Chapter 19

Accounting in International Business

Accounting

“The language of business”

Accounting information is the means by which firms communicate their financial position to the providers of capital (investors, creditors and government)

Accounting standards differ from country to country which make it difficult for investors, creditors, and governments to evaluate firms

Accounting Information and Capital Flows

Country Differences in Accounting Standards

Accounting systems in every country has evolved in response to the demands for accounting information

The International Accounting Standards Board (IASB) has made some attempts to establish common accounting and auditing standards across countries

Despite attempts to harmonize standards by developing internationally acceptable accounting conventions, differences between national accounting systems still remain

Country Differences in Accounting Standards

Five Main Variables relationship between business and the providers of

capital

political and economic ties with other countries

level of inflation

level of a country’s economic development

prevailing culture in a country

Country Differences in Accounting Standards

Relationship Between Business and Providers of Capital

Three main external sources of capital for firms are: Individual investors Banks Government

A country’s accounting system tends to reflect the relative importance of each constituency as a provider of capital

Relationship Between Business and Providers of Capital

Accounting systems in:

U.S. and Great Britain are oriented toward individual investors

Switzerland, Germany, and Japan focus on providing information to banks

France and Sweden prepare financial documents with the government in mind

Political and Economic Ties with Other Nations

Similarities in accounting systems of countries may be due to close political and/or economic ties

U.S. accounting system influences the systems in Canada and Mexico

In the European Union, countries are harmonizing their accounting practices

Inflation Accounting

The historic cost principal assumes the currency unit used to report financial results is not losing its value due to inflation

There are no adjustments to sales, purchases, etc at a later date due to inflation

This principle affects asset valuation

If inflation is high, assets will be undervalued

Level Of Development

Developed nations tend to have: large, complex organizations more sophisticated capital markets more sophisticated accounting systems

Many developing nations have accounting systems: that were inherited from former colonial powers

that may not apply to small businesses

Culture

The extent to which a culture is characterized by uncertainty avoidance (extent to which cultures socialize their members to accept ambiguous situations and tolerate uncertainty) impacts the country’s accounting system

Countries with low uncertainty avoidance cultures have strong independent auditing professions

National and International Standards

National and International Standards

Accounting Standards rules for preparing financial statements—they

define useful accounting information

Auditing standards specify the rules for performing an audit technical process by which an independent

person gathers evidence for determining if financial accounts conform to required accounting standards and also reliable

Lack Of Comparability

National differences in accounting and auditing standards limit the comparability of financial reports from one country to another

Growth of transnational financing and transnational investment has been accompanied by the growth of transnational financial reporting

But the lack of comparability between accounting standards in different nations can lead to confusion

International Standards

Substantial efforts have been made recently to harmonize accounting standards across countries

Global capital markets are adding urgency to the issue Common accounting standards will facilitate the

development of global capital markets The International Accounting Standards Board (IASB) is

a major proponent of standardization The IASB currently has 45 standards, but compliance is

voluntary About 100 nations have adopted IASB standards or

permitted their use in reporting financial results

International Standards

International Accounting Standards Board (IASB)

Major proponent of standardization

Currently has 45 standards

Compliance is voluntary

About 100 nations have adopted IASB standards or permitted their use in reporting financial results

International Standards

International Accounting Standards Board (IASB)

Most IASB standards are consistent with standards already in place in the United States

European Union has mandated harmonization of accounting principles in its member countries

By 2010, there could be only two major accounting bodies with substantial influence on global reporting FASB in the United States and IASB elsewhere

Multinational Consolidation and Currency Translation

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 one

Multinational firms typically issue consolidated financial statements for the parent company which includes the merging of subsidiaries

Consolidated Financial Statements Most multinational firms consists of a parent company and a

number of subsidiary companies that are: separate legal entities interdependent economic entities

Consolidated financial statements provide accounting information about a group of companies that recognize the economic interdependence

Transactions among members of a corporate family are not included in consolidated financial statements, only assets, liabilities, revenues, and expenses with external third parties

Since separate legal entities are required to keep their own accounting records, they record transactions with other members of the corporate group in separate statements

Currency Translation Foreign subsidiaries usually keep accounting records

and prepare financial statements in the local currency

Consolidated financial statements require all local financial statements be converted to the home currency

Two methods to determine what exchange rate should be used when translating financial currencies: the current rate method the temporal method

Current Rate Method

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

Incompatible with the historic cost principle and might provide a misleading financial picture

Temporal Method

Translates assets valued in a foreign currency into the home currency using the exchange rate that exists when assets are purchased

Avoids the problems associated with the current rate method

But still problematic because different exchange rates are used to translate foreign assets and the multinational firm’s balance sheet may not balance

Current U.S. Practice

FASB 52 Requirement for US Multinationals

The functional currency is the local currency of each self-sustaining foreign subsidiary

Balance sheets should be translated into the home currency using the exchange rate in effect at the end of the firm’s financial year

Income statements are translated using the average exchange rate for the firm’s financial year

Accounting Aspects of Control Systems

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 management2. the head office monitors subunit performance

throughout the year3. the head office intervenes if the subsidiary fails to

achieve its goal, and takes corrective actions if necessary

Two factors that can complicate the control process exchange rate changes transfer pricing practices

Exchange Rate Changes And Control Systems

Most international firms require all budgets and performance data to be expressed in the “corporate currency” (normally the home currency)

This facilitates comparisons between subsidiaries

However, it also allows exchange rate changes during the year to introduce substantial distortions

Exchange Rate Changes And Control Systems

Lessard-Lorange Model

Firms can use three exchange rates to translate foreign currencies in the corporate currency Initial Rate

spot exchange rate when the budget is adopted Projected Rate

spot exchange rate forecast for the ends of the budget picture

Ending Rate spot exchange rate when the budget and

performance are being compared

Lessard-Lorange Model

Lessard-Lorange Model

Suggests that firms use the projected spot exchange rate (usually the forward exchange rate) to translate budget and performance figures into the corporate currency

Firms can also use the internal forward rate which is the company-generated forecast of future spot rates

Transfer Pricing And Control Systems

Transfer price is the price at which goods and services are transferred within the firm: can significantly influence the performance of

subsidiaries must be considered when evaluating a

subsidiary’s performance

Firms often manipulate transfer prices to: minimize tax liability minimize import duties avoid government restrictions on capital flows

Separation of Subsidiary and Manager Performance

Since foreign subsidiaries do not operate in uniform environments, the evaluation of a:

subsidiary should be kept separate from the evaluation of its manager

manager should consider the country’s environment for business

manager should be in the local currency and allow for the consideration of those items over which they have no control