International Business
Chapter Eighteen
International Accounting
Issues
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 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
18-2
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
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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]
18-6
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:
–
–
–
–
–
–
–
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
18-8
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.
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Fig. 18.5: Cultural Differences in
Measurement and Disclosure
for Accounting Systems
18-10
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, taxbased 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
18-12
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
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Fig. 18.7: Proposed Scheme for
Classification According to Strong
and Weak Equity Market Orientation
18-14
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
18-15
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]
18-16
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.
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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 requirements, certification requirements, etc.
18-18
Map 18.1: Membership of the
International Federation of Accountants
18-19
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.
18-20
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 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.
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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
statement, thus affecting earning per share]
* the spot exchange rate on the balance sheet date
income
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Fig. 18.8:
Selection of Translation Method
18-23
Balance Sheet, December 31, 2005
TEMPORAL
CURRENT-RATE
METHOD
METHOD
POUNDS
Cash
Accts. receivable
Inventories
Fixed assets
Accum. depr.
Total
Accts. payable
Long-term debt
Capital stock
Retained earnings
Accum. trans. adj.
Total
RATE
20,000 1.6980
40,000 1.6980
40,000 1.5606
100,000 1.5000
(20,000) 1.5000
180,000
30,000
44,000
60,000
46,000
180,000
DOLLARS
33,960
67,920
64,424
150,000
(30,000)
RATE
1.6980
33,960
1.6980
67,920
1.6980
67,920
1.6980 169,800
1.6980 (33,960)
284,304
1.6980
1.6980
1.5000
-
50,940
74,712
90,000
68,652
284,304
DOLLARS
305,960
1.6980
1.6980
1.5000
-
50,940
74,712
90,000
77,481
12,507
305,640
18-24
Income Statement, 2005
POUNDS
TEMPORAL
METHOD
RATE
DOLLARS
Sales
230,000 1.5617 359,191
Expenses:
Cost of gds. sold (110,000) 1.5600 (171,600)
Depreciation
(10,000) 1.5000
(15,000)
Other
(80,000) 1.5617 (124,936)
Taxes
(6,000) 1.5617
(9,370)
Translation gain/
24,000
(9,633)
(loss)
Net Income
24,000
28,652
CURRENT-RATE
METHOD
RATE
DOLLARS
1.5617
359,191
1.5617 (171,787)
1.5617 (15,617)
1.5617 (124,936)
1.5617
(9,370)
37,481
37,481
18-25
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.
18-26
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.
18-27
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]
18-28
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.
18-29
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
A-1
A-2
A-3
P-1
P-2
P-3
E-1
E-2
E-3
budget
budget
period
Source: Donald R. Lessard and Peter Lorange, 1977. “Currency Changes and Management Control: Resolving the Centralization/
Decentralization Dilemma,” Accounting Review.
18-30
Exchange Rates Used by UK MNEs
RATE USED FOR PERFORMANCE EVALUATION
RATE USED TO
DETERMINE BUDGET
Actual at time
of budget
Projected at time
of budget
Actual at end
of period
Total firms
Actual at
time of
budget
A-1
10 firms
P-1
0 firms
E-1
0 firms
10
Projected
at time of
budget
A-2
0 firms
P-2
16 firms
E-2
0 firms
Actual at
end of
period
A-3
4 firms
P-3
11 firms
E-3
0 firms
16
15
TOTAL
FIRMS
14
27
0
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.
18-31
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.
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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
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.
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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.
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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]
18-35
• 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.
18-36