International Cost Accounting

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International Cost Accounting
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TAX ES AND TRANSFER PRICING

• Some MNCs use a reinvoicing center to avoid
  taxes.
• A French Subsidiary of a U.S.Parent produces a
  component at a cost of 100. The French
  subsidiary transfers title to a reinvoicing
  center in Puerto Rico at a transfer price of
  100. Puerto Rico has no income tax. This
  center then transfers title to the U.S.
  subsidiary of the parent corporation at a
  transfer price of 200.

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TAX ES AND TRANSFER PRICING

• The U.S. subsidiary sells the component for
  200. The component is not subject to U. S. tax
  because it is ostensibly sold at cost. Without
  the reinvoicing center, if the French subsidiary
  had set the transfer price at 200 it would have
  been subject to the French tax (40). If the
  transfer price had been set at 100, no French
  tax would have been paid, but the U.S. sub
  (selling for 200) would have

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TAX ES AND TRANSFER PRICING

• realized a profit of 100 that would have been
  subject to the U.S. tax of 35. The reinvoicing
  center took title to but never possession of the
  product. It is clearly set up to evade corporate
  income taxes.
• This is the type of abuse IRS Code Section 482
  was set up to prevent. Section 482 allows, in
  effect, three transfer pricing methods that
  approximate an arms-length

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TAX ES AND TRANSFER PRICING

• transaction and a special pricing arrangement.
• These are (1) Comparable uncontrolled price
  method (2) Resale price method and (3) Cost Plus
  method. Examples
• 1. The U.S. sub purchases a component from the
  French sub that has a market price of 38.
• Freight and insurance costs are 5. Commissions
  and marketing costs are 3.80.
• The transfer price may be set at

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TAX ES AND TRANSFER PRICING

• 38 5 - 3.80 39.20
• 2. Resale Price Method
• The component made in France has no outside
  market.
• U.S. sub sells the component for 50 and normally
  receives a mark-up of 40 on the cost of goods
  sold. The transfer price would be
• 50/1.40 35.71
• 3. Cost plus

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TAX ES AND TRANSFER PRICING

• Assume the French subs manufacturing costs are
  20. Landing costs are 5.

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TAX ES AND TRANSFER PRICING

• The transfer price is set at 25.
• 4. Advanced Pricing Agreement (APA)
• This is an advance agreement between the company
  and the IRS for a specified period of time. It
  is not made public. It may be done so that the
  IRS and the company can agree about valuing
  certain assets such as intangibles.

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TAX ES AND TRANSFER PRICING

• For example, a U.S. firm may develop a product
  and license its Puerto Rican subsidiary to
  produce it. The product would then be purchased
  by the parent for sale in the U.S., and a royalty
  would be charged to the subsidiary. The royalty
  rate would be taxable income to the parent, but
  at a low rate.

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TAX ES AND TRANSFER PRICING

• Because the transaction was similar
• to other third party transactions the IRS could
  not challenge it. The IRS added a super royalty
  provision to Section 482 linking the transfer
  price of the intangible to the income
  attributable to the intangible. Because this
  income is difficult to measure the TP is often
  negotiated using an APA.

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TAX ES AND TRANSFER PRICING

• The example in the textbook illustrates how taxes
  can distort incentives. Recall that the market
  method for transfer pricing satisfies all the
  criteria for an acceptable transfer price.
  Assuming the market is perfectly competitive for
  the intermediate product the tax saving resulting
  from use of the cost plus method would encourage
  use of that method.

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International Trade

• Imports
• When multinational corporations (MNCs) import
  materials for use in production, a tariff
• (tax, duty) is levied by the federal government.
• This tax becomes part of the cost of materials.
  Companies look for ways to reduce these taxes.
  One way is to alter the materials by adding more
  U.S. content and gain more

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.. International Trade.

• favorable tariff status. Another way is to
  utilize a foreign trade zone.
• Foreign Trade Zone (FTZ)
• FTZs are areas that are physically on U.S. soil
  but are considered to be outside U.S. commerce.
  Companies in FTZs can manufacture or warehouse.
  They also do not have to pay duty on imports
  subject to their

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International Trade...

• being reported to the U.S. Customs and remaining
  within designated FTZs. If the items leave the
  FTZ bound for non-U.S. destinations, there is no
  tariff (duty). If they leave the FTZ for U.S.
  destinations, then a tariff is due. FTZs must be
  located near a U.S. customs port of entry. Goods
  imported into an FTZ are tariff free until they
  leave the zone.

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International Trade...

• This has important implications for companies
  that import raw materials. Since duty is not due
  until the imported materials leave the zone, the
  company postpones payment and any associated loss
  of working capital. Further, the company in the
  FTZ does not pay duty on defective material not
• included in the finished product. This results

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International Trade

• in savings from not having to pay for defective
  material and not having to pay the carrying cost
  of the duty. See example on page 400 of handout.
  
• Other advantages of FTZs
• Imports that do not comply with U.S. standards
  can be imported into an FTZ and

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International Trade

• modified to comply without being subject to a
  fine.
• In an FTZ a company can assemble high tariff
  component parts into a lower tariff finished
  product. Adding domestic labor content during
  assembly makes the high tariff foreign parts
  eligible for more favorable tariff treatment.

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International Trade

• Owners of FTZs are usually city or county
  authorities. They have the authority to
  reallocate FTZ areas to other foreign trade sub
  zones if it can be justified. See example page
  401 handout. Remember there are a number of
  foreign auto plants that are FTZs. The U.S. has
  at times considered curtailing these FTZs in
  effect using them as a trade weapon against the
  home country.

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International Trade

• Exports The sale of a companys products to
• foreign countries. Products can be sold directly
  to customers in a foreign country. Or the
  company may work with a distributor in a foreign
  country. It could also buy an established
  business (create a wholly owned subsidiary or
  branch).

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International Trade

• Wholly Owned Subsidiary
• The parent company buys a foreign company.
• It is relatively simple because the foreign
  company usually has an outlet for the product

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International Trade

• See Whirlpool example on page 402 of handout.
  Some companies move a business function to
  another country. Outsourcing is the payment by a
  company for a business function that was formerly
  done in house. When a company out sources to buy
  technical expertise this is known as advantageous
  outsourcing. Outsourcing also allows

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International Trade
companies to work around the clock. See TI
example on page 402. Joint Ventures A type of
partnership in which investors co-own the
enterprise. A JV is necessary when the type of
expertise needed by the MNC is not for sale. For
example, China, India and Thailand do not allow
MNCs to purchase companies or set up subsidiaries
so JVs are required. See page 403 for examples
of JVs.
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Foreign Currency Exchange

• Currency Risk Management
• Transaction risk-future cash transactions will be
  affected by changing exchange rates.
• Economic risk-the present value of future cash
  flows will be affected by exchange rate
  fluctuations.
• Translation risk-the degree to which financial

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Foreign Currency Exchange

• statements are exposed to exchange rate changes.
• Terminology
• Spot rate the exchange rate of one currency for
  another today. Eg. 1U.S. 1.56 Canadian
• Appreciation One currency can buy more of
  another currency. Ex. 1U.S. 1.56 Canadian
  today. Next week 1 U.S. 1.80 Canadian.
• Depreciation One currency can buy less of a

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• another currency. Ex. 1U.S. 1.56 Canadian
  today. Next week 1 U.S. 1.40 Canadian.
• Transaction Risk
• Exchange rate gains and losses for receivables
  and payables. See examples on page 405 and 406
  of the handout.
• Hedging The use of forward exchange contracts
  to ensure against foreign currency

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Foreign Currency Exchange

• gains and losses. See examples on page 407.
• The premium expense needs to be netted against
  the difference between what would have been paid
  or received without the hedge to determine if the
  hedge was profitable. Even if the result is
  negative it still may be considered successful
  because it reduced risk (anxiety and worry).

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Foreign Currency Exchange

• If you are owed a receivable in foreign currency
  do you want the dollar to appreciate or
  depreciate relative to the foreign currency?
• What if you owe a payable?

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Foreign Currency Exchange..

• Economic Risk
• This occurs when exchange rates change the cost
  of competing products in different countries.
  Eg. The exchange rate changes the price for heavy
  equipment in Japan from 80,000 to 74,286 while
  the price in the U.S. remains at 80,000. This
  was caused by the dollar appreciating relative to
  the yen. In this

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Foreign Currency Exchange..

• case a strong dollar makes the U.S. less
  competitive internationally. A strong dollar
  often contributes to a large trade deficit.
• Economic risk can be managed by hedging. See
  example of page 406. It should also be managed
  by awareness in budgeting and financial planning.
  E.g. by giving consideration to exchange rate
  fluctuations.

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Foreign Currency Exchange..

• Translation Risk
• This occurs when financial statements are
  translated in the parent currency and there has
  been significant depreciation or appreciation
  between the parent currency and the home country
  currency. See example on page 409. This can be
  managed by a common sense approach. Look at the
  financial statements

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Foreign Currency Exchange..

• before translation and after translation to
  determine the economic impact in the home
  country. The objective of denominating internal
  reports in the parent currency is to
• measure all figures on the same basis. However,
  when making comparisons over time local currency
  statements should be placed alongside parent
  denominated reports.

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Foreign Currency Exchange..

• In sum transaction and economic risk can be
  managed by hedging. Translation risk is managed
  by common sense on a case by case basis.

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Measuring Performance in an MNC

• The evaluation of the manager of an MNC sub unit
  (division) should be separated from the
  evaluation of the division. The managers
  evaluation should not include factors over which
  he/she exercises no control. These factors
  include currency fluctuations and taxes.
• Managers should be evaluated on the basis of
  revenues and costs incurred.

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Measuring Performance in an MNC

• Once the manager is evaluated the sub financial
  statements can be restated to the home currency
  and uncontrollable costs can be allocated.
• Examples of Factors that differ
• Legal- Potted plants cannot enter the U.S. but
  florists have a high demand for poinsettias at
  Christmas time. See page 411

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Measuring Performance in an MNC

• Cultural The most common form of credit in
  Brazil is postdated checks. This required
  adjustments by Wal-Mart.
• Infrastructure Clothing manufacturers in
  developing countries had to put in roads and
  communication equipment in the area where the
  manufacturing plant was located. They also had
  to provide training.

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Measuring Performance in an MNC

• Comparison of Divisional Performance
• In order to measure divisional performance in
  different countries adjustments must often be
  made. Eg. The example on page 412 illustrates
  how this type of measurement should be done on a
  case by case basis. In this case the Canadian
  firm used historical cost and the Brazilian firm
  adjusted for inflation. Therefore, the return on
  investment

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Measuring Performance in an MNC

• measurements were not comparable. It is
  necessary to get behind the numbers and make
  appropriate adjustments so that comparability is
  established before performance can be effectively
  measured.
• Exhibit 11-2 on page 413 details the
  environmental factors affecting performance
  evaluation in MNCs.

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Measuring Performance in an MNC

• One example of different environmental factors
  is differences in GAPP. E.g. Canadian GAAP allows
  a company to net cash against an existing line of
  credit on the B.S. As a result Canadian balance
  sheets may show no cash.

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Measuring Performance in an MNC

• Other Factors
• Look at the last paragraph at the top of page 414
  to see how variance analysis used to be handled
  in the Soviet Union. Is this going on in Russia
  today? What about other former eastern block
  countries or anywhere for that matter?

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Ethics

• This is often a subjective area. Ethics vary
  from country to country. E.g. a service fee in
  one country is a bribe in another.
• Prerequisites for an ethical business
  environment
• societal stability, legitimacy and accountability
  of government, confidence in the system.

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Ethics

• Enforcing contracts requires some type of strong
  underlying system such as a legal system or
  cultural system. In the U.S. deviations from a
  contract are enforced by a strong legal system.
  In Japan deviations are enforced by a strong
  cultural system.

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Ethics

• Other examples of differences are
• Russian tax laws may change frequently with
  little or no notice to the MNC and they are
  usually retroactive. See example.
• Child labor laws differ between and among
  countries.
• Insider trading is illegal in the U.S. but legal
  in Europe.

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Ethics

• Sometimes making the ethically correct
  decision can have an adverse impact on the
  individuals in the home country. See the Walmart
  example on page 419. Guideline questions Is the
  action right legally? And then, is the action
  right morally?

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