Chapter 19

Accounting in the International Business

19-2

Introduction

Accounting is the language of business – it is the way firms communicate their financial positions Accounting standards differ from country to countryThese 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

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Introduction

Figure 19.1

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Country Differences In Accounting Standards

A country’s accounting system evolves in response to local demands for accounting informationWhile there have been efforts to harmonize accounting practices across countries, significant differences remainOne 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 challenges to compare financial performance of firms from different countries

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Country Differences In Accounting Standards

Five main variables influence 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. the level of inflation

4. the level of a country’s economic development

5. the prevailing culture in a country

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Country Differences In Accounting Standards

Figure 19.2

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Relationship Between Business And Providers Of Capital

The three main external sources of capital for firms are: Individual investorsBanksGovernment

A country’s accounting system reflects the relative importance of each constituency as a provider of capital So, accounting systems in the U.S. and Great Britain are oriented toward individual investors; Switzerland, Germany, and Japan focus on providing information to banks; and France and Sweden prepare financial documents with the government in mind

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Political And Economic Ties With Other Nations

Similarities in accounting systems across countries can reflect political or economic tiesThe U.S. accounting system influences the systems in Canada and MexicoIn the European Union, countries are moving toward common standards

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Inflation Accounting

The historic cost principal assumes the currency unit used to report financial results is not losing its value due to inflationThis principle affects asset valuationIf inflation is high, assets will be undervalued

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Level Of Development

Developed nations tend to have more sophisticated accounting systems than developing countriesMany developing nations have accounting systems that were inherited from former colonial powers

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Culture

The extent to which a culture is characterized by uncertainty avoidance (the extent to which cultures socialize their members to accept ambiguous situations and tolerate uncertainty) impacts the country’s accounting systemCountries with low uncertainty avoidance cultures have strong independent auditing professions

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National And International Standards

Accounting standards are rules for preparing financial statements—they define useful accounting informationAuditing 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

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Lack Of Comparability

Because of national differences in accounting and auditing standards, comparability of financial reports from one country to another is difficultThe growth of transnational financing and transnational investment is promoting the growth of transnational financial reporting

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International Standards

There has been a substantial effort recently to harmonize accounting standards across countriesMany companies obtain capital from foreign providers who are demanding greater consistencyCommon accounting standards will facilitate the development of global capital marketsThe International Accounting Standards Board (IASB) is a major proponent of standardizationThe IASB currently has 45 standards, but compliance is voluntaryAbout 100 nations have adopted IASB standards or permitted their use in reporting financial results

19-15

International Standards

Most IASB standards are consistent with standards already in place in the United StatesThe European Union has mandated harmonization of accounting principles in its member countriesBy 2010, there could be only two major accounting bodies with substantial influence on global reporting – FASB in the United States and IASB elsewhere

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Multinational Consolidation And Currency Translation

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 oneMultinational firms typically issue consolidated financial statements

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Consolidated Financial Statements

The typical multinational company is made up of a parent company and a number of subsidiary companiesEconomically, all the companies are interdependentThe consolidated financial statement provides accounting information about the group of companiesTransactions among members of a corporate family are not included in consolidated financial statements, however, because separate legal entities are required to keep their own accounting records they record transactions with other members of the corporate family in separate statementsThe IASB requires firms to prepare consolidated financial statements, as do most industrialized nations

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Currency Translation

Foreign subsidiaries usually keep accounting records and prepare financial statements in the local currencyTo 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:

1. the current rate method

2. the temporal method

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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 firmThe current rate method is incompatible with the historic cost principle

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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 purchasedSo, while the temporal method avoids the problems associated with the current rate method, it is still problematic because different exchange rates are used to translate foreign assets

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Current U.S. Practice

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

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Accounting Aspects Of Control Systems

The control process in most firms is usually conducted annually and involves three steps:

1. subunit goals are jointly determined by the head office and subunit management

2. the head office monitors subunit performance throughout the year

3. the head office intervenes if the subsidiary fails to achieve its goal, and takes corrective actions if necessary

Two factors that can complicate the control process are exchange rate changes and transfer pricing practices

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Exchange Rate Changes And Control Systems

Most international firms require budgets and performance data to be expressed in the corporate currency-normally the home currencyWhile this facilitates comparisons between subsidiaries, it can also create distortions in financial statements

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The Lessard-Lorange Model

Donald Lessard and Peter Lorange suggest that firms can deal with the problems of exchange rates and control in three ways:

1. the initial rate - the spot exchange rate when the budget is adopted

2. the projected rate - the spot exchange rate forecast for the ends of the budget picture

3. the ending rate - the spot exchange rate when the budget and performance are being compared

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The Lessard-Lorange Model

Figure 19.3

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The Lessard-Lorange Model

Lorange and Lessard suggest that firms use the projected spot exchange rate (usually the forward exchange rate) to translate budget and performance figures into the corporate currencyFirms can also use the internal forward rate (company-generated forecast of future spot rates)

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Transfer Pricing And Control Systems

The price at which goods and services transferred within the firm is the transfer priceThe choice of transfer price can significantly influence the performance of subsidiaries Transfer prices should be considered when evaluating a subsidiary’s performanceCompanies can manipulate transfer prices to minimize tax liability, minimize import duties, and avoid government restrictions on capital flows

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Separation Of Subsidiary And Manager Performance

The evaluation of a subsidiary should be kept separate from the evaluation of its managerA 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