Magnum Corporation

1. Magnum Corporation • Auto parts manufacturer headquartered in USA • Produces and sells rearview mirrors to automakers in USA • Raw materials and machinery and equipment purchased from suppliers located across the USA • Finished products sold to US automakers • Loans obtained from US banks • Common stock sold on NYSE • All business activities carried out in US dollars • Financial reporting in compliance with US Generally Accepted Accounting Principles (GAAP) • Taxes paid to US federal government and state governments

2. Sales to Foreign Customers • In 1980’s, one of Magnum’s major customer, Normal Motors Inc., acquired production facility in UK • Normal asked Magnum to supplies the UK facility (NMUK) with rearview mirrors • Most feasible means of supplying NMUK was to manufacture mirrors in USA and then ship them to the UK • Normal requires Magnum to invoice NMUK in British pound sterling (£) • Magnum must keep its records in US $ • Exposes Magnum to foreign currency exchange risk (fluctuations in £ versus $ between time of sales transaction and collection of foreign currency from NMUK) • First shipment of mirrors to NMUK was invoiced at £100,000 with credit terms of 2/10, net 30

3. Sales to Foreign Customers • Exchange rate between £ and US$ at time of transaction was £1 = US$1.60 • Magnum records $160,000 accounts receivable (£100,000 * $1.60/£) from NMUK • When NMUK pays its account in 30 days, the value of the £ had fallen to £1 = US$1.50 • £100,000 collected from NMUK by Magnum was converted into $150,000 (£100,000 * $1.50/£) • Results in foreign currency transaction loss of $10,000($160,000 – 150,000)

4. Foreign Currency Exchange Risk • Magnum can manage or hedge their exposure to foreign currency exchange risk by engaging in a forward exchange contract with a foreign currency trader on date of sale to sell £ to the foreign currency trader on the date the £100,000 are collected from NMUK • Assume a 30 day forward exchange contract on the date of sale could be purchased for £1 = US$1.55 • £100,000 collected from NMUK by Magnum will be delivered to foreign currency trader • Foreign currency trader will give Magnum $155,000 (£100,000 * $1.55/£) • Without forward exchange contract, Magnum would have received $150,000 • Therefore, by purchasing the forward exchange contract, only has a foreign currency transaction loss of $5,000 ($160,000 – 155,000) instead of a $10,000 loss ($160,000 – 150,000)

5. Foreign Direct Investment • Magnum soon discovered that foreign sales were a good way to grow revenues and, with good management of foreign currency exchange risk, would allow the company to earn adequate profit • Over time, Magnum became known throughout Europe for its quality products • Magnum entered into negotiations with and eventually landed supplier contracts with several European automakers, filling orders through export sales from its factory in the US • Because of increased shipping costs and its European customers desire to move toward just-in-time inventory systems, Magnum began investigating investment in a production facility somewhere in Europe

6. Foreign Direct Investment • Magnum could establish a manufacturing presence in Europe by either purchasing an existing mirror manufacturer or constructing a brand new plant • In early 1990s, Magnum identified a company in Portugal (Espelho Lida) as a potential acquisition candidate • To assist in determining a fair price to offer for Espelho, Magnum needed to analyze the financial statements for Espelho for the last 5 years • Espelho’s financial statements had been prepared in accordance with Portuguese accounting rules (GAAP) that were much different from the accounting rules that Mangum’s managers were familiar with (US GAAP) • Espelho’s balance sheet did not provide a clear picture of the company’s assets and many liabilities appeared to be kept off-balance-sheet • Footnote disclosure was limited and cash flow information was not provided

7. Foreign Direct Investment • To adequately incorporate tax effects into the analysis, Magnum’s management had to learn about the Portuguese income tax system and the taxes and restrictions imposed on dividend payments made to foreign parent companies • Magnum determined that purchase of Espelho would satisfy its European production needs and also generate an adequate ROI • Magnum acquired all of Espelho’s outstanding common stock and continued to operate Espelho as a Portuguese corporation or wholly-owned subsidiary

8. Financial Reporting for Foreign Operations • As a publicly traded company in US, Magnum required to prepare financial statements that combine or consolidate the assets, liabilities, equity and income of the parent and all of the companies (subsidiaries) in which Magnum holds a controlling interest. • These consolidated financial statements must be in US $ and prepared in accordance with US GAAP • Financial statements of Espelho (a Portuguese corporation) are in euros and prepared in accordance with Portuguese GAAP • First, Espelho’s financial statements must be restated to US GAAP • Second, they must be translated into US $

9. International Income Taxes • Existence of foreign subsidiary raises two kinds of questions regarding income taxes: • What are income taxes that Espelho has to pay in Portugal and how can those taxes legally be minimized? • What are the taxes, if any, that Magnum has to pay in the US related to the income earned by Espelho in Portugal and how can those taxes be legally minimized? • Magnum wants to minimize total amount of taxes paid worldwide to maximize its net income and after-tax cash flows • Magnum must have expertise in tax systems in each of countries in which it operates • Every country has unique set of accounting rules (GAAP) and unique set of tax regulations

10. International Transfer Pricing • Companies with foreign operations attempt to minimize worldwide taxes paid through use of discretionary transfer pricing • Auto mirrors consist of three major components: mirrored glass, a plastic housing, and a steel bracket • Injection-molding machinery for producing plastic housing is expensive and Espelho does not own such equipment • Plastic housings are produced by Magnum in US and shipped to Espelho as an intercompany sale • Magnum must establish prices for these intercompany transfers • Transfer price generates sales revenue for Magnum and cost of goods sold for Espelho • Since income tax rate is higher in Portugal than US, parts should be sold to Espelho at as high a price as possible • Transferring parts to Portugal at high prices shifts gross income to US that would otherwise be earned in Portugal • Reduces total taxes paid to both countries

11. Performance Evaluation of Foreign Operations • To ensure that operations in both US and Portugal are achieving their objectives, Magnum top management requests managers to submit periodic reports to headquarters detailing their unit’s performance • US headquarters is interested in evaluating the performance of the operating units as well as the individuals responsible for managing those units • Process used for evaluating US operations is not directly transferable in evaluating the performance of Espelho • Several issues unique to foreign operations must be considered in designing the evalaution system for Espelho: • Whether to evaluate Espelho’s performance on the basis of euros or US $ (translation from one currency to another can effect ROI) • Whether reported results should be adjusted to factor out those items over which Espelho’s managers had no control (foreign currency exchange risk and transfer pricing)

12. International Auditing • In addition to performance evaluation, another important component of the management control process is internal auditing • Internal auditor must: • Make sure company’s policies and procedures are being followed • Uncover errors, inefficiencies, and fraud • Several issues that make internal audit of foreign operation more difficult than domestic audits: • Ability to communicate with Espelho’s managers and employees • Local culture and customs • External auditor encounter same problems plus • Expertise in various sets of accounting rules (GAAP) • Expertise in various sets of auditing standards (GAAS)

13. Cross-Listing on Foreign Stock Exchanges • Magnum’s investment in Portugal turned out to be extremely profitable and over time the company established operations in other countries around the world • By the beginning of 21st century, Magnum had become a true multinational corporation with more than 10,000 employees in 16 different countries • Magnum decided that in addition to listing its stock on the NYSE that they would list their stock on several foreign stock exchanges • Most stock exchanges require registered companies to file an annual report and specify the accounting rules (GAAP) that must be followed in preparing this annual report • Many foreign stock exchanges allow foreign companies to use accounting rules developed by the International Accounting Standards Board (IASB) called International Financial Reporting Standards (IFRS) • Magnum determined that by preparing second set of financial statements in accordance with IFRS, it could gain access to most of the stock exchanges in the world