International Business

Chapter Eighteen

International Accounting Issues

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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

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IntroductionAccounting: 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, today’s 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

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Fig. 18.2: Accounting in International Business

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Factors Influencing the Development 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.

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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]

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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

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Fig. 18.4: Environmental Influences on Accounting Practices

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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.

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Fig. 18.5: Cultural Differences in Measurement and Disclosure for Accounting

Systems

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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

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Fig. 18.6: Classification of Accounting Systems of Developed Western

Nations

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The Differencesin 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

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Fig. 18.7: Proposed Scheme for Classification According to Strong

and Weak Equity Market Orientation

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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

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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]

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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.

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International Organization of Securities Commissions (IOSCO): the international organization of the securities regulators of the world’s 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.

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Map 18.1: Membership of the International Federation of Accountants

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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.

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The Translation of Foreign Currency Financial Statements

Translation: the process of restating foreign currency financial statements

Consolidation: the process of combining the translated financial statements of a parent company and its subsidiaries into a single set of statements

• In the U.S., financial statements are first recast according 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.

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Translation MethodsFunctional 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 owner’s equity]

Temporal method: applied when the parent’s 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

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Fig. 18.8: Selection of Translation Method

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Balance Sheet, December 31, 2005 TEMPORAL CURRENT-RATE

METHOD METHOD POUNDS RATE DOLLARS RATE DOLLARS

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

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Income Statement, 2005

TEMPORAL CURRENT-RATE

METHOD METHOD POUNDS RATE DOLLARS RATE DOLLARS

Sales 230,000 1.5617 359,191 1.5617 359,191Expenses: 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

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Environmental Reports

Although there are no specific guidelines forpreparing environmental reports, they:

• identify the impact of the firm on theenvironment

• focus on the use of natural resources,the reduction of greenhouse gas emissions,and efforts to recycle wastes

• provide useful voluntary information butvary 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.

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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.

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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 headquarter’s currency and then translates it into local curren-cy, or a budget is set at a foreign subsidiary and then translated into the MNE’s headquarter’s currency.

• The most widely used approaches for budget translation and performance comparison use forecasts of the exchange rate.

[continued]

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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.

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Possible Combinations of Exchange Rates in the Control

Process

RATE USED TO TRACKRATE USED PERFORMANCE TO BUDGETFOR RELATIVE Actual at Projected Actual atDETERMINING time of at time of end of BUDGET budget budget period

Actual at time A-1 A-2 A-3of budget

Projected at P-1 P-2 P-3 time of budget

Actual at end of E-1 E-2 E-3period (updated)

Source: Donald R. Lessard and Peter Lorange, 1977. “Currency Changes and Management Control: Resolving the Centralization/ Decentralization Dilemma,” Accounting Review.

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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 TOTALDETERMINE BUDGET budget budget period FIRMS

Actual at time A-1 A-2 A-3of budget 10 firms 0 firms 4 firms 14

Projected at time P-1 P-2 P-3of budget 0 firms 16 firms 11 firms 27

Actual at end E-1 E-2 E-3of 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.

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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.

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Conditions in a Subsidiary’s 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 partnersLower corporate tax rate Pressure for profit sharingSignificant competition Political pressure against Local loans based on financial foreign firms appearance of subsidiary Restrictions on remittancesExport subsidy or tax credit Political instabilityLower inflation rate Tie-in sales agreementsCeilings on import values Government-controlled prices

Desire to mask subsid. profitsSource: Jeffrey S. Arpan, 1972. Intracorporate Pricing: Non-American Systems and Views.

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The Balanced Scorecard

Balanced scorecard (BSC): an approach to performance 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.

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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]

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• Today’s 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.

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Accounting Clusters

South American GroupSouth American Group

Countries have experienced persistent and rapid inflation.

Accounting principles reflect the inflation.

Countries have experienced persistent and rapid inflation.

Accounting principles reflect the inflation.

Europe-Japan GroupEurope-Japan Group

Have close ties to banks. Accounting practices meet bank’s

needs.

Have close ties to banks. Accounting practices meet bank’s

needs.

British-American-Dutch GroupBritish-American-Dutch Group

Firms raise capital from investors. Accounting systems designed to inform investors

Firms raise capital from investors. Accounting systems designed to inform investors