1. International Business Environments and Operations Global Edition
Part 6
Managing International Operations
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2. Copyright © 2011 Pearson Education
Chapter 18
International Accounting Issues
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3. Copyright © 2011 Pearson Education
Chapter Objectives
To examine the major factors influencing the development of accounting practices in different countries
To examine the global convergence of accounting standards
To explain how companies account for foreign-currency transactions and translate foreign-currency financial statements
To discuss different forms of performance evaluation of foreign operations and how foreign exchange can complicate the budget process
To explain how arbitrary transfer pricing can complicate performance evaluation and control
To introduce the balanced scorecard as an approach to evaluating performance
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4. Crossroads of Accounting and Finance
The accountant is essential in providing information to financial decision makers.
MNEs must learn to cope with differing:
inflation rates
exchange-rate changes
currency controls
expropriation risks
customs duties
tax rates and methods of determining taxable income
levels of sophistication of local accounting personnel
local and home-country reporting requirements
The accounting and finance functions are closely related. Each relies on the other to fulfill its own responsibilities. The chief financial officer (CFO) of any company is responsible for procuring and managing the company’s financial resources. This individual is usually one of the members of the top management team of a company. The CFO relies on the controller, or chief accountant, to provide the right information for making decisions.
The controller of an international company must be concerned about a range of issues dealing with corporate strategy broader than just accounting issues.
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5. Accounting for International Differences
Accounting Objectives
Factors in International Accounting Practices
Cultural Differences in Accounting
Classifying Accounting Systems
International Standards and Global Convergence
The International Accounting Standards Board
Both the form and the content of financial statements are different in different countries.
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6. Accounting Objectives
Identify, record, and interpret economic events
The Financial Accounting Standards Board (FASB)
The International Accounting Standards Board (IASB)
Who uses accounting information?
The Financial Accounting Standards Board (FASB) sets accounting standards in the United States.
The International Accounting Standards Board (IASB) is an international private-sector organization that sets accounting standards.
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7. Who Uses Accounting Information?
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8. Factors Influencing International Accounting Practices
Although all of the factors shown in the figure are significant, their importance varies by country. For example, investors are influential in the United States and the United Kingdom, but creditors—primarily banks—have traditionally been more influential in Germany and Switzerland. Taxation has a big influence on accounting standards and practices in Japan and France, but it is less important in the United States. Cultural issues cut across all countries and strongly influence the development of accounting. Certain international factors also have weight, such as former colonial influence and foreign investment. For example, most countries that are current or former members of the British Commonwealth have accounting systems similar to the United Kingdom’s.
These differences in accounting influences have resulted in differences in accounting standards and practices. However, the major development in accounting worldwide is now the issue of convergence, which implies that, through negotiations between the IASB and national standards setters (such as the FASB in the United States), we are moving closer to having the International Financial Reporting Standards (IFRS) of the IASB as the one set of accounting standards that can be used in capital markets.
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9. Cultural Differences in Accounting
Culture influences measurement and disclosure practices:
Measurement—how to value assets
Disclosure—the presentation of information and discussion of results
Much of the work on culture and accounting is initially based on Hofstede’s research on the structural elements of culture, particularly those that most strongly affect behavior in the work situations of organizations and institutions.
Hofstede’s work was then extended into the accounting area by Gray, which resulted in classifying countries according to disclosure and measurement principles, specifically secrecy/transparency and optimism/conservatism.
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10. Disclosure/Assessment Matrix for National Accounting Systems
Depicts the accounting practices of various groupings of countries within a matrix of the cultural values of secrecy–transparency and optimism–conservatism. With respect to accounting, secrecy and transparency indicate the degree to which companies disclose information to the public. Countries such as Germany, Switzerland, and Japan tend to have less disclosure (illustrating the cultural value of secrecy) than do the United States and the United Kingdom (Anglo-American countries, which are more transparent or open with respect to disclosure).
Optimism and conservatism (in an accounting, not a political, sense) are the degree of caution companies exhibit in valuing assets and recognizing income—an illustration of the measurement issues mentioned earlier. Countries more conservative from an accounting point of view tend to understate assets and income, whereas optimistic countries tend to be more liberal in their recognition of income.
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11. Classifying Accounting Systems
From Macro-Uniform to Micro Based Systems
Strong versus Weak Equity Markets
Differences in Financial Statements
Language
Currency
Type of statements
Financial statement format
Extent of footnote disclosures
Underlying GAAP on which the financial statements are based
Macro-uniform accounting systems are shaped more by government influence, whereas micro-based systems rely on pragmatic business practice.
Micro-based systems include features that support pragmatic business practice and have evolved from the British system. The United States is an example of a country that fits in the micro category. It exhibits more optimism and transparency than countries in the macro category, and it also relies less on legal and tax requirements than Germany, France, and Japan.
Countries can be distinguished between those with strong and weak equity market and shareholder orientations.
Major Reporting Issues:
Language: English tends to be the first choice of companies choosing to raise capital abroad. Many companies also provide a significant amount of information on their home pages on the Internet in different languages.
Currency: A second issue in classifying systems is currency. Companies around the world prepare their financial statements in different currencies. Daimler presents its financial statements in euros. Ericsson presents its financial statements in Swedish kronor. Intel presents its financial statements in U.S. dollars.
Statements-Type/Format/Footnote Disclosures: Financial-statement format is not a big issue, but it can be confusing for a manager to read a balance sheet prepared in an analytical format when the manager is used to seeing it in the balance format. A major area of difference is the use of footnotes. Footnote disclosures in the United States tend to be the most comprehensive in the world.
GAAP Usage: A major hurdle in raising capital in different countries is dealing with widely varying accounting and disclosure requirements. Although this problem is decreasing as more stock exchanges and countries allow the use of International Financial Reporting Standards, some countries care more about those differences than others. In addition, most countries may apply one set of accounting standards for consolidated groups, whereas they use another set for the individual companies in the group.
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12. Reporting Differences
Major approaches to dealing with accounting and reporting differences:
• Mutual recognition
• Reconciliation to local GAAP
• Recasting of financial statements in terms of local GAAP
Before the rise in importance of global capital markets, it was common for most countries to apply the principle of mutual recognition. That means that a regulator, such as the German stock exchange, would accept financial statements provided in the GAAP of a foreign issuer, such as U.S. GAAP by a U.S. company wanting to list securities in Germany. The second approach is reconciliation, where a company can list American Depositary Receipts on a U.S. exchange and then reconcile its home-country GAAP with U.S. GAAP in a special statement called Form 20-F on net income and shareholders’ equity.
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13. International Standards and Global Convergence
Major forces leading to convergence:
Investor orientation
Global integration of capital markets
MNEs’ need for foreign capital
Regional political and economic harmonization
MNEs’ desire to reduce accounting and reporting costs
Convergence efforts of standards-setting bodies
Convergence is the process of bringing different national Generally Accepted Accounting Principles (GAAP) into line with International Financial Reporting Standards (IFRS) issued by the IASB.
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14. International Accounting Standards Board
The relationship between the FASB and IASB
The European Response to Convergence
Convergence and Mutual Recognition
In March 2001, the IASC was reorganized into the International Accounting Standards Committee Foundation and the International Accounting Standards Board. The new IASCF is the parent entity of the IASB, which assumed the major standards-setting functions of the old IASC. Trustees for the IASC foundation search for and appoint members of the IASB. The trustees come from countries all over the world, although the developing countries had
not been as represented as the developed countries earlier on. However, of the 22 trustees in place as of August 2009, four were from Brazil, India, China, and Poland. The trustees serve for three years.
The IASB is attempting to harmonize accounting standards through issuing International Financial Reporting Standards (IFRS).
FASB and IASB are trying to converge their standards through a variety of different activities.
In 2002, the FASB and the IASB reached the Norwalk Agreement. In this agreement, the two boards pledged to use their best efforts to achieve several goals:
1. “To make their existing financial reporting standards fully compatible as soon as is practicable; and
2. To coordinate their future work programmes to ensure that once achieved, compatibility is maintained.”
The process to convergence takes several forms. Initially, the two boards identified standards that could easily be converged. Now that the FASB and the IASB have joint projects to establish new standards, they are trying to eliminate existing differences in standards in a short-term convergence project for standards that should be easy to converge, and the FASB is explicitly considering the impact of IFRS on every standard it sets.
Some standards are more complicated to converge, and they are part of a long-term convergence process.
The EU has adopted most IFRS as written, but they “carved out” or suspended the standard on financial instruments due largely to political pressure from French banks, which has been a problem. The fear is that the EU could end up with its own version of IFRS, resulting from political pressures rather than sound accounting judgment. The convergence process has been very unsettling to some Europeans, especially the French, because they feel the close cooperation of the two boards is making the new IFRS suspiciously similar to standards issued by the FASB.
The move to convergence adds an interesting twist to mutual recognition. Today’s version of mutual recognition in the United States is that foreign issuers are allowed to list securities using IFRS without reconciliation to U.S. GAAP. However, mutual recognition does not extend to companies that generate financial statements in their home-country GAAP. They are still required to issue Form 20-F. Recently, representatives of the SEC and the U.S.
Treasury have made statements that support the mutual recognition of IFRS in the United States. However, two things have changed the landscape for convergence. The first is the global economic crisis, which diverted attention away from convergence to trying to resolve the credit crisis and the global recession. The second is the election of U.S. president Barack Obama and the selection of a new SEC chairman, Mary Schapiro, who is less inclined to pursue the Roadmap to convergence than her predecessor.
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15. Transactions in Foreign Currencies
Recording Transactions
Correct Procedures for U.S. Companies
When a company operates outside the domestic market, it must concern itself with the proper recording and subsequent accounting of assets, liabilities, revenues, and expenses that are measured or denominated in foreign currencies.
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.
The FASB requires that U.S. companies report foreign currency transactions at the original spot exchange rate and that subsequent gains and losses on foreign-currency receivables or payables be put on the income statement. The same procedure must be followed according to IFRS.
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16. Translating Foreign Currency Financial Statements
Translation Methods
Temporal Method: applies when the parent’s reporting currency is the functional currency.
Current Rate Method: applies when the local currency is the functional currency.
Translation—the process of restating foreign-currency financial statements.
Consolidation—the process of combining the translated financial statements of a parent and its subsidiaries into one set of financial statements.
Translation in the United States is a two-step process:
1. Companies recast foreign-currency financial statements into statements consistent with U.S. GAAP.
2. Companies translate all foreign-currency amounts into U.S. dollars.
With the current-rate method, the translation gain or loss is recognized in comprehensive income rather than net income, and therefore it goes to owners’ equity. With the temporal method, the translation gain or loss is recognized on the income statement.
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17. Managing Accounting Issues
Performance, Evaluation, and Control
Transfer Pricing and Performance Evaluation
The Balanced Scorecard
Different measures are used to evaluate performance of foreign operations, including ROI, sales, cost reduction, quality targets, market share, profitability, and budget to actual.
There are many different ways that firms can translate the budget from the local currency into the parent currency and then monitor actual performance.
Three different exchange rates are used:
1. The actual exchange rate in effect when the budget was established
2. The rate that was projected at the time the budget was established in the local currency
3. The actual exchange rate in effect when the budgeted period takes place
When using a budget, management must select a currency to set the budget and a currency to evaluate performance.
The most widely used approaches to translate budgets and compare with performance use forecasts of the exchange rate.
The use of a forecast rate for setting budgets is by far the preferred approach. A forecast is usually made by the
economists in the corporate treasury or in consultation with banks. If the budget process is centralized, corporate treasury probably consults its lead money center bank or a couple of banks to get a consensus forecast of exchange rates. If the process is decentralized, the local operations probably consult one or more local banks for a consensus forecast of exchange rates.
Hedging Strategies: The company may use a hedge rate instead of a forecast rate for setting budgets. Assume, for example, that a U.S.-based MNE decides to hedge its future balance sheet and income statement in Brazil by entering into forward contracts. Because management knows the forward rate, it could set its budget at the forward rate instead of a forecast rate from a bank. The variance would be the difference between the forward rate and the future spot rate.
Transfer pricing refers to prices on intra-company transfers of goods, services, and capital. One of the important reasons for arbitrarily establishing transfer prices is taxation. However, taxation is only one of a number of reasons why internal transfers may be priced with little consideration for market prices or production costs. Companies may underprice goods sold to foreign affiliates so the affiliates can then sell them at prices that their local competitors cannot match. If tough antidumping laws exist on final products in the affiliate country, a company could underprice components and semifinished products to its affiliates. The affiliates could then assemble or finish the final product at prices that would have been classified as dumping prices had they been imported directly into the country rather than produced domestically.
High transfer prices might be used to circumvent or significantly lessen the impact of national controls. A government prohibition on dividend remittances could restrict a firm’s ability to maneuver income out of a country. However, overpricing the goods shipped to a subsidiary in such a country would make it possible for funds to be taken out.
The concept of the balanced scorecard (BSC) is another approach to performance measurement increasingly being used by companies, especially in the United States and Europe. This approach endeavors to link more closely the strategic and financial perspectives of a business and takes a broad view of business performance.
The BSC provides a framework for looking at the strategies giving rise to value creation from the following perspectives:
1. Financial—growth, profitability, and risk from the perspective of shareholders
2. Customer—value and differentiation from the customer perspective
3. Internal business processes—the priorities for various business processes that create customer and shareholder satisfaction
4. Learning and growth—the priorities to create a climate supporting organizational change, innovation, and growth
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18. Copyright © 2011 Pearson Education
Corporate Governance
External Control Mechanism: The Legal System
Internal Control Mechanisms
An important external mechanism in corporate governance is the legal system. Countries like the United States have a very litigious environment that allows people to sue company management. Countries with a strong legal tradition, such as most developing countries, must have corporate governance practices put into law to ensure that companies will follow the best practices.
Many countries, especially developing countries, have an underdeveloped and poorly functioning legal system that pays scant attention to corporate governance. Other countries have moved forward to institute corporate governance legislation. Internal mechanisms refer to the management and ownership structure of the firm as well as the role of the board of directors in overseeing the operations of the firm. Large U.S.-based MNEs rely on the stock market as a major source of financing. Thus the firm’s corporate governance system has to take into account how it protects investors and discloses information to the public.
Firms in developing countries tend to be family-controlled, with family members in key management positions and occupying important positions on the boards of directors. This is a major problem that led to Parmalat’s fraud. Voting rights for stocks tend to be in the hands of family members instead of outside investors. Thus the rights of minority owners are not protected very much in the absence of legal requirements. Firms from developing countries that list on foreign stock exchanges, however, have to conform more to corporate governance practices in the developed countries.
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19. Future: Will IFRS Become the Global Accounting Standard?
IFRS is modeled after capital market orientation of U.K. and U.S.
More companies are choosing to list on the European stock markets
Sarbanes-Oxley Act 2002
IFRS has a lot going for it, and its proponents are working hard to ensure that it is accepted around the world.
They’re appealing to the Europeans, because they have a lot of influence in the development of the standards, and the IFRS are free of regulation by the U.S. SEC.
At some point, it’s possible that the United States will simply adopt IFRS, but that is not likely in the near future. The major vote in favor of U.S. GAAP is that half of the world’s stock market capitalization is located in the United States, and companies that want access to U.S. capital must play by U.S. rules.
As European stock markets continue to increase in importance, more European companies are choosing to list in Europe instead of the United States. In 2009, about 40 percent of the Global 500 companies listed according to U.S. GAAP, about the same percentage used IFRS, and 20 percent listed in their home markets using home country GAAP. An additional complication to combining or converging IFRS and U.S. GAAP is the Sarbanes-Oxley
Act of This act requires companies to establish solid internal controls over financial reporting, limits the types of services that may be performed by primary auditors in addition to the financial-statement audit, and requires the managers of publicly traded companies to assess internal controls and make a statement on this assessment, which must be examined and opined on by external auditors. All of these requirements add additional costs to
those already related to complying with U.S. GAAP. Although perhaps good for companies in the long term, as companies must establish effective controls over financial reporting, the initial costs of complying with the Sarbanes-Oxley Act of 2002 may be too great for some firms to consider listing on U.S. exchanges.
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