Chapter Nineteen Accounting in the International Business

McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Case: Adoption of International Accounting Standards in Germany In Germany, market for debt is expensive; limited possibility for raising additional equity German firms begin to raise equity on international capital markets only in 1990 Major German firms apply for listing on the US Securities and Exchange commission (SEC) SEC was not responsive because German accounting standards were not comparable to those in the US. Not enough information to investors Adhering to generally accepted accounting principles (GAAP) has its positives and negatives

McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Accounting Information and Capital Flows

McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Determinants of National Accounting Standards

McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Relationship Between Business and Providers of Capital Three external sources of capital: -Individual investors Buying shares and bonds -Banks Loan capital -Government Make loans or investment Importance of each varies from country to country

McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Political and Economic Ties With Other Countries Accounting convergence: -Influence of NAFTA -Influence of the former British Empire -Influence of the European Union

McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Inflation Accounting Historic cost principle: -Assumes currency is not losing value to inflation -Most significant impact in the area of asset valuation -Appropriateness varies with inflation Current cost accounting: -Factors out inflation -Used in Great Britain until inflation rate declined

McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. 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

McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Culture Hofstede’s uncertainty avoidance has an impact on accounting systems -Low uncertainty avoidance - these countries tend to have strong independent auditing professions that ensure a firm’s compliance with rules

McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. National and International Standards Diverse accounting practices are enshrined in national accounting and auditing standards Accounting standards: Rules for preparing financial statements Auditing standards: Specify rules for performing an audit

McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Lack of Comparability One result of national differences in auditing and accounting standards is lack of comparability of financial reports With growth of global capital markets both transnational financing and transnational investment have grown Firm has to explain to investors why its financial position looks different in two accountings

McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. International Standards Efforts to harmonize accounting standards across countries Formation of International Accounting Standards Board Members represent 79 countries Responsible for formulating international accounting standards (IAS) Has issued over 30 IAS -Difficult to get requisite votes -Voluntary compliance Recognition is growing

McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Multinational Consolidation and Currency Translation Subsidiaries of multinationals are separate legal entities but not separate economic entities Transactions among members of a corporate family not included in consolidated financial statements. Only assets, liabilities, revenues, and expenses statements with external trade parties are shown Purpose is to provide accounting info about a group of companies that recognizes economic interdependence (subsidiaries) Financial statements of subsidiaries are prepared in the local currency For the consolidated accounts of a multinational, these accounts then have to be converted into currency of multinational’s home country

McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Currency Translation The current rate method: -Exchange rate at the date on the balance sheet 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 of purchase of the asset -Changing exchange rates may mean the balance sheet may not balance!

McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Current US 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 -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 period Firms using multidomestic or international strategies. Firms using global or transnational strategies.

McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Accounting Aspects of Control Systems Annual control process involves three steps: -Head office and sub-unit management jointly determine sub-unit goals for the coming year -Throughout year, head office monitors sub-unit performance against agreed goals -If sub-unit fails to achieve goals, head office intervenes to determine why the shortfall occurred, taking corrective action when appropriate

McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Exchange Rate Combinations in the Control Process

McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Accounting Aspects of 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 International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Transfer Pricing and Control Systems Transfer prices introduce significant distortions into the control process Transfer price must be taken into account when setting budgets and evaluating a subsidiary’s performance

McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Separation of Subsidiary and Manager Performance Valuation of a subsidiary should be separate from the evaluation of the subsidiary manager Manager’s evaluation should take into consideration how hostile or benign the country’s environment is for business and make allowances over items for which the manager has no control, e.g. inflation rates, interest rates, exchange rates

McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Looking Ahead to Chapter 20 Financial Management in the International Business -Investment Decisions -Financing Decisions -Global Money Management: The efficiency Objective -Global Money Management: The Tax Objective -Moving Money Across Borders: Attaining Efficiencies and Reducing Taxes -Techniques for Global Money Management