1. International Business 8e
By Charles W.L. Hill
Welcome to International Business, Eighth Edition, by Charles W.L. Hill.

2. Accounting in the International Business
Chapter 19
Accounting in
the International Business
Chapter 19: Accounting in International Business
McGraw-Hill/Irwin
Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

3. What Is Accounting?
Accounting is the language of business – it is the way firms communicate their financial positions
Accounting is more complex for international firms because of differences in accounting standards from country to country
differences make it difficult for investors, creditors, and governments to evaluate firms
The International Accounting Standards Board (IASB) has made some attempts to establish common accounting and auditing standards across countries
Accounting is sometimes referred to as “the language of business.”
It’s the way firms communicate their financial position to investors, to banks, and to governments.
When it comes to accounting and international business, things get a little complicated mainly because each country has its own accounting standards. So, for example, the way profit and loss statements, balance sheets, and so on are created varies by country making it difficult to compare the financial performance of companies across countries.
The International Accounting Standards Board, or IASB as it’s known, has made some headway in creating common international accounting standards, but it still has a long way to go.
We’ll talk more about the IASB later, but first, let’s look at some country differences in accounting standards.

4. How Is Accounting Information Used?
Accounting Information and Capital Flows
Here you can see the process of communicating financial information via the accounting function.

5. Why Do Countries Use Different Accounting Systems?
A country’s accounting system evolves in response to local demands for accounting information
One study found that among 22 countries, there were 76 ways to assess the cost of goods sold, 65 differences in the calculation of return on assets, and 20 ways to calculate net profits
The differences make it challenging to compare financial performance of firms from different countries
While there have been efforts to harmonize accounting practices across countries, significant differences remain
Why do countries use different accounting systems? Well, the answer to that question lies with how accounting standards evolve.
The accounting standards followed in a country have been developed in response to demand for certain types of information.
So, just as every country has its own culture, political system, and economic system. Each country has its own accounting system.
As we said earlier, there have been efforts to harmonize accounting practices across countries, but a recent study illustrated just how little has been accomplished.
The study found that among 22 countries, there were 76 differences in the way costs of goods sold were assessed, 65 differences in the assessment of return on assets, and 20 differences in the way net profits were calculated!
Why are these differences important? They’re important because they make comparisons of the financial performance of companies from different countries difficult!

6. What Determines National Accounting Standards?
Five main variables influence the development of a country’s accounting system
The relationship between business and the providers of capital
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
There are five main variables that affect the development of a country’s accounting system:
1. the relationship between business and the providers of capital
2. political and economic ties with other countries
3. A country’s level of inflation
4. the level of a country’s economic development
5. the prevailing culture in a country
Let’s talk about each variable and how it influences accounting.

7. What Determines National Accounting Standards?
Determinants of National Accounting Standards
Here you can see the five variables that influence the development of a county’s accounting system.

8. How Do Providers Of Capital Influence Accounting?
The three main external sources of capital for firms are
individual investors
banks
government
A country’s accounting system reflects the relative importance of each constituency as a provider of capital
accounting systems in the 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
When we look at the relationship between business and providers of capital, we need to consider three sources of capital—individual investors, banks, and government.
In developed countries, all three are usually important.
In the U.S. for example, firms can raise capital by selling stocks and bonds to individual investors, borrowing from banks, and sometimes the government.
How important each source of capital is varies by country, and is reflected in the country’s accounting system.
In the U.S., individual investors are the key source of capital and so the country’s accounting system has evolved to reflect that.
In contrast, banks are a more important source of capital in Japan, and so the accounting system is Japan has been developed with banks in mind.
French companies often obtain loans from the government and so France’s accounting system is oriented towards the government.

9. How Do Political And Economic Ties Influence Accounting?
Similarities in accounting systems across countries can reflect political or economic ties
the U.S. accounting system influences the systems in Canada and Mexico
in the European Union, countries are moving toward common standards
the British system of accounting is used by many former colonies
Some countries have similar accounting systems because the countries have close economic or political ties.
The U.S. accounting system, for example, has influenced the accounting systems in both Canada and Mexico.
Similarly, the European Union countries are moving towards common standards.
Many former colonies of Great Britain use an accounting system based on the British system.

10. How Does Inflation Influence Accounting?
The historic cost principal assumes the currency unit used to report financial results is not losing its value due to inflation
affects asset valuation
if inflation is high, assets will be undervalued
The third factor that affects the development of a country’s accounting system is how inflation is treated.
Many countries like the U.S., Germany, and Japan follow the historic cost principle which assumes the currency unit used to report financial results is not losing value due to inflation.
So, firms record sales, purchases, and so on at the original transaction price and make no adjustments to the price later.
Consequently, when inflation is high, the value of assets is underestimated.
Why is this important?
Well, it means that the depreciation charged on the assets may be inadequate to replace the assets when they wear out or become obsolete.

11. How Do Levels of Development Influence Accounting?
Developed nations tend to have more sophisticated accounting systems than developing countries
larger, more complex firms create accounting challenges
providers of capital require detailed reports
Many developing nations have accounting systems that were inherited from former colonial powers
lack of trained accountants
The fourth factor affecting the development of accounting practices is a country’s level of development.
Developed countries tend to have more sophisticated accounting systems than developing economies.
In developed countries, the more sophisticated systems have evolved in response to the growth in capital markets.
Developed countries have legions of well-educated accountants and other financial specialists who can perform complex accounting functions.
In contrast, developing countries often have a shortage of well-qualified accountants and usually follow an accounting system that was inherited from a former colonial power.

12. How Does Culture Influence Accounting?
Uncertainty avoidance - the 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
Finally, a nation’s culture influences the development of its accounting system.
Recall our discussion in Chapter 3 of Hofstede’s cultural dimensions. One dimension was uncertainty avoidance — the extent to which cultures socialize their members to accept ambiguous situations and tolerate uncertainty.
Countries with low uncertainty avoidance like the U.S. and Britain, are more willing to take risks, so it makes sense that they also have strong independent auditing professions.
Countries like Japan and Mexico have high uncertainty avoidance and a strong need for rules and regulations.

13. What Are Accounting And Auditing Standards?
Accounting standards are rules for preparing financial statements
they define useful accounting information
Auditing standards specify the rules for performing an audit
the technical process by which an independent person gathers evidence for determining if financial accounts conform to required accounting standards and if they are also reliable
It is difficult to compare financial reports from country to country because of national differences in accounting and auditing standards
Each country’s accounting system is organized into accounting standards and auditing standards.
Accounting standards are the rules for preparing financial statements—they define useful accounting information.
Auditing standards specify the rules for performing an audit—the technical process by which an independent person gathers evidence for determining if financial accounts conform to required accounting standards and if they are also reliable.

14. Why Are International Accounting Standards Important?
The growth of transnational financing and transnational investment has created a need for transnational financial reporting
many companies obtain capital from foreign providers who are demanding greater consistency
The International Accounting Standards Board (IASB) is a major proponent of standardization of accounting standards
common accounting standards will facilitate the development of global capital markets
most IASB standards are consistent with standards already in place in the United States
Historically, the national differences in accounting and auditing standards has made comparability across nations a challenge.
Today, we see some movement towards more common standards.
Why? Well, over the last twenty years, global capital markets have developed along with transnational financing and transnational investment.
Both of these have created a need for transnational financial reporting.
However, because of differences in accounting standards between nations, confusion still exists. You can learn more about some of the challenges in the Management Focus on The Consequences Of Different Accounting Standards in your text.
Who is demanding greater consistency in accounting standards across countries?
Certainly foreign providers of capital would like to see greater consistency in financial reporting. If there’s greater consistency, it’ll be much easier for the capital providers to make informed investment decisions.
As we said earlier, the International Accounting Standards Board, or IASB, is leading the way to harmonize accounting standards.

15. Why Are International Accounting Standards Important?
About 100 nations have adopted IASB standards or permitted their use in reporting financial results
the EU has mandated harmonization of accounting principles for members
By 2010, there could be only two major accounting bodies with substantial influence on global reporting – FASB in the United States and IASB elsewhere
The IASB, which replaced the International Accounting Standards Committee, has issued a number of international accounting standards. However, while about 100 nations have adopted these standards or permitted their use in financial reporting, compliance with the IASB standards is voluntary.
U.S. companies, for example, still follow the standards set by the Financial Accounting Standards Board, or FASB, though its standards are consistent with IASB standards.
The European Union has committed to standardizing accounting standards for its members. As part of this commitment, The European Union has required that publicly listed companies be in accordance with IASB standards.
It’s expected that by 2010, the only two bodies with substantial influence on international accounting standards will be the IASB and FASB.
To see what this means to companies like Switzerland’s CIBA , go to the Management Focus in your text.

16. What Is A Consolidated Financial Statement?
A 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 really one
used by multinational firms
Transactions among members of a corporate family are not included in consolidated financial statements
they are recorded in separate statements
The IASB requires firms to prepare consolidated financial statements, as do most industrialized nations
Now, let’s move on to talk about how multinationals prepare their financial statements.
Most multinationals are comprised of a parent firm and several subsidiaries.
Usually, multinationals issue consolidated financial statements which combine the separate financial statements of two or more companies to yield a single set of financial statements as if the individual companies were really one. So, a consolidated financial statement provides accounting information about the group of companies rather than the individual subunits.
Transactions among members of the corporate family are not included in consolidated financial statement, however, so each subunit is required to maintain two sets of records – one that includes internal transfers and one that doesn’t.
The IASB and most industrialized countries require consolidated financial statements.

17. How Do MNCs Handle Currency Translation?
Foreign subsidiaries usually keep accounting records and prepare financial statements in the local currency
To prepare consolidated financial statements, all local financial statements must be converted to the home currency
There are two methods to determine what exchange rate should be used when translating financial statement currencies
The current rate method
The temporal method
Which currency do firms keep their records in?
Usually, foreign subsidiaries keep accounting records and prepare financial statements in the local currency. To prepare the consolidated financial statement, local statements are converted to the home currency.
Ho do firms choose which exchange rate to use when they translate documents?
There are two methods – the current rate method and the temporal method.
Let’s look more closely at each one.

18. What Is The Current Rate Method?
Under the current rate method, the 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
can present a misleading picture of the financial situation
method is incompatible with the historic cost principle
Under the current rate method, the 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.
So, this rate is incompatible with the historic cost principle.

19. What is The Temporal Method?
The 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
is still problematic because different exchange rates are used to translate foreign assets
Firms can avoid the problems associated with the current rate method by using the temporal method.
The temporal method translates assets valued in a foreign currency into the home currency using the exchange rate that exists when assets are purchased.
Keep in mind that this method can still be problematic because different exchange rates are used to translate foreign assets potentially causing in-balances in the balance sheet!

20. What System Do U.S. Firms Use?
U.S. multinationals are required to follow FASB 52 which states
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
What do U.S. companies do?
Currently, U.S. companies are required to follow FASB 52 which states that the functional currency is the local currency of each self-sustaining foreign subsidiary, that balance sheets should be translated into the home currency using the exchange rate in effect at the end of the firm’s financial year, and that income statements are translated using the average exchange rate for the firm’s financial year.

21. How Does Accounting Influence Control Systems?
The control process in most firms is usually conducted annually and involves three steps
Subunit goals are jointly determined by the head office and subunit management
The head office monitors subunit performance throughout the year
The head office intervenes if the subsidiary fails to achieve its goal, and takes corrective actions if necessary
Now, let’s look at the accounting aspects of control systems.
Recall that headquarters is responsible for to controlling subunits and making sure that they achieve the best possible performance.
To do this, firms follow three steps.
First, subunit goals are jointly determined by the head office and subunit management.
Next, the head office monitors subunit performance throughout the year.
Finally, the head office intervenes if the subsidiary fails to achieve its goal, and takes corrective actions if necessary.
What might complicate the control process?
Well, two factors - exchange rates changes and transfer pricing – can affect the control process.
Let’s look at each one beginning with exchange rate changes.

22. How Do Exchange Rates Influence Control?
Budgets and performance data are usually expressed in the corporate currency-normally the home currency
facilitates comparisons between subsidiaries
but, can create distortions in financial statements
Donald Lessard and Peter Lorange - firms can deal with the problems of exchange rates and control in three ways
The initial rate - the spot exchange rate when the budget is adopted
The projected rate - the spot exchange rate forecast for the end of the budget picture
The ending rate - the spot exchange rate when the budget and performance are being compared
Most multinationals require that budgets and performance data be expressed in the corporate currency –which is usually the same as the home currency.
Keep in mind that while this facilitates comparisons between subsidiaries, it can lead to substantial distortions in financial statements. Two researchers, Donald Lessard and Peter Lorange, devised a possible solution to the problem.
They suggest three possible exchange rates:
First, the initial rate, which is the spot exchange rate when the budget is adopted.
Second, the projected rate, which is the spot exchange rate forecast for the ends of the budget picture.
Finally, the ending rate, which is the spot exchange rate when the budget and performance are being compared.
Which rate is best?
Out of the possible combinations, Lorange and Lessard suggest when translating budget and performance figures into the corporate currency, firms should use the projected spot exchange rate, which is usually the forward rate, or the internal forward rate, which is just some other company-generated forecast of future spot rates.

23. What Is The Lessard-Lorange Model?
Possible Combinations of Exchange Rates in the Control Process
Here you can see the three exchange rates, and their possible combinations.

24. How Does Transfer Pricing Influence Control?
The price at which goods and services are transferred within the firm is the transfer price
Transfer prices can be manipulated to
minimize tax liability
minimize import duties
avoid government restrictions on capital flows
The second factor to consider from a control perspective is transfer prices.
The transfer price is the price at which goods and services are transferred within the firm.
Why are transfer prices important?
They’re important because the choice of transfer price can significantly affect the performance of subsidiaries. For example, if a firm internally raises prices, the profits in the unit that’s “buying” will fall.
So, it’s important to consider the effect of transfer prices when subsidiary performance is evaluated.
Keep in mind that by carefully manipulating transfer prices, firms can minimize tax liability, minimize import duties, and avoid government restrictions on capital flows.
We’ll talk more about this in the next chapter.

25. Why Separate Subsidiary and Managerial Performance?
Subsidiaries operate in different environments which influence profitability
So, the evaluation of a subsidiary should be kept separate from the evaluation of its manager
A manager’s evaluation should consider the country’s environment for business, and should take place after making allowances for those items over which managers have no control
Finally, many accountants suggest that firms need to keep the evaluation of a subsidiary separate from the evaluation of its manager.
Why?
Well, because foreign subsidiaries don’t operate in uniform environments—and depending on the type of environment, the cost of doing business at a given subsidiary can differ substantially.
How should managers be evaluated?
Many accounts suggest that managers should be evaluated in local currency terms, and that they should only be evaluated after making allowances for things like interest rate and tax rates over which they have no control.

26. Review Question _______ has an accounting system that was
developed with the government in mind.
a) France
b) Japan
c) Great Britain
d) Germany
Now, let’s see how well you understand the material in this chapter. I’ll ask you a few questions. See if you can get them right. Ready?
_______ has an accounting system that was developed with the government in mind.
a) France
b) Japan
c) Great Britain
d) Germany
The answer is a.

27. Review Question Which organization is responsible for formulating
international accounting standards?
the Global Federation of Accountants
the World Bank
the International Accounting Standards Board
the International Panel of Accounting Standards and Ethics
Which organization is responsible for formulating international accounting standards?
a) the Global Federation of Accountants
b) the World Bank
c) the International Accounting Standards Board
d) the International Panel of Accounting Standards and Ethics
The answer is c.

28. Review Question By 2010, which two accounting bodies are expected
to dominate accounting practices?
a) The historic cost principle and FSAB
b) FSAB and the IASB
c) The IASB and the historic cost principle
d) The current rate method and the historic cost principle
By 2010, which two accounting bodies are expected to dominate accounting practices?
a) The historic cost principle and FSAB
b) FSAB and the IASB
c) The IASB and the historic cost principle
d) The current rate method and the historic cost principle
The answer is b.

29. Review Question When a firm uses the exchange rate at the
balance sheet date to translate financial statements
of a foreign subsidiary into the home currency, the
firm is using
a) the temporal method
b) the current rate method
c) FASB 52
d) the historic cost principle
When a firm uses the exchange rate at the balance sheet date to translate financial statements of a foreign subsidiary into the home currency, the firm is using
a) the temporal method
b) the current rate method
c) FASB 52
d) the historic cost principle
The answer is b.

30. Review Question Financial statements of U.S. firms must be
prepared according to
a) FASB
b) IASB
c) IFAC
d) EUAC
Financial statements of U.S. firms must be prepared according to
a) FASB
b) IASB
c) IFAC
d) EUAC
The answer is a.