CHAPTER 18
1 International Accounting and Financial Management
2 Learning Objectives
LO18-1 Identify the major international accounting issues that international firms face,
operating in foreign currencies.
LO18-2 Describe the relationship between accounting and culture
LO18-3 Describe the international accounting standards’ convergence process and its im–
portance to international firms.
LO18-4 Outline the arguments for and against 3BL
LO18-5 Explain the capital structure choices open to international firms and their signifi-
cance.
LO18-6 Describe why ICs move funds.
LO18-7 Explain the utility of an international finance center
LO18-8 Describe multilateral netting and its benefits
LO18-9 Categorize foreign exchange risks faced by the international firm into transaction
exposure, translation exposure, and economic exposure.
LO18-10 Describe ways to hedge transaction exposure
NOTE:
International business statistics, data, and facts about countries, regions, governments, and companies can
change rapidly and dramatically. We recommend that you update this information regularly and on an
as-needed basis to present your students with timely data reflecting current global events. Also, we may
include additional information for you to use as you see fit.
As an adopter of this text, McGraw-Hill Irwin offers you a complementary online resource each month,
the International Business Newsletter. The IB Newsletter gives you an array of timely and relevant
articles, videos, country profiles, teaching suggestions, and data resources to add breadth, depth, and
richness to the ever–changing topic of international business.
3 Overview
Accounting is a fundamental tool of financial management. Because accounting practices and standards
vary across national borders, we examine these differences and the move toward convergence of
standards in international accounting. We use the U.S. MNC for the sake of simplicity, remembering that
MNCs can be any nationality and increasingly are headquartered in emerging market economies such as
India and China.
After accounting, we move into how the company’s capital is structured, then to cash
management, including techniques such as multilateral netting and approaches to managing
currency fluctuations.
The lack of a global currency creates foreign exchange risk for international companies. International
businesses have contracts, investments, assets and liabilities in more than one currency, many of which
fluctuate in terms of each other. It is this fluctuation that causes risk. Due to this risk the companies may
gain or lose depending on what currencies they hold.
Finance and accounting managers have tools to help mitigate various risks associated with transaction or
translation risk. Some of the tools available to management include hedging, exposure netting price
adjustment, balance sheet neutralizing, and swaps.
Management must manage currency risk while making investment decisions and decisions regarding the
acquisition of capital. Financial management must determine what currency to use, the relative strength
or weakness of that currency, whether to use equity or debt, sources of capital, where to source capital,
how much money and for how long and if there are other capital sources like governmental program or
joint ventures. The other financial management issue that has direct impact on the financial
management of the firm is taxation.
4 Suggestions and Comments
1. The topics covered in this chapter tend to unnerve students who lack confidence in their
quantitative skills. To address this issue, you might focus on the logic and goals of the specific
techniques and from there move to application.
2. From an international perspective, accounting is in a state of flux. By focusing on this situation,
you can help your students understand that globalization class for new ways of thinking and
collaborating.
3. Illustrate a transaction loss with an example of an obligation of an American importer to pay a
Finnish exporter five million Finnish markka (Fm) in 180 days. Assume the exchange rate on the
date of sale to be Fm 8 = US$ 1. Show the financial result if the rate changes during the 180 days to
Fm9 = US$1 or to Fm 7 = US$ 1.
4. Explain that importers and exporters usually do not want to bear currency exchange risks but that
others are in the business of doing so. Banks or currency market makers or traders take such risks.
5. Show how the importers and exporters can use hedging and other devices to avoid currency
exchange risks.
6. Illustrate how currency rate changes can affect a firm’s profit and loss statement. When assets and
liabilities or payables and receivables within an IC group of companies are denominated in
different currencies, during consolidation, they must all be translated to a single currency, usually
that of the home country where the IC parent company is located. This is referred to as the
translations risk.
5
6 Student Involvement Exercises
1. When a DC based IC has a subsidiary in a country which imposes currency exchange controls, the
subsidiary may not be able to remit its profits to the parent. Have your students make a list of uses
to which that trapped money may be put. Reinvestment, barter, participation in local money
markets are all possibilities, among others.
2. Have students research of the various capital markets of the world, the differences, advantages and
disadvantages of each. Have them track market movements for two weeks and report on factors
that may have caused these changes. Have students discuss the question, “Do changes in one mark
affect the others? Why or why not?”
7 Guest Lecturers
1. International department officers of banks could speak on hedges and swaps, also on the role of
banks as capital sources for ICs.
2. Accountants may be found to speak on translation risks and other international accounting issues.
3. Someone from the financial department from a company that faces transaction risks should be
interesting.
4. The same sort of person might speak on decisions involved in capital sourcing.
8 Lecture Outline
I. International Accounting
Globally, accounting provides financial data for management decision making and quantitative data
to external constituents for informed decisions. Governments use accounting data to levy taxes. The
local practice of accounting is culturally-based.
A. Accounting and Foreign Currency: Two occurrences that impact accounting:
1. Transactions in foreign currencies, such as sales, purchases, and loans
2. Consolidation of international branch and subsidiary results into parent company financial
reports. GAPP used in U.S.
a. If functional currency is that of host country, the current rate method is used
b. If functional currency is that of parent company’s country, the temporal rate is used.
c. Temporal rate translates non-current assets (capital equipment, for example, and real estate)
at their historic costs.
3. Choice of translation method depends on the functional currency of the operation. See Fig.
18.1.
B. Accounting and Culture: Two dimensions. See Fig 18.2
1. Secrecy-transparency
2. Optimism-conservatism
C. Convergence of Accounting Standards:
1. Cross-listing – MNCs listing of their stock on various foreign exchanges
2. Two bodies:
a. Financial Accounting Standards Board (FASB) — used in U.S. (GAAP)
b. International Accounting Standards Board (IASB) — used in most other countries
International Financial Reporting Standards (IFRS)
3. GAAP relies on rules and regulations; IFRS relies on principles based on social obligation
4. Convergence is underway, but progress has been slow.
D. Triple Bottom Line Accounting (3BL)
1. Effort to capture measurement of business impact on social performance and effects on
environment
2. Can social performance and environmental impact be measured in ways parallel to those that
give us an economic measure of the firm?
II. International Financial Management
Major issues include firm’s capital structure, cash flow management across borders, monitoring
financial flows, and FX risk management.
III. Capital Structure of the Firm
There are three ways firms can source their capital:
A. Retained earnings
B. Equity
1. Foreign markets create a broader investment pool.
2. Shares parallel to ADRs (American Depository Receipt) in foreign exchanges.
C. Debt (leveraging)
1. Growing tendency for subsidiaries to tap their local markets first
2. Bonds or loans?
3. Off-shore financial centers have few banking regulations and low taxes
D. Decisions related to raising capital
1. What ration of debt to equity is best?
2. What currency should it be in?
3. What sources of capital are available? Many choices: loan, swap, public offering
4. Which markets will provide lowest cost?
5. Are there other sources available? JV, private capital?
6. How much capital and for how long?
IV. Cash Flow Management
International cash flow management differs significantly from domestic cash flow management.
Risks include FX movements, interest rates, inflation, government regulation, and taxes.
A. Why Funds are Moved
1. Reasons: dividends, royalties, fees, and transfer pricing
2. Techniques: Fronting loan, transfer pricing
B. International Financial Center
1. Complexity of global financing causes ICs to pay increased attention to financial
management and creating the international finance center:
Floating FX rates
Growth in capital and FX markets
Inflation rates
E-cash management
Innovative idle cash management
Derivatives
2. Centralization of financial management allows moves from service to profit center
3. Profit made by monitoring and leveraging risks
C. Multilateral Netting – Fig. 18.4
1. Subsidiaries transfer net cash flows through a clearing center
2. Savings on transaction costs and foreign exchange costs
D. Leading and Lagging
1. Timing payments to take advantage of anticipated currency movements
a. lead approach is used to collect funds when currency is expected to weaken and fund
payables when currency is expected to strengthen
b. lag approach is used to collect receivables late when currency is expected to
strengthen and fund payables when currency is expected to weaken
2. Allows IC to maneuver when blocked funds are anticipated
V. Foreign Exchange Risk Management
A. Transaction Exposure
In any transaction which involves payment or receipt in the future of a foreign currency, there
is a transaction risk that the foreign currency’s value against the home currency will change.
The party that bears the risk can protect itself in several ways. Exposure netting hedges
transaction exposure.
1. Hedging currency occurs in forward market, options market, and money market.
2. Examples:
a. The forward market hedge involves a contract for a future exchange at a specified
rate. Usually the hedger is a bank, who bears all the risk, for a fee.
b. The currency option hedge is similar to a forward hedge, but it is an optional
contract; it does not need to be exercised. The option writer assumes the currency
exchange risk for which it charges a fee. If the party at risk does not exercise the
option but lets it lapse, it bought and paid for protection which it turned out not to
need.
c. The money market hedge involves borrowing and lending simultaneously in the
domestic and foreign money markets. Here essentially exposure is neutralized by
matching a liability with an asset.
d. Swap contracts are used to hedge foreign currency exposure.
B. Translation Exposure – problems due to currency exchange rates
1. Translation risks involve longer term exposures arising from investment in different
countries. In ICs, they are realized when foreign earnings are consolidated to the IC.
a. Foreign earnings are usually stated in foreign currencies and those currencies will
fluctuate in value, becoming stronger or weaker, buying more or less home-country
currency.
b. The fixed investments in other countries (stocks, bonds, land, or buildings) have
values expressed in the currencies of those countries. All those assets and
accompanying liabilities, payables and receivables must be expressed in the currency
of the home country in order to be comprehensible to bankers and other creditors,
stockholders and government regulators of the home country. All those numbers must
be translated from the “foreign” currencies to the home country currency.
2. To minimize translation-caused profit/loss swings, management can:
a. Neutralize the balance sheet by trying to equalize assets and liabilities in each
currency in which the firm does business.
b. Use parallel loans or swaps, described earlier
c. Many ICs do not hedge translation exposure, because doing so can increase
transaction exposure.
C. Economic Exposure
1. The potential for the value of future cash flows to be affected by unanticipated exchange
rate movements.
2. Its management draws on hedging and swap contracts and a portfolio approach to foreign
markets
3. Operating exposure is exposure of cash flow to currency fluctuations.
VI. Taxation: Important impact on IC tax exposure
A. Three types of taxes:
1. Income tax, paid by earner
2. Value-Added Tax (VAT)—tax on value added along the value chain
3. Withholding tax, paid by payer typically on passive income
B. Tax implications for U.S. ICs
1. Foreign branches are taxed as if they were in the U.S.
2. Subsidiaries are of two types:
a. Minority Company (<50% ownership)
b. Controlled Foreign Corporation (CFC) (>50% ownership)
3. Subsidiary tax implications:
a. Minority Company is taxed only when income is remitted to parent company
b. CFCs active income is taxed when repatriated
c. CFCs passive income (royalties, dividends) is taxed as it occurs
d. Transfer pricing can reduce tax liability
9
Global Debate
The focus of this Global Debate explores “Microloan Bankers: Charity or For-Profit
Business Model?” The growing trend of microloans is changing access to capital for extremely
small business start-ups by individuals traditional bankers would view as “high risk” borrowers.
What initially started as a small loan initiative with social implications is now becoming a
for-profit niche market world-wide. Microloans serves as a starting point for a stimulating class
discussion on the question, “Is profiting from microloans to the poor ethical?”
Worldview
“The On-going Effects of SOX as a Symptom, Not a Cause” explores American geocentrism as
evidenced in the SOX legislation.