International Business
by
Daniels and Radebaugh
Chapter 19
Multinational
Accounting and Tax
Functions
© 2001 Prentice Hall
19-1
Objectives
To examine the major factors influencing the development of
accounting practices in different countries and the worldwide
harmonization of accounting principles
To explain how companies account for foreign-currency transactions
and translate foreign-currency financial statements
To describe the impact of accounting methods on the evaluation of
foreign operations
To investigate the U.S. taxation of foreign-source income
To examine some of the major non–U.S. tax practices and to show how
international tax treaties can alleviate some of the impact of double
taxation
© 2001 Prentice Hall
19-2
Introduction
Accounting and finance functions are closely related
• Financial manager—responsible for procuring and managing
financial resources
– relies on accountants to provide financial information
– flow of assets across national boundaries complicates both
functions
• Controller—collects and analyzes data for internal and external
uses
– must be concerned about different currencies and accounting
systems
– engaged in many activities associated with international
business
– foreign managers and subsidiaries usually evaluated based
on data provided by controller
© 2001 Prentice Hall
19-3
Accounting in International Business
OPERATIONS
EXTERNAL INFLUENCES
OBJECTIVES
PHYSICAL AND
SOCIETAL FACTORS
STRATEGY
MEANS
COMPETITIVE
ENVIRONMENT
Modes
© 2001 Prentice Hall
Overlaying
Alternatives
Functions
• Marketing
• Exporting and importing
• Global manufacturing
• Supply chain
management
• ACCOUNTING
• Finance
• Human resources
19-4
Factors influencing the development of accounting
around the world
Both the form and substance of financial statements are different in
different countries
• Statements differ in format—relatively minor matter
• Terms differ
– companies can measure assets and determine income
differently in different countries
• Some companies present only consolidated financial statements
– others present separate statements for parent and
subsidiaries
© 2001 Prentice Hall
19-5
Accounting Objectives
Accounting—provides quantitative information about economic entities
for making economic decisions
Financial Accounting Standards Board (FASB)—sets accounting
standards in the U.S.
• Financial reporting provides information for:
– investment and credit decisions
– assessment of cash flow prospects
– evaluation of enterprise resources, claims to those
resources, and changes in them
International Accounting Standards Committee (IASC)—private sector
group that sets accounting standards
Users have different foci
• Creditors—focus on the balance sheet
• Investors—focus on the income statement
Generally accepted accounting principles (GAAP)—local standards that
must be followed by companies when preparing financial statements
© 2001 Prentice Hall
19-6
Environmental Influences on Accounting Practices
Other external
users
Nature of the
enterprise
Enterprise
users
Development of
Accounting
Objectives,
Standards, and
Practices
Accounting
profession
International
influences
Characteristics of
the local environment
Academic
influences
© 2001 Prentice Hall
Government
19-7
Cultural Differences in Accounting
Culture influences:
• Measurement—how companies value assets
• Disclosure—how and what information companies provide in
reports for external users of financial data
Countries differ with respect to:
• Secrecy and transparency—indicate the degree to which
companies disclose information to the public
• Optimism and conservatism—degree of caution companies
exhibit in valuing assets and recognizing income
• Countries moving toward greater optimism and transparency
– reflects influence of capital markets that require disclosures
consistent with Anglo-Saxon model
© 2001 Prentice Hall
19-8
Cultural Differences in Measurement and
Disclosure in Accounting Systems
Secrecy
Less public disclosure
Less developed
Latin
Germanic
Near Eastern
Japan
Less developed
Asian More developed
Latin
African
Transparency
Asian
colonial
Nordic
Anglo-Saxon
Optimism
Conservatism
Greater caution in assessment
© 2001 Prentice Hall
19-9
Cultural Differences in Accounting (cont.)
Classification of accounting systems—group systems according to
common characteristics
Macrouniform systems—shaped by governmental influence
• Strong legal systems
• Tax law
• Tend to be more conservative and secretive
Microbased systems—support pragmatic business practice
• Exhibit more optimism and transparency
• Rely less on legal and tax requirements
Accounting for IB more complex and costly
• Financial statements differ across countries
- language
- currency
- statement type
-financial statement format
-extent of footnote disclosure
-underlying GAAP
© 2001 Prentice Hall
19-10
Classification of Accounting Systems of Developed
Western Countries
Class
Subclass
Family
Government,
economics
Macro-uniform
Sweden
Law-based
Continental:
government,
tax legal
Developed
Western
Countries
Pragmatic
business practices,
British origin
Microbased
Business
economics, theory
© 2001 Prentice Hall
Species
Tax-based
United Statesinfluenced
United Kingdominfluenced
Japan
Germany
Spain
Belgium
France
Italy
Canada
United States
Ireland
United Kingdom
New Zealand
Australia
Netherlands
19-11
Harmonization of Differences in Accounting Standards
Major forces leading to harmonization
• Investor orientation
• Global integration of capital markets
• MNEs’ needs for foreign capital
• Regional political and economic harmonization
• Desire to reduce accounting and reporting costs
EU—harmonizing accounting to promote the free flow of capital
• Has identified the:
– type and format of financial statements
– measurement bases for financial statements
– importance of consolidated financial statements
• Improved the comparability of financial statements
© 2001 Prentice Hall
19-12
Harmonization of Differences in Accounting Standards
(cont.)
International Accounting Standards Committee (IASC)
• Comprises 143 professional accounting organizations from 104
countries
• Has worked toward harmonizing standards
• Standards endorsed by the International Organization of
Securities Commissions (IOSCO)
• U.S. GAAP standards are dominant in the world
– challenge IASC standards
International Accounting Standards (IAS)
• Convergence increasing among national standards and IASs
© 2001 Prentice Hall
19-13
Transactions in Foreign Currencies
Recording of transactions—importer must keep track of transactions
when it trades its own currency for that of the exporter to make
payment
• Foreign-currency receivables and payables give rise to gains and
losses whenever the exchange rate changes
• Transaction gains and losses must be included in the income
statement in the accounting period in which they arise
Correct procedures for U.S. companies
• Spelled out in Financial Accounting Standards Board (FASB)
Statement No. 52
• FASB requires U.S. firms to report foreign-currency transactions
at the original spot exchange rate and to record subsequent gains
and losses for foreign-currency receivables (or payables) on the
income statement
• Procedures vary in other countries
© 2001 Prentice Hall
19-14
Translation of Foreign-Currency Financial Statements
Translation—process of restating foreign-currency financial statements
into a common currency
Consolidation—process of combining the financial statements of a
parent and its subsidiaries
Translation methods—firm chooses the method most appropriate for a
particular foreign subsidiary
• Functional currency—the currency of the primary economic
environment in which the firm operates
• Current-rate method—selected if functional currency is the local
currency
– firms translate all assets and liabilities at the current
exchange rate
• Temporal method—functional currency is that of the parent
company
– only monetary assets and liabilities are translated at the
current exchange rate
© 2001 Prentice Hall
19-15
Selection of Translation Method
Functional
currency
Local
currency
Reporting currency
of parent
Current-rate
method
Temporal
method
© 2001 Prentice Hall
19-16
Balance Sheet, December 31, 1999
TEMPORAL METHOD
CURRENT-RATE METHOD
POUNDS
RATE
DOLLARS
RATE
DOLLARS
Cash
Accounts receivable
Inventories
Fixed assets
Accumulated dep.
Total
20,000
40,000
40,000
100,000
(20,000)
180,000
1.6980
1.6980
1.5606
1.5000
1.5000
33,960
67,920
62,424
150,000
(30,000)
284,304
1.6980
1.6980
1.6980
1.6980
1.6980
33,960
67,920
67,920
169,800
(33,960)
305,640
Accounts payable
Long-term debt
Capital stock
Retained earnings
Accum. trans. adj.
Total
30,000
44,000
60,000
46,000
_____
180,000
1.6980
1.6980
1.5000
*
50,940
74,712
90,000
68,652
______
284,304
1.6980
1.6980
1.5000
*
50,940
74,712
90,000
77,481
12,507
305,640
© 2001 Prentice Hall
19-17
Income Statement, 1999
TEMPORAL METHOD
POUNDS RATE DOLLARS
Sales
Expenses
CGS
Depreciation
Other
Taxes
RATE
DOLLARS
230,000
1.5617
359,191
1.5617
359,191
(110,000)
(10,000)
(80,000)
(6,000)
24,000
1.5600
1.5000
1.5617
1.5617
(171,600)
(15,000)
(124,936)
(9,370)
8,285
(9,633)
1.5617
1.5617
1.5617
1.5617
(171,787)
(15,617)
(124,936)
(9,370)
37,481
Transl. gain (Loss)
Net income
CURRENT-RATE METHOD
24,000
28,562
© 2001 Prentice Hall
37,481
19-18
Translation of Foreign-Currency Financial Statements
(cont.)
Disclosure of foreign-exchange gains and losses
• Current-rate method—translation gain or loss is recognized in
owner’s equity
• Temporal method—translation gain or loss is recognized in the
income statement
Environmental reports
Identify the impact of the company on the environment
• Reports not required
– vary substantially from company to company and from
country to country
• Focus on the use of natural resources and efforts to recycle
waste
© 2001 Prentice Hall
19-19
Taxation
Exports of goods and services
• Foreign sales corporation (FSC)—used to shelter some of its
export income from taxation
– qualifications to become an FSC include:
» maintain a foreign office
» operate under foreign management
» keep a permanent set of books at foreign office
» conduct foreign economic processes
» be a foreign corporation
– a portion of the income of foreign corporations that qualify as
FSCs is exempt from U.S. corporate income tax
Foreign branch—extension of the parent company
• Income is directly included in the parent’s taxable income
© 2001 Prentice Hall
19-20
Taxation (cont.)
Foreign subsidiary—a foreign corporation established in a country as an
independent legal entity
• Subsidiary—a foreign corporation purchased or established by an
MNE
• Income is taxable to the parent or tax deferred
– tax deferred income—not taxed until it is remitted to the
parent company as a dividend
• Controlled foreign corporation (CFC)—foreign corporation of
which more than 50% of its voting stock is held by U.S.
shareholders
– CFC income classified as either:
» active income—derived from the direct conduct of a
trade or business
» passive income—usually derived from operations in a
tax-haven country
• Tax haven—country with low or no taxes on foreign-source
income
© 2001 Prentice Hall
19-21
A Tax-Haven Subsidiary as a Holding Company
Parent Company in
the United States
Tax-Haven
Subsidiary
Grandchild
Subsidiary
Grandchild
Subsidiary
© 2001 Prentice Hall
Grandchild
Subsidiary
19-22
Taxation (cont.)
Transfer price—price on goods and services sold by one member of a
corporate family to another
• Price is arbitrary due to:
– differences in taxation between countries
– competitive reasons
– restrictions on currency flows
• Arbitrary pricing makes evaluating subsidiary and management
performance difficult
• Arm’s-length price—price between two companies that do not
have ownership interest in each other
Tax credit—dollar-for-dollar reduction of tax liability by the amount of
foreign tax already paid
• Must coincide with the recognition of income
• Intended to avoid double taxation
© 2001 Prentice Hall
19-23
A Tax-Haven Subsidiary as a Holding Company
U.S. Stockholder
(parent company)
Foreign Corporation
(non-CFC)
Income is taxable to the
parent when declared as
a dividend, regardless
of whether the income
is active or Subpart F.
Deferral applies
CFC
Active income is
tax-deferred
Foreign Branch
All income is taxable to
the parent when earned
by the branch
Subpart F. income is
taxable to the parent
when earned by the CFC
© 2001 Prentice Hall
19-24
Taxation (cont.)
Taxation of U.S. citizens abroad
• Governments treat overseas compensation in a variety of ways
• U.S. policy has changed over the years
– U.S. citizens working abroad can exclude $74,000 of their
income from U.S. taxation and can claim a housing exclusion
for housing expenses in excess of a base amount
determined by the Internal Revenue Service
© 2001 Prentice Hall
19-25
Non–U.S. Tax Practices
Differences in tax practices around the world cause problems for MNEs
• Different GAAPs lead to differences in the determination of
taxable income
• Taxation of corporate income differs
– separate entity approach—each separate unit is taxed when
it earns income
» results in double taxation
– integrated system—tries to avoid double taxation of
corporate income through split tax rates or tax credits
Value-added tax (VAT)—each independent company is taxed only on the
value it adds at each stage in the production process
• EU is narrowing differences among members’ VAT practices
© 2001 Prentice Hall
19-26
Non–U.S. Tax Practices (cont.)
Tax treaties—intended to prevent international double taxation or to
provide remedies when it occurs
• Several similar treaties and protocols were signed between the
U.S. and foreign countries
Planning the Tax Function
Taxes are a consideration in MNEs’ investment decisions
• Branches or foreign subsidiaries typically are used to establish a
foreign operation
– if losses are expected at the start, branch is the advisable
form
» parent can deduct branch losses against parent income
– as operation becomes profitable, subsidiary form is advisable
» tax deferral applies to subsidiary income
© 2001 Prentice Hall
19-27