International Accounting

1
International Accounting

• Chapter 19

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International Accounting Topic Outline

• Introduction
• causes and implications of differences in
  accounting practices across nations
• Accounting for IB activities assets
• accounting for transactions
• accounting for assets
• valuing non-financial assets
• International Taxation Issues
• transfer pricing
• tax havens

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Figure 19.1 Influences on a Countrys Accounting
System
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Influences on National Accounting Practices

• In common law countries such as the U.S.,
  accounting procedures typically evolve from the
  decisions of independent standards-setting
  boards. However, in code law countries such as
  France, accounting practices are determined by
  the law. The enforcement of accounting practices
  is also impacted by a countrys legal system.

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Influences on National Accounting Practices

• National culture may also play a role in a
  countrys accounting system. For example, French
  firms, the text notes, produce a social balance
  sheet that details their treatment and
  compensation of workers.

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Influences on National Accounting Practices

• Political ties between countries may impact a
  countrys accounting system in that former
  colonies often follow procedures similar to those
  of their former rulers. A countrys economic
  situation may direct its accounting system.
• For example, a market economys system will be
  driven by profit- and cost-oriented information,
  while a centrally planned economys system
  emphasizes output-oriented information.

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Influences on National Accounting Practices

• Finally, capital markets may also affect
  national accounting standards. For example, in
  the US firms rely heavily on outside investors,
  and outside investors in turn rely heavily on
  good information about the condition and
  prospects of firms to make their decisions about
  where to invest.

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Influences on National Accounting Practices

• Thus, US financial reporting tends to be much
  more transparent than for nations like Germany,
  where insiders such as banks have traditionally
  been the most important providers of investment
  capital.

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Implications of Differences in National
Accounting Practices

• Because rules differ among countries as to how a
  firms assets should be valued, firms are advised
  to exercise caution when comparing the strength
  of balance sheets of firms from different
  countries. For example, Dutch firms are permitted
  to revalue assets upwards to reflect replacement
  value, the US forbids that practice, and in the
  UK accountants have wide discretion.

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Implications of Differences in National
Accounting Practices

• Firms should be aware of how inventories are
  being valued when comparing the performance of
  firms. For example, the text notes that in
  general, U.S., Japanese, and Canadian firms can
  use either LIFO or FIFO to value inventories,
  while in Great Britain and Brazil, only FIFO is
  normally used.

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Implications of Differences in National
Accounting Practices

• A firms accounting records are important because
  they are the basis on which taxes are assessed.

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Implications of Differences in National
Accounting Practices

• Firms use accounting reserves to adjust for
  foreseeable future expenses that affect their
  operations. Because countries have different
  laws regarding the use of accounting reserves, it
  can be difficult to assess a firms performance.

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Implications of Differences in National
Accounting Practices

• For example, in the US, reserves are not welcomed
  by the IRS because they reduce taxable income.
• However, in Germany reserves are used
  aggressively precisely because they do hide
  earnings and lower taxes payable. Reserves make
  it difficult to assess how German firms are
  performing.

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Implications of Differences in National
Accounting Practices

• There are many other differences in how countries
  treat accounting issues including the
  capitalization of financial leases, preparation
  of consolidated financial statements,
  capitalization of RD expenses, and treatment of
  goodwill.

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Implications of Differences in National
Accounting Practices

• In conclusion, differences in accounting
  practices can distort the measured performance of
  firms incorporated in different countries, making
  it difficult to compare the performance of
  companies across national boundaries.

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Implications of Differences in National
Accounting Practices

• An MNCs ability to manage its foreign operations
  may be complicated by differences in accounting
  procedures. Most parent firms dictate what
  procedures should be used, and, in addition,
  select the currency that will be used in
  assessing performance. Most companies use a
  combination of the parent countrys currency and
  local currencies.

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Implications of Differences in National
Accounting Practices

• Because centrally planned economy (CPE)
  accounting systems are designed to provide
  information about an enterprises aggregate
  production, rather than profits and costs,
  international businesses should exercise caution
  when examining financial statements developed in
  CPEs. This problem may be magnified if firms are
  involved in joint ventures with CPE counterparts.

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Accounting for IB Activities Assets

• Most international firms must deal with two
  specific types of accounting problems
• accounting for transactions denominated in
  foreign currencies.
• reporting the operating results of foreign
  subsidiaries in the firms consolidated financial
  statements.

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Accounting for IB Transactions

• U.S. firms, in accordance with FASB Statement 52,
  must account for international transactions that
  are settled in a foreign currency using a
  two-transaction approach in their financial
  statements.
• The two-transaction approach highlights any
  foreign-exchange loss or gain resulting from a
  sale or purchase.

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Currency Translation for Financial Reporting
Purposes

• Because most foreign subsidiaries conduct their
  business using the local currency, firms must
  convert their subsidiaries financial statements
  into their home currency.

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Currency Translation for Financial Reporting
Purposes

• Translation is the process of transforming a
  subsidiarys reported operations denominated in a
  foreign currency into the parents home currency.
  Consolidated financial statements report the
  combined operations of a parent and its
  subsidiaries in a single set of accounting
  statements denominated in a single currency.

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Currency Translation for Financial Reporting
Purposes

• An issue that is raised as a firm translates
  financial reports from one currency to another is
  which exchange-rate to use, the rate on the date
  the transaction occurred (the historical rate),
  or the current rate.

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Currency Translation for Financial Reporting
Purposes

• In the U.S., firms approach the question by
  following FASB Statement 52. According to the
  statement, firms use one of the following
  methods cost, equity, or consolidation to treat
  foreign investments.

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Currency Translation for Financial Reporting
Purposes

• Firms that have a portfolio investment in a
  foreign firm must use the cost method whereby the
  investment is recorded in the U.S. firms
  accounting record at cost using the historical
  exchange rate.

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Currency Translation for Financial Reporting
Purposes

• A U.S. firm that owns between 10 and 50 percent
  of a foreign firms stock must use the equity
  method whereby the initial investment in the
  foreign firm is recorded using the historical
  rate, but subsequent profits or losses are
  recorded at the rate prevailing when they
  occurred.

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Currency Translation for Financial Reporting
Purposes

• When a U.S. firm owns more than 50 percent of a
  foreign firm, it must use the consolidated method
  which calls for the accounting records of the two
  firms to be consolidated when the U.S. subsidiary
  reports operating results to shareholders and the
  SEC.

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Currency Translation for Financial Reporting
Purposes

• The process first involves restating the
  subsidiarys financial statements using U.S.
  GAAP, then the functional currency (the currency
  of the principal economic environment in which
  the subsidiary operates) is determined.

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Currency Translation for Financial Reporting
Purposes

• Depending on the subsidiarys functional
  currency, one of two methods will be used to
  translate the subsidiarys financial statements
  into the U.S. dollar. The current rate method is
  used if the subsidiarys functional currency is
  the host countrys currency, and the temporal
  method is used if the subsidiarys functional
  currency is the U.S. dollar.

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Currency Translation for Financial Reporting
Purposes

• Under the temporal method, translation losses and
  gain appear on the firms income statement, but
  under the current rate method, they appear as an
  adjustment to shareholders equity.
• Firms tend to prefer the current rate method
  because foreign exchange related shifts in profit
  can add a lot of volatility to reported earnings
  and, therefore, to stock prices.

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Currency Translation for Financial Reporting
Purposes

• U.S. firms, in accordance with FASB Statement 52,
  use the current rate method to show in their
  income statements either the exchange rate on the
  day the transaction occurred or a weighted
  average of exchange rates during the period the
  income statement covers. Dividends are
  translated using the exchange-rate effective on
  the day they are paid.

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Applying the Current Rate Method to Balance Sheets

• Assets and liabilities on a subsidiarys balance
  sheet are translated under the current rate
  method using the exchange rate in effect on the
  date for which the balance sheet was prepared.
  Equity accounts are treated on a historical
  basis. In addition, the firm makes an entry
  known as the cumulative translation adjustment
  which makes the firms assets equal the sum of
  its liabilities and shareholders equity.

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Applying the Current Rate Method to Balance Sheets

• U.S. MNCs often make large (in absolute terms)
  cumulative translation adjustments. Typically,
  firms with more extensive foreign investments
  tend to have higher cumulative translation
  adjustments relative to their shareholders
  equity.

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Valuing Non-Financial Assets

• This topic will be given in a separate handout.

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International Taxation Issues

• National accounting practices and national
  taxation policies are often closely related. For
  firms, the goal is to take advantage of tax
  incentives and avoid punitive taxes.

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International Taxation Issues

• International businesses can reduce their overall
  tax burdens by using transfer pricing and tax
  havens. Transfer pricing refers to the prices
  one branch or subsidiary of a parent charges a
  second branch or subsidiary for goods or
  services. Transfer prices can be calculated
  using a market-based approach, or a non-market
  method.

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International Taxation Issues

• The market-based method utilizes prices
  determined in the open market to transfer goods
  between units of the same company.
• A primary benefit of the market-based approach is
  that it reduces conflict between units over the
  appropriate price. Furthermore, the approach
  promotes the MNCs overall profitability by
  encouraging the efficiency of the selling unit.

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International Taxation Issues

• Nonmarket-based approaches set prices through
  negotiations between the buying and selling units
  or on the basis of cost-based rules of thumb.
  These methods may be used when no real market for
  the product or service exists outside the firm
  however, managers may waste time and energy
  haggling over prices and the selling unit may be
  less efficient.

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International Taxation Issues

• Firms may be able to reduce their tax burdens by
  using nonmarket-based transfer prices in a
  strategic manner. In addition, firms may be able
  to evade restrictions on the repatriation of
  profits by carefully adjusting transfer prices.

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International Taxation Issues

• Governments, aware that firms may attempt to
  reduce their tax burdens through the use of
  transfer prices, frequently scrutinize MNC
  policies to ensure that they receive the taxes
  they are entitled to. One approach is to use an
  arms length test whereby government officials
  attempt to determine the price that two unrelated
  firms operating at arms length would have agreed
  on.

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International Taxation Issues

• MNCs also reduce their tax burdens by locating
  their activities in tax havens, countries that
  impose little or no corporate income taxes. MNCs
  using tax havens divert income from subsidiaries
  in high-tax countries to the subsidiary operating
  in the tax haven country.