International Business Fourth Edition CHAPTER 19 Accounting in the International Business 19-3 Chapter Focus Examine the problems arising when an international business with operations in more than one country must produce consolidated financial statements. Look at control (from an accounting perspective) in international business. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 19-4 Accounting Information and Capital Flows $ Resource Users Business Enterprise Resource Providers Providers of Capital (investors, Creditors and Government) Information Users Information Providers Financial Accounting Information McGraw-Hill/Irwin Figure 19.1 © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 19-5 Country Differences in Accounting Standards 5 variables that influence a country’s accounting system: The relationship between business and the providers of capital. The political and economic ties with other countries. The level of inflation. The level of a country’s economic development. The prevailing culture in a country. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 19-6 Determinants of National Accounting Standards Relationship Between Business and Providers of Capital Level of Inflation National Accounting System Political and Economic Ties with Other Countries National Culture Figure 19.2 McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 19-7 Relationship Between Business and Providers of Capital External sources of capital: Individual investors. Buying shares and bonds. Banks. Loan capital. Government. Make loans or investment. McGraw-Hill/Irwin Importance of each varies from country to country © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 19-8 Political and Economic Ties with Other Countries Accounting convergence: Impact of political ties between/among nations. U.S. Influence of NAFTA. U.S. role as Philippine protectorate. Influence of the former British Empire. Influence of the European Union. Probable convergence by 2005. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 19-9 Inflation Accounting Historic cost principle: Assumes currency is not losing value to inflation. Most significant impact = asset valuation. Appropriateness varies with inflation. Current cost accounting: Factors out inflation. Used in Great Britain until inflation rate declined. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 19-10 Level of Development Developed countries have more sophisticated accounting procedures. Accounting problems are more complex. Sophisticated capital markets. Lenders require comprehensive reports. Educated workforce can perform complex accounting functions. Developing countries: Tend to use systems inherited from colonial powers. May not work for small businesses in poorly developed economies. Lack of trained accountants. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 19-11 Culture Hofstede’s uncertainty avoidance has an impact on accounting systems. Refers to the extent to which cultures socialize their members to accept ambiguous situations and tolerate uncertainty. High uncertainty avoidance – countries have strong need for rules and regulations. (Mexico, Japan) Low uncertainty avoidance – Greater readiness to take risks and less emotional resistance to change (U.S., U.K.) These countries tend to have strong independent accounting professions that ensure a firm’s compliance with rules. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 19-12 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. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 19-13 National and International Standards lack of comparability firm reports results in one country to citizens of another fueled by growth transnational transnational financing investment McGraw-Hill/Irwin international standards International Accounting Standards Committee European Union © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 19-14 International Accounting Standards Committee Members represent 79 countries. Responsible for formulating international accounting standards (IAS). Has issued over 40 IAS. Difficult to get requisite votes. Voluntary compliance. Recognition is growing. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 19-15 Multinational Consolidation and Currency Translation Consolidated Financial Statements Currency Translation McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 19-16 Consolidated Financial Statements Consolidated Financial Statements Cash Receivables Payables Revenues Expenses Cash Receivables Payables Revenues Expenses Parent $1,000 3,000* 300 7,000** 2,000 Parent $1,000 3,000 300 7,000 2,000 Foreign Subsidiary $250 *Subsidiary owes Parent $300 900 *Subsidiary pays Parent $1000 500 5,000 in royalties for products licensed from Parent 3,000 Eliminations Foreign Subsidiary $250 900 500* 5,000 3,000** Debit $300 1,000 Credit $300 1,000 Consolidated $1,250 3,600 500 11,000 4,000 *Subsidiary owes Parent $300. **Subsidiary pays Parent $1,000 in royalties for products licensed from Parent. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 19-17 Currency Translation The current rate method: the exchange rate at the balance sheet’s date is used to translate foreign subsidiary financial statements into home country currency. Incompatible with ‘historic cost principle’. The temporal method: translates foreign subsidiary assets into home-country currency at the time the asset is purchased. Changing exchange rates may mean the balance sheet may not balance! McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. U.S. Practice Statement 52 “Foreign Currency Translation” Self-sustaining autonomous subsidiary: Functional currency is local currency. Balance sheet uses exchange rate at end of financial year. 19-18 Firms using multidomestic or international strategies. Income statement is financial year average. Integral subsidiary: Functional currency is US currency. Financial statements use the temporal method. Dangling credit or debit increases or decreases consolidated earnings for the McGraw-Hill/Irwin Firms using global or transnational strategies. period. © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 19-19 The Temporal Method Yen Exchange Rate U.S. Dollars Cash 10,000,000 ($1 =Yen 100) 100,000 Owner’s Equity 10,000,000 ($1 =Yen 100) 100,000 Yen Exchange Rate U.S. Dollars Fixed Assets 5,000,000 ($1=Yen 95) 52,632 Inventory 5,000,000 ($1=Yen90) 55,556 Total 10,000,000 Owner’s Equity 10,000,000 McGraw-Hill/Irwin 108,188 ($1=Yen100) 100,000 © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 19-20 Accounting Aspects of Control Systems Annual control process involves three steps: Head office and suibunit management jointly determine subunit goals for the coming year. Throughout year, head office monitors subunit performance against agreed goals. If subunit fails to achieve goals, head office intervenes to determine why the shortfall occurred, taking corrective action when appropriate. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 19-21 Importance of Financial Criteria Used to Evaluate Performance of Foreign Subsidiaries and Their Managers Item Subsidiary Manager Return on investment (ROI) 1.9 2.2 Return on equity (ROE) Return on assets (ROA) Return on sales (ROS) Residual income Budget compared to actuaL sales Budget compared to actual profit Budget compared to actuaL ROI Budget compared to actual ROA Budget compared to actuaL ROE 3.0 2.3 2.1 3.4 1.9 1.5 2.3 2.7 3.1 3.0 2.3 2.1 3.3 1.7 1.3 2.4 2.5 3.0 Importance of criteria ranked on a scale from 1=very important to 5=unimportant. McGraw-Hill/Irwin Table 19.1 © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 19-22 Exchange Rate Changes and Control Systems Lessard-Lorange Model: Three exchange rates used to translate foreign currency into corporate currency for budget and performance purposes. The initial rate, the spot exchange rate when the budget is adopted. The projected rate,the spot exchange forecast for the end of budget period (I.e., the forward rate) The ending rate, the spot exchange rate when the budget and performance are being compared. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 19-23 Possible Combinations of Exchange Rates in the Control Process Rates Used to Translate Actual Performance for Comparison with Budget Initial (I) Projected (P) Ending (E) (II) Budget at Initial (IE) Actual at Budget at Initial Initial (I) Budget at Initial Actual at Initial Projected Actual at Ending Rates Budget at Used Projected Projected (P) for Actual at Initial Translating Budget at Budget Ending Ending (E) Figure 19.3 McGraw-Hill/Irwin Actual at Initial (PP) (PE) Budget at Projected Budget at Actual at Projected Projected Actual at Ending Budget at Ending (EE) Actual at Budget at Ending Projected Actual at Ending © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 19-24 Transfer Pricing and Control Systems Before Change in Transfer Price After 20% Increase in Transfer Price Revenues per unit $230 $230 Cost of component per unit 100 100 Revenues per unit 100 100 Profit per unit 30 10 McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 19-25 Separation of Subsidiary and Manager Performance Suggested that manager and subsidiary performance be kept separate. Consider how hostile or benign the country’s environment. Evaluation should be in local currency terms. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved.