International Business Chapter Eighteen International Accounting Issues Chapter

International Business Chapter Eighteen International Accounting Issues

Chapter Objectives • To examine the major factors influencing the development of accounting practices in different countries and the worldwide convergence of accounting standards • To explain how companies account 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 complicate 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 2

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, 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 3

Fig. 18. 2: Accounting in International Business 4

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 Germany, and taxation is a major influence in France and Japan. 5

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 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] 6 of

International Accounting Standards Board (IASB): an international private sector organization that sets financial accounting standards for worldwide use • The IASB and its predecessor, the International Accounting Standards Committee, identified the following key users of accounting information: – – – – 7 investors employees lenders suppliers and other trade creditors customers governments and their agencies the public

Fig. 18. 4: Environmental Influences on Accounting Practices 8

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. 9

Fig. 18. 5: Cultural Differences in Measurement and Disclosure for Accounting Systems 10

The Classification of Accounting Systems International accounting standards (IAS): , IASCsponsored 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 worldwide, systems can nonetheless be classified according to common characteristics: – macro-uniform accounting systems, which are largely shaped by government influences (strong, codified, taxbased legal systems) – micro-based accounting systems, which rely on pragmatic business practices 11

Fig. 18. 6: Classification of Accounting Systems of Developed Western Nations 12

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 13

Fig. 18. 7: Proposed Scheme for Classification According to Strong and Weak Equity Market Orientation 14

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 recast financial statements 15

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] 16

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 International 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. 17

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 requirements, certification requirements, etc. 18

Map 18. 1: Membership of the International Federation of Accountants 19

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. 20

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. 21

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 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 22

Fig. 18. 8: Selection of Translation Method 23

Balance Sheet, December 31, 2005 POUNDS Cash Accts. receivable Inventories Fixed assets Accum. depr. Total TEMPORAL METHOD RATE DOLLARS 20, 000 1. 6980 40, 000 1. 5606 100, 000 1. 5000 (20, 000) 1. 5000 180, 000 33, 960 67, 920 64, 424 150, 000 (30, 000) 284, 304 Accts. payable 30, 000 1. 6980 Long-term debt 44, 000 1. 6980 Capital stock 60, 000 1. 5000 Retained earnings 46, 000 Accum. trans. adj. Total 180, 000 50, 940 74, 712 90, 000 68, 652 24 284, 304 CURRENT-RATE METHOD RATE DOLLARS 1. 6980 33, 960 1. 6980 67, 920 1. 6980 169, 800 1. 6980 (33, 960) 305, 960 1. 6980 1. 5000 - 50, 940 74, 712 90, 000 77, 481 12, 507 305, 640

Income Statement, 2005 POUNDS TEMPORAL CURRENT-RATE METHOD RATE DOLLARS Sales 230, 000 1. 5617 359, 191 1. 5617 Expenses: Cost of gds. sold (110, 000) 1. 5600 (171, 600) 1. 5617 Depreciation (10, 000) 1. 5000 (15, 000) 1. 5617 Other (80, 000) 1. 5617 (124, 936) 1. 5617 Taxes (6, 000) 1. 5617 (9, 370) 1. 5617 Translation gain/ 24, 000 (9, 633) (loss) Net Income 24, 000 28, 652 25 359, 191 (171, 787) (15, 617) (124, 936) (9, 370) 37, 481

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 emissions, 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. 26

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. 27

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 currency, 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] 28

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. 29

Possible Combinations of Exchange Rates in the Control Process RATE USED FOR RELATIVE DETERMINING BUDGET Actual at time of budget Projected at time of budget Actual at end of period (updated) RATE USED TO TRACK PERFORMANCE TO BUDGET Actual at time of Projected at time of Actual at end of budget period A-1 A-2 A-3 P-1 P-2 P-3 E-1 E-2 E-3 Source: Donald R. Lessard and Peter Lorange, 1977. “Currency Changes and Management Control: Resolving the Centralization/ Decentralization Dilemma, ” Accounting Review. 30

Exchange Rates Used by UK MNEs RATE USED FOR PERFORMANCE EVALUATION Actual at RATE USED TO time of DETERMINE BUDGET budget Actual at time A-1 of budget 10 firms Projected at time P-1 of budget 0 firms Actual at end E-1 of period 0 firms Total firms 10 Projected at time of budget A-2 0 firms P-2 16 firms E-2 0 firms 16 Actual at end of period A-3 4 firms P-3 11 firms E-3 0 firms TOTAL FIRMS 14 27 0 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. 31

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. 32

Conditions in a Subsidiary’s Country That Induce High and Low Transfer Prices on Flows between Affiliates and the Parent Conditions inducing low transfer prices on flows from parent and high transfer prices on flows to parent Conditions inducing high transfer prices on flows from parent and low transfer prices on flows to parent High ad valorem tariffs Lower corporate tax rate Significant competition Local loans based on financial appearance of subsidiary Export subsidy or tax credit Lower inflation rate Ceilings on import values Local partners Pressure for profit sharing Political pressure against foreign firms Restrictions on remittances Political instability Tie-in sales agreements Government-controlled prices Desire to mask subsid. profits Source: Jeffrey S. Arpan, 1972. Intracorporate Pricing: Non-American Systems and Views. 33

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. 34

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] 35

• Today’s global capital markets force countries to at least consider, if not pursue, the harmonization 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. 36

Accounting Clusters British-American-Dutch Group Firms raise capital from investors. Accounting systems designed to inform investors Europe-Japan Group Have close ties to banks. Accounting practices meet bank’s needs. South American Group Countries have experienced persistent and rapid inflation. Accounting principles reflect the inflation. 37