriate for foreign currency translation, indeed that such 
constructs might be superior to exchange rates for the purpose. At the time the committee raised this 
question, no empirical accounting research had been done to make the comparison between PPP 
constructs and exchange rates and suggest an answer. The committee was, in effect, calling for such 
research to be performed. 

A small number of early papers (described in the literature review) provided theoretical 
insights into the consequences of using PPP numbers instead of exchange rates for currency 
translation and even presented fully developed translation methodologies based on PPP. 

In more recent years, some empirical work has been done (also described in the literature 
review) to compare the consequences of using PPP instead of exchange rates and to bring accounting 
standard setting bodies and other accounting professionals closer to the answer to the committee’s 
original question. These studies were based on translations between the US dollar and the UK pound. 
No similar empirical studies exist to describe what happens when PPP numbers are used instead of 
exchange rates for currency translation between the US dollar and various currencies other than the 
UK pound. 

When foreign currency translation is required prior to consolidation of a parent and a foreign 
subsidiary, the current and historical exchange rates are assumed to represent the time-relevant 



COMPARISON OF PRICE PARITY CONSTRUCTS WITH EXCHANGE RATES 

  78  

relationship between the two currencies. But actual exchange rates used for conversions of currencies 
are affected by numerous factors, some of which are transient. Indeed, day-to-day market and political 
factors can have major impacts on the conversion exchange rate. 

Ideally, accountants would use the equilibrium exchange rate for currency translation. As 
discussed in detail in the literature review, PPP is the main determinant of the equilibrium exchange 
rate because the value of a currency is basically determined by its domestic purchasing power (Officer, 
1982, page 93). Very early work (Cassel, 1916) demonstrates that the equilibrium exchange rate tends 
to equal the PPP. In fact, Cassel (1926) equates the PPP time series with the equilibrium exchange rate 
series. 

Since the numbers used to translate foreign currency significantly affect all the numbers 
consolidated financial statements, it is theoretically sound to allege that the usefulness of reported 
earnings per share and numerous other ratios and relationships would be enhanced by using PPP 
numbers which are closer to the equilibrium exchange rate. The transient noise factors in conversion 
exchange rates can be expected to reduce the information content of consolidated financial statements 
to users. 
 

Motivation 

 

Accordingly, the purpose of the present study is to examine the characteristics of PPP time 
series constructs compared with exchange rate time series. One of the assumptions of the present 
inquiry is that the relative variability of the PPP series and the exchange rate series results in relative 
variability of reported earnings. 

This study uses what may be referred to as “country pairings,” one of which is always the 
United States. For example, one pairing would be the United Kingdom and the United States. Another 
could be Russia and the United States. No pairings are considered which do not involve the United 
States. For example, the purpose of the study does not encompass PPP and exchange rate 
comparisons between say, Russia and the United Kingdom. For convenience, the term “country 
pairings” will be used in this study. For example, a “Germany pairing” will mean PPP time series and 
exchange rate comparisons between Germany and the United States. 

To what extent the relative characteristics of PPP and exchange time series are the same for all 
currencies translated into the US dollar is not known. Such knowledge has substantial implications for 
any proposal to use PPP numbers instead of exchange rates for translation. Although the economics 
literature does suggest that a PPP time series for a given country (in a “country pairing” between that 
country and the United States) should have lower variability than an exchange rate time series, the 
extent to which this is true for all countries is not known. Such knowledge is critical to PPP translation 
proposals; despite the theoretical economics literature and the theoretical accounting literature, it may 
be true that PPP translation methodologies might be highly meaningful and useful in some country 
pairings, but less useful, even harmful in terms of financial statement information content, in other 
country pairings. 

 

Literature Review 

 

Does lower variability of reported earnings result in more useful information? That is, is lower 
variability of reported earnings a normative criterion against which to evaluate alternative accounting 
methods? There are numerous research articles in the accounting literature that indicate that managers 
and other users view high variability of earnings as undesirable and less accurate depictions of the 



   Holt 
 

77 

results of operations than lower variability of earnings. 
 

Relevant and Representative 20th Century Literature 

A number of foreign currency translation articles indicate that the requirements of SFAS #8 
were perceived by many financial statement users, especially managers, to result in greater variability of 
reported earnings than other possible translation methodologies (Allan, 1976; Biel, 1976; Herschman, 
1976; Mattlin, 1976; Merjos, 1977; Aggarwal, 1978; Porter, 1983; Selling and Sorter, 1983). Collins and 
Salatka (1993) concluded that including the translation adjustment in net income as required by SFAS 
#8 generated noise that made reported earnings less meaningful. But the translation adjustment is 
determined by the net effect of all the translated subsidiary numbers. None of these studies 
contemplated the issue of PPP versus ER to eliminate some of the noise in consolidated financial 
statement numbers. 

From the economics literature, the PPP theory of exchange rates is summarized in Officer 
(1982) in three propositions: (1) PPP is the principal determinant of the long-run equilibrium exchange 
rate, (2) the short-run equilibrium exchange rate in any current period is a function of the long-run 
equilibrium exchange rate in the sense that the latter variable is the principal determinant of, and tends 
to be approached by, the former, and (3) the short-run equilibrium exchange rate in any current period 
is determined principally by the PPP, with the former variable tending to equal the latter. 

The equilibrium exchange rate is the rate at which the demand for a currency and supply of the 
same currency are equal. At the equilibrium exchange rate, the price for exchanging two currencies will 
remain stable (The Free Financial Dictionary, 12/18/2014). 

Actual exchange rates are not likely to be equilibrium. Temporary factors affecting exchange 
rates are always in play, a condition that continually adds to the variability of exchange rates. Under the 
PPP theory as described by Officer, PPP would mitigate the effects of these temporary noise factors. 
This is a reasonable argument in favor of the use of PPP numbers instead of exchange rates for foreign 
currency translation, but the argument is theoretical and is not acceptable in accounting standard 
setting without supporting empirical and normative research. 
 

Relevant and Representative 21st Century Literature 

Bazaz and Senteney (2001) used an equity valuation model to investigate the extent to which 
SFAS No. 52 unrealized foreign currency translation gains and losses are reflected in levels of equity 
security prices. It is a sound theoretical observation that using numbers closer to the equilibrium 
exchange rate would increase the studied relationship, although this has not yet been demonstrated 
with normative research. 

Louis (2003) studied the association between change in firm value and the foreign translation 
adjustment. Accounting rules for currency translation usually result in financial statement numbers 
opposite to the economic effects of exchange rate variations. Thus, the translation adjustment could 
be associated with a loss of value instead of an increase in value. Comments similar to those made 
above in relation to Bazaz and Senteney (2001) are appropriate here. 

Holt (2004), a descriptive study, used a complex method of estimating the temporal 
characteristics of accounts and compared the information content of return on assets across 
translation methodologies, including PPP. The study provides a short step toward answering the 
Committee on International Accounting’s question regarding the viability of PPP for translation. But 
the study does not relate various returns on assets to any normative criterion, and because of its scope 
was unable to relate the findings to any implications of noise. 

Kwon (2005) indicated that foreign investors generally price exchange risk differently from 
local investors, and that the source and magnitude of differences in exchange risk pricing varied 



COMPARISON OF PRICE PARITY CONSTRUCTS WITH EXCHANGE RATES 

  78  

significantly across countries. It is not known, based on existing research, whether the use of PPP 
would mitigate the observed differences, or whether the differences are related to transient factors. 

In another empirical study, Pinto (2005) tested foreign currency translation adjustment value 
relevance in an earnings and book value model and observed that foreign currency translation 
adjustments are significantly value relevant. But the study did not include a PPP methodology for 
testing against ER. 

Liu (2006) used an accounting-based equity valuation model for multinational firms to 
examine the forecasting and valuation properties of foreign currency translation gains and losses. It 
found that translation gains and losses could be subdivided into a core component and a transitory 
component. The combined effect was that translation gains and losses were more transitory than 
transitory earnings. Current research does not answer the question as to how much of the transitory 
component is due to the use of ER instead of PPP. 

Wang et al (2006) suggested that currency-translation differences are at times incrementally 
relevant to returns. In remains to be determined which performs better, PPP or ER in this regard. 

Chambers et al (2007) provided evidence in the post-SFAS #130 period that other 
comprehensive income is priced by investors on a dollar-for-dollar basis. Two components of other 
comprehensive income, foreign currency translation adjustment and unrealized gains and losses on 
available-for-sale securities, were found to be priced by investors. But the study suggests that investors 
pay greater attention to other comprehensive information reported in the statement of changes in 
equity, rather than in a statement of financial performance. 

Holt (2011) made a normative evaluation of translation methodologies based on firm 
valuation and found that PPP performed well against this criterion compared to exchange rates. Holt 
(2006) suggested superiority of the use of PPP over exchange rates for variability of reported earnings. 
Holt(2012) focused on two short-term liquidity ratios, the current ratio and inventory turnover and 
attempted to identify, in terms of empirical properties, if and in what ways foreign currency translation 
methodologies generate different results. Analysis of meaningfully-paired observations indicated 
substantially different current ratio and inventory turnover numbers across translation methodologies. 
But the results were not consistent from year to year and the results of all the fifty sample companies, 
taken together, did not hold for all the individual companies. At the firm level, the results were highly 
firm specific. 

Holt (2013) tested alternative translation methodologies against the Fischer Black Method of 
Evaluating accounting alternatives with a conclusion favorable to PPP. Holt (2014a) tested alternative 
translation methodologies against the normative criterion of present values of future cash flows to 
investors and concluded a favorable result for PPP. Holt (2014b) tested methodologies against the 
predictability of reported earnings with similar favorable results for PPP. 
 

Methodology 

 

The countries used to form the “country pairs” were taken from the top twenty-five countries 
according to gross domestic product as indicated in International Monetary fund 2013 and augmented 
by Treasury Direct 2005 and United States Census 2014. As noted above, all country pairs include the 
United States leaving twenty-four countries for pairing. For various economic reasons, Iraq and 
Turkey were excluded, resulting in twenty-two country pairings. 

Month-end exchange rates between each of the twenty-two countries and the United States 
were obtained from January 1999 through December 2013. In order to construct the PPP monthly 
time series for the same period, the United States monthly consumer price indexes and the 
corresponding consumer price indexes for the twenty-two countries were obtained. 



   Holt 
 

77 

Purchasing Power Parity (PPP) Time Series Construction 

The use of exchanges rates in translation has no rigorous defense, and exchange rates are not 
related in any clear way to accounting measures. None of the exchange-rate based translation 
methodologies has been shown theoretically or empirically to be superior to the others under all 
circumstances. Patz (1978) suggests this may result from the use of exchange rates themselves. The 
Price Parity Method of translation is described in full in Patz (1981). For an analysis of the state of the 
art of currency translation theory and the lack of definitive research of the PPP alternative, see Patz 
(2006). 

Using the price parity methodology, foreign accounts are translated into dollars using a 
temporal method approach, but using a time series of price parity relative purchasing power indices. 
The purpose is to reflect the command over goods and services in the economy in which the 
subsidiary operates. It is assumed that foreign subsidiaries do not exist solely for the purpose of 
generating dollar cash flows to the parent, but rather for the maximization of economic power which 
can be defined as the size of assets held (Churchman, 1961). 

The price parity indices needed for translation from foreign currency to dollars under the price 
parity method were calculated as follows: 
 

PPt = PPb(CPItk/CPIts) 

Where  

PPt = the price parity index for point in time t, 

PPb = an exchange rate assumed to approximate purchase power parity at the point in time b (b = December 31, 1993, 
a base point.) 

CPItk = consumer price index in the foreign environment at time t, standardized to base period b = 100, and 

CPIts = consumer price index for the U.S. at time t, standardized to base period b = 100. 

 

The foregoing is called the “constructed rate” approach for obtaining a price parity index time 
series. It is the method suggested by Patz (1981) as the simplest and most practical. 

This calculation must be performed for each point of time need for translation, and the 
purpose of the calculation is to generate a time series of PPP numbers which are closer to the 
equilibrium exchange rate than observed conversion exchange rates. Patz (1977) pointed out that 
foreign currency translation is a mathematical exercise in which measures scaled in a foreign currency 
are transformed into measures scaled in the domestic currency. It is a restatement process, not a 
remeasurement. The restatement should not introduce transient noise factors. The PPP theory of 
translation alleges that less noise is generated by the use of PPP numbers than by the use of conversion 
exchange rates. 
 

Research Questions 

The study addressed two research questions: 

 

(1) For how many of the twenty-two country pairings is the variability of PPP less than the variability 
of exchange rates, and which country pairings exhibit this characteristic? 

(2) Do any of the twenty-two country pairings exhibit anomalous results that would affect the use of 
PPP for currency translation in lieu of exchange rates, and what are the causes of these anomalies? 

 



COMPARISON OF PRICE PARITY CONSTRUCTS WITH EXCHANGE RATES 

  78  

Results and Conclusions 

  

The rank ordering of countries by gross domestic product according to the International 
Monetary Fund (2012) is as follows: 

1. United States 

2. China 

3. Japan 

4. Germany 

5. France 

6. United Kingdom 

7. Brazil 

8. Russia 

9. Italy 

10. India 

11. Canada 

12. Australia 

13. Spain 

14. Mexico 

15. South Korea 

16. Indonesia 

17. Turkey 

18. Netherlands 

19. Saudi Arabia 

20. Switzerland 

21. Iran 

22. Sweden 

23. Norway 

24. Poland 

25. Belgium 

The purpose of consulting this list was to select countries which are active in international 
commerce. Such countries contain businesses which are likely to have Multi-national subsidiaries, and 
thus are affected by accounting principles relating to foreign currency translation. The list was used 
merely for selection for use the in present study. Factors such as the precise rank ordering were not 
relevant. 

As indicated under methodology, for various economic reasons, Iraq and Turkey were 
excluded, resulting in twenty-two country pairings with the United States. 

Several of these countries use the euro. Although the time series of exchange rates between 
those countries’ currencies and the United States dollar is the same, the time series of the constructed 
PPP numbers is different. Thus, the fact that several countries use the same currency does not 
eliminate the use of that country in the present study. 

An implication of Officer (1982) was that the PPP construct’s variance is lower than that 
exchange rate variance. Tables 1 and 2 make that comparison for the study period. Countries are 
ordered by gross domestic product. 

Table 1 was constructed with a United States parent and a foreign subsidiary in mind, 
translating foreign currency into dollars, whereas Table 2 used the opposite scenario, a foreign parent 
and a United States subsidiary. 

To answer research question #1, in each table we observe sixteen of the country pairings with 
higher variances for exchange rates than for PPP and six country pairings with the opposite result. The 
six countries for which the results were contrary to Officer (1982) arranged in order of gross domestic 
product are: Japan, Brazil, Russia, India, South Korea, and Indonesia. A tentative and cautious 
implication is that the use of PPP instead of exchange rates for currency translation between these 
countries and the United States might not be advantageous from the viewpoint of the information 
content of consolidated financial statements. 

Of special interest among these six countries is Japan, as it is the fourth largest trading partner 
with the United States. It is important to understand why these results are observed for Japan. A major 
factor in constructing the PPP series, as described in the methodology section of this paper, is the  
variability of the consumer price index. The following table shows the rank orderings of countries 
based on the lowest variances of the consumer price indexes. This result for Japan is an anomalous 
result mentioned in research question #2. 

 

 



COMPARISON OF PRICE PARITY CONSTRUCTS WITH EXCHANGE RATES 

  78  

Table 1. Variances of Exchange Rates Compared to Variances of PPP (Dollars per Foreign Currency) 

 

 

Country 

Exchange 
Rate Variance 

PPP 
Variance 

X = Exchange Rate 
Variance > PPP Variance 

China 0.0308 0.0298 x 

Japan 0.0001 0.0028  

Germany 0.2528 0.0777 x 

France 0.2528 0.0739 x 

United Kingdom 0.0075 0.0011 x 

Brazil 0.0969 0.1671  

Russia 0.0031 0.0168  

Italy 0.2528 0.0207 x 

India 0.0048 0.0075  

Canada 0.1767 0.0273 x 

Australia 0.1712 0.0364 x 

Spain 0.2528 0.0301 x 

Mexico 0.0200 0.0191 x 

South Korea 0.00004 0.00004  

Indonesia 0.00004 0.00005  

Netherlands 0.2528 0.0258 x 

Switzerland 0.3465 0.1210 x 

Iran 0.0004 0.00034 x 

Sweden 0.0296 0.0107 x 

Norway 0.0270 0.0060 x 

Poland 0.0616 0.0130 x 

Belgium 0.2528 0.1809 x 

 

 



   Holt 
 

77 

Table 2. Variances of Exchange Rates Compared to Variances of PPP (Foreign Currency per Dollar) 

 

 

Country 

Exchange 
Rate Variance 

PPP 
Variance 

X = Exchange Rate 
Variance > PPP Variance 

China 1.5529 1.5226 x 

Japan 1.4051 29.9925  

Germany 0.1822 0.0684 x 

France 0.1822 0.0654 x 

United Kingdom 0.0028 0.0004 x 

Brazil 0.4036 0.9102  

Russia 2.9367 44.7313  

Italy 0.1822 0.0196 x 

India 12.9564 26.1340  

Canada 0.2774 0.0549 x 

Australia 0.2903 0.0945 x 

Spain 0.1822 0.0307 x 

Mexico 2.4754 2.3257 x 

South Korea 52.2268 61.9771  

Indonesia 3,337 5,187  

Netherlands 0.1822 0.0248 x 

Switzerland 0.4929 0.2391 x 

Iran 16,273 7,213 x 

Sweden 1.677 0.6954 x 

Norway 1.3309 0.3599 x 

Poland 0.7790 0.2386 x 

Belgium 0.1822 0.1437 x 

 



COMPARISON OF PRICE PARITY CONSTRUCTS WITH EXCHANGE RATES 

  78  

Table 3. Rank Ordering of Countries by Lowest Variances of Consumer Price Indexes 

 

Rank Country Variance of CPI 

1 Japan 0.0131 

2 China 0.0193 

3 Switzerland 0.0631 

4 Belgium 0.0712 

5 Sweden 0.1567 

6 Germany 0.1772 

7 France 0.1816 

8 Norway 0.2116 

9 Canada 0.2204 

10 Netherlands 0.2375 

11 Italy 0.2455 

12 United Kingdom 0.2692 

13 United States 0.2735 

14 Spain 0.3167 

15 South Korea 0.3496 

16 Australia 0.3592 

17 Poland 0.3602 

18 Mexico 0.6194 

19 Brazil 0.9868 

20 India 1.1083 

21 Indonesia 1.2881 

22 Russia 2.4444 

23 Iran 5.9975 

 

 

 

 

Pursuant to officer (1982) and the methodology of the PPP time series construction used in 
this paper, a preliminary observation is that the higher the variance of a country’s CPI, the less valuable 
would be the use of PPP for foreign currency translation compared to exchange rates. The striking 
result from Table 3, compared with the results from Tables 1 and 2, is that Japan has the lowest 
variability among the countries included in this study. 

The other major factor in the construction of the PPP series is the CPI in the United States. 
Hence, the coefficient of variation between the foreign country’s CPI series and the United States CPI 
series is highly relevant. Intuitively, the coefficient of variation would be positive for all countries for 
which a constructed PPP series would be viable for currency translation. 

Table 4 rank orders countries by the coefficient of variation between that country’s CPI series 
and the United States CPI series, showing the lowest coefficients first. 
 



   Holt 
 

77 

Table 4. Rank Ordering of Countries by Lowest Coefficient of Variation Between That Country’s 
CPI series and the United States CPI Series 

 

Country Coefficient of Variation 

Japan -0.5951 

China 0.4737 

India 0.8399 

Mexico 0.8546 

Iran 0.8952 

Switzerland 0.9573 

United Kingdom 0.9697 

Poland 0.9762 

Belgium 0.9772 

Netherlands 0.9825 

Norway 0.9836 

Sweden 0.9862 

Brazil 0.9876 

Russia 0.9896 

South Korea 0.9915 

Australia 0.9939 

Italy 0.9944 

Indonesia 0.9948 

Canada 0.9955 

Germany 0.9956 

France 0.9969 

Spain 0.9971 

 

Table 4 reveals Japan as a striking outlier; Japan’s CPI series does not correlate with the United 
States series, an explanation for the anomalous result observed for the Japan pairing. This evidence 
suggests that the use of PPP for translation of accounts between the Japanese yen and the United 
States dollar for consolidation purpose is not likely to produce financial statements with information 
content superior to the use of exchange rates. 
 

Limitations and Suggestions for Future Research 

 

The present study drew on the implications of Officer (1982) and thus assumed that the use of 
an equilibrium exchange rate series, represented by PPP, rather than a market-generated exchange rate 
series would result in consolidated financial statements with greater information content. The study 
did not actually perform the daunting task of translating a significantly large sample of actual 
companies from one currency to another. Thus, no rank ordering of translation methodologies was 
done based on any normative criterion. 



COMPARISON OF PRICE PARITY CONSTRUCTS WITH EXCHANGE RATES 

  78  

A number of papers reflect accounting normative criteria against which translation 
methodologies can be evaluated. For example,  

Ohlson (2001) studied the relationship between earnings, book values, and dividends in equity 
valuation. Ohlson (2005) examined accounting-based valuation formulae, and Ohlson and 
Juettner-Nauroth (2005) studied the relationship between earnings per share and firm value. 

The explanation of the anomalous Japan pairing was based on the lack of correlation between 
the Japanese CPI series and the United States CPI series. This was a mathematical explanation, but the 
underlying business environment and cultural explanations for this phenomenon remain unknown. 

Despite the results of this study related to Japan, the author believes future research should 
perform currency translations between the Japanese yen and the U.S. dollar for the purpose of 
comparing the results with a wide range of normative criteria. Such research should also be performed 
for the other twenty-one country pairs. 
 

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Paul E. Holt is Professor of Accounting at Texas A&M University – Kingsville. His research interests 
include foreign currency translation, price parity, and earnings quality. 


