Chapter 19 Accounting in International Business

“The language of 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

FASB 52 Requirement for US Multinationals 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 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 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