International Business

1
International Business

• Chapter Eighteen
• International Accounting Issues

2
Chapter Objectives

• To examine the major factors influencing the
  develop-ment of accounting practices in different
  countries and the worldwide convergence of
  accounting standards
• To explain how companies account for foreign
  currency transactions and translate foreign
  currency financial statements
• To illustrate how companies issue environmental
  reports
• To discuss different forms of performance
  evaluation of foreign operations and how foreign
  exchange can com-plicate the budget process
• To explain how arbitrary transfer pricing can
  complicate performance evaluation and control
• To introduce the balanced scorecard as an
  approach to evaluating performance

3
Introduction

• Accounting a service activity whose function is
  to provide quantitative information, primarily
  functional in nature, about economic entities
  that is intended to be useful in making economic
  decisions and reasoned choices among alternative
  courses of action
• In addition to his/her traditional roles, todays
  corporate controller (chief accountant) engages
  in activities such as
• evaluating potential foreign acquisitions
• disposing of subsidiaries and/or divisions
• managing cash flows
• seeking new sources of financing
• hedging currency and interest rate risks
• tax planning
• assisting in the planning of corporate strategy

4
Fig. 18.2 Accounting in International Business
5
Factors Influencing the Develop-ment of
Accounting Worldwide

• Generally accepted accounting principles (GAAPs)
  those standards established in each country that
  must be followed by organizations when generating
  their financial statements
• The accounting process identifies, records, and
  inter-prets economic events.
• Accounting standards and practices vary around
  the world.
• Financial statements in different countries look
  different both in form (format) and content
  (substance).
• While equity markets are a major influence on
  accounting standards in the U.S. and the
  U.K., banks are more influential in Switzerland
  and Germany, and taxation is a major
  influence in France and Japan.

6
Accounting Objectives

• Financial Accounting Standards Board (FASB) the
  private sector body that establishes accounting
  standards in the United States
• The FASB states that the external reporting
  of accounting information in the U.S. should
  provide information for the purposes of
• investment and credit decisions
• the assessment of cash flow prospects
• the evaluation of enterprise resources, claims to
  those resources, and changes in those resources
  
• continued

7

• International Accounting Standards Board (IASB)
  an international private sector organization that
  sets financial accounting standards for
  world-wide use
• The IASB and its predecessor, the International
  Accounting Standards Committee, identified the
  following key users of accounting information
• investors
• employees
• lenders
• suppliers and other trade creditors
• customers
• governments and their agencies
• the public

8
Fig. 18.4 Environmental Influences on Accounting
Practices
9
Cultural Differences in Accounting

• Secrecy and transparency the degree to which
  firms disclose information to the public
• Optimism and conservatism the degree of caution
  that firms display in valuing assets and
  recognizing income
• Culture influences
• measurement practices, i.e., the methods of
  valuing of assets
• disclosure practices, i.e., the presentation of
  information and the discussion of results
• While Anglo-Saxon countries such as the U.K. and
  the U.S. have accounting systems that tend
  to be transparent and optimistic, Germanic
  and Latin countries tend to be secretive and
  conservative.

10
Fig. 18.5 Cultural Differences in Measurement
and Disclosure for Accounting
Systems
11
The Classification of Accounting Systems

• International accounting standards (IAS),
  IASC-sponsored standards designed to harmonize
  the national treatment of accounting issues
  across its members countries they more closely
  approximate the standards used in micro-based
  systems
• Although accounting standards and practices
  vary world-wide, systems can nonetheless be
  classified according to common characteristics
• macro-uniform accounting systems, which are
  largely shaped by government influences (strong,
  codified, tax-based legal systems)
• micro-based accounting systems, which rely on
  pragmatic business practices

12
Fig. 18.6 Classification of Accounting Systems
of Developed Western Nations
13
The Differences in Financial
Statements

• Financial statements differ from one country to
  another in six major ways
• language
• currency
• type of statement (balance sheet,
  income statement, etc.)
• format
• extent of footnote disclosures
• underlying GAAPs on which statements are based

14
Fig. 18.7 Proposed Scheme for Classification
According to Strong and Weak Equity
Market Orientation
15
Dealing with Accounting and Reporting Differences

• Major approaches to dealing with accounting and
  reporting differences include
• mutual recognition a foreign registrant need
  only provide information prepared according to
  the GAAPs of the home country
• reconciliation to the local GAAPs a foreign
  registrant reconciles its home-country financial
  statement with the local GAAPs
• recasting financial statements in terms of local
  GAAPs in the U.S. a Form 20-F is used to
  re-cast financial statements

16
International Accounting Standards and Global
Convergence

• Forces encouraging the harmonization of national
  accounting standards include
• investor orientation
• the global integration of capital markets
• the need for MNEs to raise foreign capital
• regional economic integration
• the pressure from MNEs for more uniform standards
  to improve the ease and reduce their costs of
  reporting
• The most ambitious harmonization efforts are
  occurring in the EU, which has directed its
  member countries to adopt the International
  Accounting Standards, as set forth by the ISAB,
  by 2005.
• continued

17

• International Accounting Standards Committee
  (IASC) a private-sector organization formed in
  1973 by the professional accounting bodies of ten
  nations to work toward the harmonization of
  accounting standards on a worldwide basis (the
  predecessor of the IASB)
• International Financial Reporting Standards
  (IFRSs) a set of global accounting standards
  that require high quality, transparent, and
  comparable information in financial statements
  and reports (replaced the original Interna-tional
  Accounting Standards of the IASB)
• Although the FASB and the IASB are attempting to
  establish common new
  standards and eliminate existing differences in
  those standards that can be easily converged,
  their efforts are unsettling to many
  Europeans.

18

• International Organization of Securities
  Commissions (IOSCO) the international
  organization of the securities regulators of the
  worlds stock markets
• In 2000 the IASB completed a core set of
  standards that the IOSCO agreed to endorse
  as a result, the IOSCO now permits foreign firms
  to list on their exchanges using IASC standards,
  without having to reconcile to local GAAPs.
• International Federation of Accountants (IFAC)
  comprised of 163 accounting organizations
  representing 119 countries and more than 2.5
  million accountants worldwide responsible for
  issues affecting accountants, such as ethics,
  auditing standards, educational require-ments,
  certification requirements, etc.

19
Map 18.1 Membership of the International
Federation of Accountants
20
Transactions in Foreign Currencies

• Whenever the relevant exchange rate
  changes, foreign currency receivables
  and payables result in gains and
  losses.
• Transaction gains and losses must be
  included on the income statement in
  the accounting period in which
  they occur.
• FASB 52 requires U.S. firms to report foreign
  currency transactions at the original spot
  exchange rate on the initial transaction date and
  to report receivables and payables at the
  subsequent balance sheet date at the spot
  exchange rate on those dates.

21
The Translation of Foreign Currency Financial
Statements

• Translation the process of restating
  foreign currency financial statements
• Consolidation the process of combining the
  trans-lated financial statements of a parent
  company and its subsidiaries into a single set of
  statements
• In the U.S., financial statements are first
  recast accord-ing to U.S. GAAPs then all foreign
  currency amounts are translated into U.S.
  dollars.
• All U.S. firms, as well as foreign companies
  listed on a U.S. exchange, must follow FASB 52
  when translating their foreign currency financial
  statements into U.S. dollars.

22
Translation Methods

• Functional currency the currency of the primary
  economic environment in which an entity operates
• determined by cash flows, sales prices,
  expenses, financing, intercompany
  transactions, etc.
• Current-rate method applied when the local
  currency is the functional currency, it provides
  that all assets and liabilities be translated at
  the current exchange rate
• the accumulated translation adjustment, i.e.,
  the gain or
  loss, is recognized in owners equity
• Temporal method applied when the parents
  currency is the functional currency, it provides
  that only monetary assets (cash, marketable
  securities, and receivables) and liabilities be
  translated at the current exchange rate
• the translation gain or loss is recognized in
  the income statement,
  thus affecting earning per share
• the spot exchange rate on the balance sheet date

23
Fig. 18.8 Selection of
Translation Method
24
Balance Sheet, December 31, 2005

• TEMPORAL CURRENT-RATE
  METHOD METHOD
• POUNDS RATE DOLLARS RATE
  DOLLARS
• Cash 20,000 1.6980 33,960
  1.6980 33,960
• Accts. receivable 40,000 1.6980
  67,920 1.6980 67,920
• Inventories 40,000 1.5606 64,424
  1.6980 67,920
• Fixed assets 100,000 1.5000 150,000
  1.6980 169,800
• Accum. depr. (20,000) 1.5000
  (30,000) 1.6980 (33,960)
• Total 180,000 284,304
  305,960
• Accts. payable 30,000 1.6980 50,940
  1.6980 50,940
• Long-term debt 44,000 1.6980 74,712
  1.6980 74,712
• Capital stock 60,000 1.5000 90,000
  1.5000 90,000
• Retained earnings 46,000 - 68,652 -
  77,481
• Accum. trans. adj. 12,507
• Total 180,000 284,304 305,640

25
Income Statement, 2005

• TEMPORAL CURRENT-RATE
• METHOD METHOD
• POUNDS RATE DOLLARS RATE
  DOLLARS
• Sales 230,000 1.5617 359,191
  1.5617 359,191
• Expenses
• Cost of gds. sold (110,000) 1.5600
  (171,600) 1.5617 (171,787)
• Depreciation (10,000) 1.5000
  (15,000) 1.5617 (15,617)
• Other (80,000) 1.5617 (124,936)
  1.5617 (124,936)
• Taxes (6,000) 1.5617 (9,370)
  1.5617 (9,370)
• Translation gain/ 24,000 (9,633)
  37,481
• (loss)
• Net Income 24,000 28,652
  37,481

26
Environmental Reports

• Although there are no specific guidelines for
  preparing environmental reports, they
• identify the impact of the firm on the
  environment
• focus on the use of natural resources,
  the reduction of greenhouse gas emis-
  sions, and efforts to recycle
  wastes
• provide useful voluntary information but
  vary from firm to firm and country to
  country
• Typically, the environmental report is separate
  from the annual report and is not part of the
  financial statements or footnotes.

27
Performance Evaluation and Control

• Measures used to evaluate the performance of
  foreign operations may include
• return on investment market share
• sales profitability
• cost reduction budget to actual
• quality targets environmental targets
• The choice of performance measure depends upon
  the firm, its home country, its strategic intent,
  etc.
• There are major national differences in the
  selection of performance evaluation tools most
  MNEs use a variety of measures.

28
Foreign Exchange and the Budget Process

• When developing a budget, a firm must select a
  currency with which to set the budget and a
  currency with which to evaluate performance.
• Either a MNE sets a budget in its headquarters
  currency and then translates it into local
  curren-cy, or a budget is set at a foreign
  subsidiary and then translated into the MNEs
  headquarters currency.
• The most widely used approaches for budget
  translation and performance comparison use
  forecasts of the exchange rate.
• continued

29

• Lessard and Lorange have identified three
  alternative ways in which firms can translate a
  budget from the local currency into the parent
  currency and then monitor actual performance by
  using
• the actual exchange rate in effect when the
  budget is established an actual spot rate
  in effect on a given day
• the rate that was projected at the time the
  budget was established in local currency
• a forecasted exchange rate for the budgeted
  time period
• the actual exchange rate in effect when the
  budgeted period actually occurs
• an actual, updated exchange rate for the
  budgeted time period
• The FASB requires that U.S. firms report foreign
  currency translations at the original spot
  exchange rate and that subsequent gains and
  losses on foreign currency receivables or
  payables be put on the income statement.

30
Possible Combinations of Exchange Rates in the
Control Process

• RATE USED TO TRACK
• RATE USED PERFORMANCE TO BUDGET
• FOR RELATIVE Actual at Projected
  Actual at
• DETERMINING time of at time of
  end of
• BUDGET budget budget period
• Actual at time A-1 A-2 A-3
• of budget
• Projected at P-1 P-2 P-3
• time of budget
• Actual at end of E-1 E-2 E-3
• period (updated)
• Source Donald R. Lessard and Peter Lorange,
  1977. Currency Changes and Management Control
  Resolving the Centralization/ Decentralization
  Dilemma, Accounting Review.

31
Exchange Rates Used by UK MNEs

• RATE USED FOR PERFORMANCE
  EVALUATION
• Actual at Projected
  Actual at
• RATE USED TO time of at time
  of end of TOTAL
• DETERMINE BUDGET budget budget
  period FIRMS
• Actual at time A-1 A-2 A-3
• of budget 10 firms 0 firms
  4 firms 14
• Projected at time P-1 P-2 P-3
• of budget 0 firms 16 firms 11
  firms 27
• Actual at end E-1 E-2 E-3
• of period 0 firms 0 firms 0
  firms 0
• Total firms 10 16 15
• Source Adapted from Demirag De Fuentes, 1999.
  Exchange Rate Fluctuations and Management
  Control in UK-Based MNCs An Examination of
  Theory and Practice, The European Journal of
  Finance.

32
Transfer Pricing and Performance Evaluation

• Transfer prices prices on intracompany
  (internal) transfers of materials, components,
  finished goods, services, and capital
• Arbitrary transfer prices are designed to
  maximize profitability and currency flows, but
  they make an unbiased performance evaluation
  nearly impossible.
• Firms may establish arbitrary transfer prices
  because of
• differences in national tax rates
• tough competition in foreign markets
• anti-dumping legislation
• Internal transfer prices may also include the
  allocation of fixed costs, loans, fees,
  royalties, and other factors.

33
Conditions in a Subsidiarys Country That Induce
High and Low Transfer Prices on Flows between
Affiliates and the Parent

• Conditions inducing low transfer
  Conditions inducing high transfer prices on flows
  from parent and prices on flows from parent and
  high transfer prices on flows to low transfer
  prices on flows to parent parent
• High ad valorem tariffs Local partners
• Lower corporate tax rate Pressure for
  profit sharing
• Significant competition Political
  pressure against
• Local loans based on financial foreign firms
• appearance of subsidiary
  Restrictions on remittances
• Export subsidy or tax credit Political
  instability
• Lower inflation rate Tie-in sales
  agreements
• Ceilings on import values
  Government-controlled prices
• Desire to mask subsid. profits
• Source Jeffrey S. Arpan, 1972. Intracorporate
  Pricing Non-American Systems and Views.

34
The Balanced Scorecard

• Balanced scorecard (BSC) an approach to
  perform-ance measurement that closely links the
  strategic and financial perspectives of a
  business but takes a broad view of business
  performance
• The balanced scorecard provides a framework for
  examining the strategies giving rise to value
  creation from the following perspectives
• financial growth, profitability, and risk
• customer value and differentiation
• internal business processes the creation of
  customer and shareholder satisfaction
• learning and growth the creation of a supportive
  climate for change, innovation, and growth
• The balanced scorecard approach reveals the
  drivers of long-term
  competitive performance.

35
Implications/Conclusions

• The accounting function concerns the collection
  and analysis of data for both internal and
  external users.
• Some of the most important sources of influence
  upon the development of accounting standards and
  practices are culture, capital markets, regional
  and global standard-setting groups, management,
  and accountants.
• continued

36

• Todays global capital markets force countries to
  at least consider, if not pursue, the
  harmoniza-tion of their accounting and reporting
  standards.
• Culture can have a strong influence on the
  accounting dimensions of measurement and
  disclosure.
• A variety of different performance evaluation
  measures are used for global operations,
  including return on investment and budget as
  compared to actual performance.