Chapter 19 - Accounting in the International Business
Accounting in the International Business
Learning objectives

Discuss the source of country
differences in accounting
standards.

Discuss the consequences of
national differences in
accounting standards.

Explain the implications of the
rise of international accounting
standards.

Understand the accounting
implications of currency
translation.

Explain how accounting
systems impact upon control
systems within the
multinational enterprise.
19
Accounting, the language of business, provides the means
for firms to communicate their financial positions to
investors, creditors, and the government. Financial
information also is used in making resource allocations.
International businesses are confronted with a number of
accounting challenges that do not arise in the case of
domestic businesses. They must prepare reports for
international constituencies and translate and consolidate
information across countries and currencies.
The opening case, Chinese Accounting, and the closing
case, Adopting International Accounting Standards,
illustrate some of the issues accountants address in the
international sphere.
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Chapter 19 - Accounting in the International Business
OUTLINE OF CHAPTER 19: ACCOUNTING IN INTERNATIONAL BUSINESS
Opening Case: Chinese Accounting
Introduction
Country Differences in Accounting Standards
Relationship between Business and Providers of Capital
Political and Economic Ties with Other Countries
Inflation Accounting
Level of Development
Culture
National and International Standards
Lack of Comparability
International Standards
Management Focus: The Consequences of Different Accounting Standards
Management Focus: Novartis Joins the International Accounting Club
Multinational Consolidation and Currency Translation
Consolidated Financial Statements
Currency Translation
The Current Rate Method
The Temporal Method
Current U.S. Practice
Accounting Aspects of Control Systems
Exchange Rate Changes and Control Systems
The Lassard-Lorange Model
Transfer Pricing and Control Systems
Separation of Subsidiary and Manager Performance
Chapter Summary
Critical Discussion Questions
Closing Case: Adopting International Accounting Standards
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Chapter 19 - Accounting in the International Business
CLASSROOM DISCUSSION POINT
Ask students about the accounting system in the United States. Why is it mandatory for
companies to abide by the system? Then, ask students to take the perspective of an
investor. How does the system in the United States help investors? Try to focus on
issues like reliability and comparability. Then, ask students how they might assess a
company from another country that follows a different accounting system. What happens
to reliability and comparability? Finally, ask students to consider the need for an
international accounting system. What issues could emerge in the development of such a
system?
OPENING CASE: Chinese Accounting
The opening case describes the evolving nature of the accounting system in China, and
the challenges that this creates for Western firms. Discussion of the case can revolve
around the following questions:
1. What factors have shaped the accounting system currently in use in China?
2. What problems does the accounting system currently in use in China present to foreign
investors in joint ventures with Chinese companies?
3. If the evolving Chinese system does not adhere to IASC standards, but instead to
standards that the Chinese government deems appropriate to China’s “special situation,”
how might this affect foreign firms with operations in China?
LECTURE OUTLINE FOR CHAPTER 19
This lecture outline follows the Power Point Presentation (PPT) provided along with this
instructor’s manual. The PPT slides include additional notes that can be viewed by
clicking on “view”, then on “notes”. The following provides a brief overview of each
Power Point slide along with teaching tips, and additional perspectives.
Slides 19-3-19-4 Introduction
Accounting is the language of business – it is the way firms communicate their financial
positions.
Slides 19-5-19-7 Country Differences in Accounting Standards
Accounting is shaped by the environment in which it operates. In each country the
accounting system has evolved in response to the nature of the demands for accounting
information.
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Chapter 19 - Accounting in the International Business
Slide 19-5 Determinants of National Accounting Standards
Five main factors influence the development of a country’s accounting system: 1) the
relationship between business and the providers of capital, 2) political and economic ties
with other countries, 3) levels of inflation, 4) the level of a country's development, and 5)
the prevailing culture in a country.
Slide 19-8 Relationship between Business and Providers of Capital
Three main external sources of capital for business enterprises are: (1) individual
investors, (2) banks, and (3) government.
Slide 19-10 Political and Economic Ties with Other Countries
Similarities in accounting systems across countries can reflect political or economic ties.
Slide 19-11 Inflation Accounting
The historic cost principal assumes the currency unit used to report financial results is not
losing its value due to inflation.
Slide 19-12 Level of Development
Developed nations tend to have more sophisticated accounting systems than developing
countries.
Slide 19-13 Culture
The extent to which a culture is characterized by uncertainty avoidance (the extent to
which cultures socialize their members to accept ambiguous situations and tolerate
uncertainty) impacts the country’s accounting system.
Slide 19-14 National and International Standards
Accounting standards are rules for preparing financial statements—they define useful
accounting information. Auditing standards specify the rules for performing an audit—
the technical process by which an independent person gathers evidence for determining if
financial accounts conform to required accounting standards and if they are also reliable.
Slide 19-15 Lack of Comparability
Because of national differences in accounting and auditing standards, comparability of
financial reports from one country to another is difficult.
Slides 19-16-19-19 International Standards
There has been a substantial effort recently to harmonize accounting standards across
countries. The International Accounting Standards Board (IASB) is a major
proponent of standardization.
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Chapter 19 - Accounting in the International Business
Another Perspective: To see a complete summary of the accounting standards already set
forth, and current efforts at developing new standards, go to the IASB’s web site at
{http://www.iasb.org/Home.htm}.
Slide 19-21 Multinational Consolidation and Currency Translation
Subsidiaries of multinationals are separate legal entities but not separate economic
entities. A consolidated financial statement combines the separate financial statements
of two or more companies to yield a single set of financial statements as if the individual
companies were really one.
Slide 19-22 Consolidated Financial Statement
The IASB requires firms to prepare consolidated financial statements, as do most
industrialized nations.
Slide 19-23 Currency Translation
There are two methods to determine what exchange rate should be used when translating
financial statement currencies:
1. the current rate method
2. the temporal method
Slide 19-24 The Current Rate Method
Under the current rate method, the exchange rate at the balance sheet date is used to
translate the financial statements of a foreign subsidiary into the home currency of the
multinational firm. This can cause problems due to exchange rate fluctuations.
Slide 19-25 The Temporal Method
Under the temporal method, assets valued in a foreign currency are translated into the
home currency using the exchange rate that existed when the assets were originally
purchased. One problem with this approach is that the balance sheet of the multinational
may no longer balance.
Slide 19-26 Current US Practice
Under US FASB regulations, a self-sustaining subsidiary is said to have its own local
currency as its functional currency. The balance sheet for such subsidiaries is translated
into the home currency using the exchange rate in effect at the end of the firm's financial
year, while the income statement is translated using the average exchange rate in effect
during the firm's financial year. On the other hand, an integral subsidiary has US dollars
as its functional currency.
Another Perspective: The Financial Accounting Standards Board (FASB) and the IASB
have made a commitment to work together to harmonize accounting standards. More on
this agreement is available at the FASB web site at
{http://www.fasb.org/intl/convergence_iasb.shtml}.
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Chapter 19 - Accounting in the International Business
Slide 19-29 Accounting Aspects of Control Systems
The control process in most firms is usually conducted annually and involves three steps:
1. subunit goals are jointly determined by the head office and subunit management
2. the head office monitors subunit performance throughout the year
3. the head office intervenes if the subsidiary fails to achieve its goal, and takes corrective
actions if necessary
Slide 19-30 Exchange Rate Changes and Control Systems
Most international firms require budgets and performance data to be expressed in the
corporate currency-normally the home currency.
Slides 19-31-19-33 The Lessard- Lorange Model
Lorange and Lessard suggest that firms use the projected spot exchange rate (usually
the forward exchange rate) to translate budget and performance figures into the corporate
currency.
Slide 19-34 Transfer Pricing and Control Systems.
The price at which goods and services transferred within the firm is the transfer price.
Transfer prices can critically affect the performance of two subsidiaries that exchange
goods or services and can also introduce significant distortions into the control process.
Transfer prices must be taken into account when setting budgets and evaluating a
subsidiary's performance.
Slide 19-35 Separation of Subsidiary and Manager Performance.
The evaluation of a subsidiary should be kept separate from the evaluation of its
manager.
CRITICAL THINKING AND DISCUSSION QUESTIONS
QUESTION 1: Why do the accounting systems of different countries differ? Why do
these differences matter?
ANSWER 1: Accounting systems are shaped by the environment of the country, and
have evolved to meet the nature of demand for accounting information in that country.
Five factors seem to influence the type of accounting system in a country. These are 1)
the relationship between business and the providers of capital, 2) political and economic
ties with other countries, 3) levels of inflation, 4) the level of a country's development,
and 5) the prevailing culture of a country. These differences are important because they
affect the way financial reports are created and interpreted, ad make comparisons across
borders difficult.
QUESTION 2: Why are transactions among members of a corporate family not included
in consolidated financial statements?
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Chapter 19 - Accounting in the International Business
ANSWER 2: Consolidated financial statements combine the separate financial
statements of two or more companies to yield a single set of financial statements as if the
individual companies were really one. In order to provide a true picture of the financial
situation of the firm, transactions among family members are not included in
consolidated financial statements. If such transactions were included, they could provide
misleading information to stakeholders.
QUESTION 3: The following are selected amounts from the separate financial
statements of a parent company (unconsolidated) and one of its subsidiaries:
Cash
Receivables
Accounts payable
Retained Earnings
Revenues
Rent Income
Dividend Income
Expenses
Parent
$ 180
$ 380
$ 245
$ 790
$4,980
$
0
$ 250
$4,160
Subsidiary
$ 80
$ 200
$ 110
$ 680
$3,520
$ 200
$
0
$2,960
Notes:
(i) Parent owes subsidiary $70
(ii) Parent owns 100% of sub. During the year sub paid parent a dividend of $250.
(iii) Subsidiary owns the building that parent rents for $200
(iv) During the year parent sold some inventory to subsidiary for $2,200. It had cost
Parent $1,500. Subsidiary, in turn, sold the inventory to an unrelated party for $3,200.
Given this information
(a) What is the parent's (unconsolidated) net income?
(b) What is the subsidiary's net income?
(c) What is the consolidated profit on the inventory that the parent originally sold to the
subsidiary?
(d) What are the amounts of consolidated cash and receivables?
ANSWER 3:
(a) Parent's unconsolidated net income: Revenues (4980-2200) + Rent Income (0) +
Dividend Income (250 - 250) - Expenses (4160 -1500-200) = 320
(b) Subsidiary's net income: Revenues (3520) + Rent Income (200) + Dividend Income
(0) - Expenses (2960) = 490
(c) Consolidated profit on the inventory: 3200 - 1500 = 1700
(d) Cash: 180 + 80 = 260, Receivables: 380 - 70 +200 = 510
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Chapter 19 - Accounting in the International Business
QUESTION 4: Why might an accounting-based control system provide headquarters
management with biased information about the performance of a foreign subsidiary?
How can these biases be corrected?
ANSWER 4: There are three primary reasons why accounting based control systems
may provide headquarters management with biased information about the performance of
a subsidiary: exchange rate changes, transfer prices, and general economic conditions.
Because exchange rates can change over the course of a budget, translated financial data
can be misleading - an increase in domestic sales could actually show up as a decrease
after translation due to home currency appreciation. By using a common exchange rate
for both budget setting and evaluation (i.e. the initial rate or a forecast rate), this problem
can be addressed. Since multinational firms often have significant intra-firm
transactions, prices have to be set on these transactions. Due both to the difficulty of
setting such prices fairly, and the incentives to set prices in order to minimize tax or
import duties, profitability of units can be distorted by unrealistic transfer prices. Since it
can be impossible and inefficient to use only fair transfer prices, the effects of transfer
prices have to be taken into consideration when evaluating the performance of a
subsidiary. Lastly, different foreign subsidiaries may be operating in vastly different
business environments. The subsidiary that is growing and barely showing a profit in an
economy that is in recession is clearly doing better than one that is growing quickly and
is profitable, but in country where the GDP is growing twice as fast as the subsidiary.
CLOSING CASE: Adopting International Accounting Standards
The closing case examines the trend toward a more harmonized international accounting
system. The European Union has been especially active in promoting a more harmonized
system, and now some 65 other countries have also adopted IASB standards. Where
differences in accounting system prevail, comparability across borders is difficult.
Discussion of the case can revolve around the following questions:
QUESTION 1: What are the benefits of adopting international accounting standards for
a) investors and b) for business enterprises?
ANSWER 1: For investors, the adopting of a common set of international accounting
standards is the key to facilitating comparisons of companies across borders. When
companies use different accounting systems, comparisons are difficult. For businesses,
the adopting of international accounting standards can be difficult. Some companies like
Shell, find that their financial situation is not as attractive thanks to differences in the way
financial statements are prepared. Others however, like Vodafone, benefit from the shift.
QUESTION 2: What are the potential risks associated with a move in a nation towards
the adopting of international accounting standards?
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Chapter 19 - Accounting in the International Business
ANSWER 2: There are a number of risks associated with adopting international
accounting standards. Some students will probably point out that in a nation with a
accounting system that tends to overstate the value of a company as compared to the
value IASB standards would indicate, economic difficulties could emerge. Other
students may suggest that a one-size-fits-all approach might benefit some companies, but
harm others. Students making this point might point out that accounting systems have
evolved in each country because of its unique situation, and implementing a common set
of standards could create problems for some companies.
QUESTION 3: In which nation is the move to adoption of IASB standards likely to
cause revisions in the reported financial performance of business enterprises, the United
States or China? Why?
ANSWER 3: Most students will probably suggest that the adoption of IASB standards
would be more difficult for Chinese firms as compared to U.S. firms. While the U.S.
follows the accounting standards set forth by FASB, there has been an effort to mesh
FASB standards with IASB standards.
INTEGRATING iGLOBES
There are several iGLOBE video clips that can be integrated with the material presented
in this chapter. In particular, you might consider the following:
Title: CEO Weighs Consequences of Globalization
Run Time: 11:25
Abstract: This video explores globalization from the perspective of Farooq Kathwari,
CEO of American furniture maker, Ethan Allen.
Key Concepts: globalization, international trade, economic development, offshore
manufacturing, global sourcing, and international standards
Notes: The Ethan Allen furniture company evokes an image of solid, traditional
American values. The company, headquartered in Connecticut, is Vermont’s biggest
employer. Yet, on closer examination, the company could be said to define globalization.
At the helm of Ethan Allen is CEO Farooq Kathwari, an American immigrant who was
born and raised in Kashmir, and educated at New York University. Under the guidance
of Kathwari, who has been president and part owner since 1985, Ethan Allen has become
a truly global corporation. Today, 40 percent of Ethan Allen’s products come from
countries like China, the Philippines, Vietnam, Indonesia, and India.
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Chapter 19 - Accounting in the International Business
Kathwari demonstrates the global nature of Ethan Allen furniture noting that a chair
frame might be made in the United States, while its leather upholstery is cut and sewn in
Mexico. Similarly, the American flag throw pillow decorating the chair is made in
China. Kathwari argues though, that globalization goes beyond simply buying products
more cheaply from low cost countries. He suggests that globalization implies a shrinking
of the world, and a desire by people to do better for themselves. He also claims that
many companies rush the process, and in doing so, fail to consider the long term
implications of moving manufacturing abroad. According to Kathwari, globalization is
actually a conflict comprised of environmental conflicts, trade conflicts, rule of law
conflicts, and expectations conflicts. To resolve these conflicts, Kathwari believes that
international standards should be set governing minimum wages, environmental issues,
heath issues, and so on. He feels that only when there is an effort to help improve
everyone’s lot will these conflicts dissolve.
For its part, to remain a viable competitor in the industry, Ethan Allen has closed 13
American plants, and increased its imports. However, the company, unlike its
competitors, maintains that a domestic manufacturing presence is important. Kathwari
notes that some of the raw materials used in furniture are abundantly available in the
United States, but are actually being imported by South East Asian countries. He
believes that staying close to these resources will be beneficial in the long run. Kathwari
also worries that manufacturing costs could rise in China, and believes that by
maintaining some domestic manufacturing, the company could absorb an increase in
costs. Ethan Allen has also added to its domestic staff, particularly at the management
level.
Discussion Questions:
1. Consider Ethan Allen CEO Farooq Kathwari’s interpretation of globalization. He
notes that for him, globalization means the world has become smaller. What does he
mean by this? Do you agree with his interpretation of globalization? Why or why not?
2. What advantages does Ethan Allen have over its competitors that manufacture all of
their products offshore? Are there any disadvantages to Ethan Allen’s strategy?
3. Ethan Allen CEO Farooq Kathwari has suggested that the conflicts inherent in
globalization should be resolved through the establishment of international standards.
Kathwari argues that by doing so, everyone can share in the benefits of globalization. Do
you agree with him? What problems do you see with his argument?
4. In your opinion, does globalization have a negative impact on the United States?
Would the fact that Ethan Allen still makes some products domestically influence your
furniture purchasing decisions? Why?
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Chapter 19 - Accounting in the International Business
INTEGRATING VIDEOS
There are also several longer video clips that can be integrated with the material
presented in this chapter. In particular, you might consider the following:
Title 3: China Rising Part II: The Boom
Notes: China is considered to be the fastest growing major economy in the world, a
country with more than twice as many people as the U.S. and Europe combined. In cities
like Shanghai and Beijing the landscape is changing virtually overnight. Just twenty
years ago, Shanghai boasted a single skyscraper. Today, the city has over three hundred
skyscrapers. China’s economic boom started in the late 1970s, and since then, the
Chinese economy has doubled every eight years. In contrast, the U.S. economy has
doubled only once over the same time period. Chinese consumers now have ten times the
purchasing power they had just a quarter century ago. If the trend continues, China’s
purchasing power will mirror that of the U.S. in only two decades, and exceed that of the
U.S in thirty years. The growth rate in China’s cities is fueled by the influx of peasants
from the countryside. While some 60 percent of China’s population still farms for a
living, that number is dwindling as 20 million people leave the farm each year in search
of a better life in the city. This large migration leads to new demands for housing adding
to the economic boom.
With Chinese factory workers earning about $1.25 per hour including benefits,
manufacturing is booming too. China’s total trade now exceeds that of Japan, and comes
in second only to that of the U.S. Perhaps more importantly, China is now moving into
higher-tech exports such as computers. To move all of these exports, Shanghai has its
sights set on becoming the world’s largest port within a few years. Shanghai’s ambitious
plans reflect a general sense of economic energy and optimism in China-- an energy and
optimism that manifests itself in the plans of China’s young people to achieve evergreater success.
Discussion Guide:
1. What does China’s extraordinary growth mean to companies in other parts of the
world? How can companies such as Ford or Microsoft capitalize on China’s growth?
What problems does China’s economic growth create for these companies?
2. How does the personal ambition of individuals spur China’s economic boom? The
U.S. has often been considered the land of opportunity. In your opinion does the name
still fit? Does it apply to China? Why or why not?
3. Consider the problems associated with influx of people from rural China to its cities.
How should the Chinese government respond to the situation?
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Chapter 19 - Accounting in the International Business
4. Discuss the trends in China. With its red-hot economy, huge population, and
movement into higher-tech exports, China is becoming a force to be reckoned with.
What will China’s role be in the global economy over the next ten years? In twenty
years?
globalEDGE™ Exercise Questions
Use the globalEDGE™ site {http://globalEDGE.msu.edu/} to complete the following
exercises:
Exercise 1
The globalEDGE™ site offers a “country comparator” tool that allows investigators to
compare countries based on statistical indicators. Utilize this tool to identify in which of
the following countries the historic cost principle of accounting cannot provide accurate
results: Argentina, Bulgaria, Ecuador, Indonesia, Latvia, Malaysia, Mexico, Romania,
Russia, and Senegal. Use the “rank countries” tool to identify other countries in which
the historic cost principle would not provide valid results.
Exercise 2
Deloitte hosts an International Accounting Standards (IAS) webpage called IAS PLUS
that provides information and guidelines regarding accounting procedures approved by
IASC. Locate the website, the section on Standards, and subsequently prepare a short
description of the IAS approach for recording inventory levels.
Answers to the Exercises
Exercise 1
The Country Comparator section is located under the “country insights” and “tools &
games” section of the globalEDGE website. The countries specified in the exercise can
be compared using this tool according to the inflation rate. In countries with high
inflation rates the historic cost principle would not provide accurate results.
Resource Name: “Country Comparator”
Website: {http://globaledge.msu.edu/countryInsights/countryComparator.asp}
globalEDGE™ Location: “Country Insights / Tools & Games”
Exercise 2
The IAS website can be located by searching for the term “IAS Plus” at
{http://globaledge.msu.edu/ResourceDesk/}. The resource is titled “IAS Plus” and is
located under the globalEDGE™ Category “Money: Finance”.
Search Phrase: “IAS Plus”
Resource Name: IAS Plus
Website: {http://www.iasplus.com/}
globalEDGE™ Category: “Money: Finance”
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