Fourth Edition

1. International Business Fourth Edition

2. CHAPTER 19 Accounting in the International Business

3. Chapter Focus • Examine the problems arising when an international business with operations in more than one country must produce consolidated financial statements. • Look at control (from an accounting perspective) in international business.

4. $ Resource Users Resource Providers Providers of Capital (investors, Creditors and Government) Business Enterprise Information Users Information Providers Financial Accounting Information Accounting Information and Capital Flows Figure 19.1

5. Country Differences in Accounting Standards • 5 variables that influence a country’s accounting system: • The relationship between business and the providers of capital. • The 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.

6. Political and Economic Ties with Other Countries Relationship Between Business and Providers of Capital National Accounting System Level of Economic Development Level of Inflation National Culture Determinants of National Accounting Standards Figure 19.2

7. Relationship Between Business and Providers of Capital • 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

8. Political and Economic Ties with Other Countries • Accounting convergence: • Impact of political ties between/among nations. • U.S. • Influence of NAFTA. • U.S. role as Philippine protectorate. • Influence of the former British Empire. • Influence of the European Union. • Probable convergence by 2005.

9. Inflation Accounting • Historic cost principle: • Assumes currency is not losing value to inflation. • Most significant impact = asset valuation. • Appropriateness varies with inflation. • Current cost accounting: • Factors out inflation. • Used in Great Britain until inflation rate declined.

10. 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. • Developing countries: • Tend to use systems inherited from colonial powers. • May not work for small businesses in poorly developed economies. • Lack of trained accountants.

11. Culture • Hofstede’s uncertainty avoidance has an impact on accounting systems. • Refers to the extent to which cultures socialize their members to accept ambiguous situations and tolerate uncertainty. • High uncertainty avoidance – countries have strong need for rules and regulations. (Mexico, Japan) • Low uncertainty avoidance – Greater readiness to take risks and less emotional resistance to change (U.S., U.K.) • These countries tend to have strong independent accounting professions that ensure a firm’s compliance with rules.

12. British-American-Dutch Group Europe-Japan Group Firms raise capital from investors. Accounting systems designed to inform investors Have close ties to banks. Accounting practices meet bank’s needs. South American Group Countries have experienced persistent and rapid inflation. Accounting principles reflect the inflation. Accounting Clusters

13. National and International Standards international standards lack of comparability firm reports results in one country to citizens of another International Accounting Standards Committee fueled by growth European Union transnational financing transnational investment

14. International Accounting Standards Committee • Members represent 79 countries. • Responsible for formulating international accounting standards (IAS). • Has issued over 40 IAS. • Difficult to get requisite votes. • Voluntary compliance. • Recognition is growing.

15. Multinational Consolidation and Currency Translation Consolidated Financial Statements Currency Translation

16. Consolidated Financial Statements Parent Foreign Subsidiary Cash $1,000 $250 *Subsidiary owes Parent $300 Receivables 3,000* 900 *Subsidiary pays Parent $1000 in royalties for products licensed from Parent Expenses 2,000 3,000 Eliminations Parent Foreign Subsidiary Debit Credit Consolidated Cash $1,000 $250 $1,250 Receivables 3,000 900 $300 3,600 Payables 300 500* $300 500 Expenses 2,000 3,000** 1,000 4,000 *Subsidiary owes Parent $300. **Subsidiary pays Parent $1,000 in royalties for products licensed from Parent. Consolidated Financial Statements Payables 300 500 Revenues 7,000** 5,000 Revenues 7,000 5,000 1,000 11,000

17. Currency Translation • Thecurrent rate method: the exchange rate at the balance sheet’s date 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 the asset is purchased. • Changing exchange rates may mean the balance sheet may not balance!

18. U.S. Practice Firms using multidomestic or international strategies. • 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 global or transnational strategies.

19. The Temporal Method

20. Accounting Aspects of Control Systems • Annual control process involves three steps: • Head office and suibunit management jointly determine subunit goals for the coming year. • Throughout year, head office monitors subunit performance against agreed goals. • If subunit fails to achieve goals, head office intervenes to determine why the shortfall occurred, taking corrective action when appropriate.

21. Item Subsidiary Manager Return on investment (ROI) 1.9 2.2 Return on equity (ROE) 3.0 3.0 Return on assets (ROA) 2.3 2.3 Return on sales (ROS) 2.1 2.1 Residual income 3.4 3.3 Budget compared to actuaL sales 1.9 1.7 Budget compared to actual profit 1.5 1.3 Budget compared to actuaL ROI 2.3 2.4 Budget compared to actual ROA 2.7 2.5 Budget compared to actuaL ROE 3.1 3.0 Importance of criteria ranked on a scale from 1=very important to 5=unimportant. Importance of Financial Criteria Used to Evaluate Performance of Foreign Subsidiaries and Their Managers Table 19.1

22. Exchange Rate Changes and 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.

23. Rates Used to Translate Actual Performance for Comparison with Budget Initial (I) Projected (P) Ending (E) (II) Budget at Initial Actual at Initial Budget at Initial Actual at Projected (IE) Budget at Initial Actual at Ending Initial (I) Rates Used for Translating Budget Budget at Projected Actual at Initial (PP) Budget at Projected Actual at Projected (PE) Budget at Projected Actual at Ending Projected (P) Budget at Ending Actual at Initial Budget at Ending Actual at Projected (EE) Budget at Ending Actual at Ending Ending (E) Possible Combinations of Exchange Rates in the Control Process Figure 19.3

24. Before Change in Transfer Price After 20% Increase in Transfer Price Revenues per unit $230 $230 Cost of component per unit 100 100 Revenues per unit 100 100 Profit per unit 30 10 Transfer Pricing and Control Systems

25. Separation of Subsidiary and Manager Performance • Suggested that manager and subsidiary performance be kept separate. • Consider how hostile or benign the country’s environment. • Evaluation should be in local currency terms.