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CHAPTER NINETEEN
INTERNATIONAL ACCOUNTING AND FINANCE
ISSUES
OBJECTIVES
19-1 Explain the crossroads of accounting and finance
19-2 Identify the major factors affecting the development of accounting objectives,
standards, and practices
19-3 Describe international accounting standards and the process of global convergence
19-4 Demonstrate how companies account for foreign-currency transactions
19-5 Determine how companies can translate foreign-currency financial statements
19-6 List some of the key international finance functions
19-7 Show how companies protect against foreign-exchange risk
CHAPTER OVERVIEW
The international accounting and taxation functions comprise great challenges for today’s
global business managers. Chapter Nineteen presents the key accounting and taxation
issues confronting firms that do business abroad. First, the chapter examines the ways in
which national accounting systems differ and how today’s global capital markets force
countries to consider the harmonization of their accounting and reporting standards. It
then explores a number of unique issues MNEs face, such as the valuation and translation
of transactions and assets that are denominated in foreign currencies. The chapter
concludes with an examination of the impact of transfer pricing on business unit
performance evaluation and an explanation of the balanced scorecard approach to
performance evaluation.
CHAPTER OUTLINE
OPENING CASE: GPS Capital Markets: In the Market for an Effective
Hedging Strategy?
Founded in 2002, GPS Capital Markets, Inc. became a leading brokerage firm in the
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corporate foreign exchange business. The first choice for most companies when it comes
to foreign exchange is to use their commercial bank with which they already have a good
relationship. GPS was able to overcome that by relying on three key competitive
advantages: lower transaction costs, 100 percent transparency, and customizing solutions
to satisfy customer needs. Thomson Reuters and Bloomberg play an important role in the
business of GPS, with their powerful analytical tools, market information, real-time
pricing, and a trading platform. When the global economic crisis hit in 2008, many
companies flocked to it to handle their foreign-exchange transactions, which caused a
large spike in activity. GPS developed proprietary software called FXpert to help its
clients monitor foreign-exchange flows and determine how to save money on
transactions. In addition to technical expertise, GPS has developed a solid marketing
strategy, continuing to focus on SMEs while expanding its client base by setting up
business centers in Los Angeles, Phoenix, Dallas, Boston, and London. Entering London
has opened up significant opportunities for GPS in the UK and the rest of Europe.
I. THE CROSSROADS OF ACCOUNTING AND FINANCE
The accounting and finance functions are closely related, with each relying on the
other to fulfill its responsibilities. The CFO relies on the controller, or chief
accountant, to provide the right information for making decisions, while the internal
audit staff ensures that corporate policies and procedures are followed. The internal
auditors, the controller, and the CFO work closely with the external auditor to try to
safeguard the assets of the business. The actual and potential flow of assets across
national boundaries complicates the finance and accounting functions. So MNEs
must learn to cope with differing inflation rates, exchange-rate changes, currency
controls, expropriation risks, customs duties, tax rates and methods of determining
taxable income, levels of sophistication of local accounting personnel, and local as
well as home country reporting requirements.
A. What Does the Controller Control?
A company’s controller collects and analyzes data for internal and external
users. The role of the controller has expanded beyond the traditional roles of
management accounting and now involves strategic issues.
B. Differences in Financial Statements Internationally
Accounting origins and traditions are as individual as the languages of the
nations that produce them. As a result, financial statements in different countries
appear different from each other both in form (format) and in content
(substance).
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C. Differences in the Content of Financial Information.
Because MNEs must adjust to different accounting systems on a worldwide
basis, the international accounting function becomes increasingly complex and
costly. Providers of financial information for the broader investing community
need to consider the following three factors: (i) language, (ii) currency, (iii)
Underlying GAAP on which the statements are based.
1. Language Differences. English tends to be the first choice of companies
choosing to raise capital abroad. Many companies provide their financial
statements in different languages.
2. Currency Differences. Companies around the world prepare their
financial statements in different currencies.
3. Underlying GAAP. A major hurdle in raising capital in different countries
is dealing with widely varying accounting and disclosure requirements.
I. FACTORS AFFECTING ACCOUNTING OBJECTIVES, STANDARDS, AND
PRACTICES [see Figs 19.1]
Figure 19.1 identifies some of the factors affecting the development of accounting
standards and practices both domestically and internationally. As we will discuss in
more detail below, cultural issues cut across all countries and strongly influence the
development of accounting. The regulatory environment, including legal and tax
systems, is very influential, especially in countries with weak stock markets.
However, the regulatory environment is also influential on stock markets. Certain
international factors also have weight, such as former colonial influence, foreign
investment, and the influence of regional economic agreements, such as the EU.
A. Cultural Differences in Accounting
Culture influences both measurement practices (how firms value assets) and
disclosure practices (how and what information firms provide and discuss).
1. The Secrecy-Transparency/Optimism-Conservatism Matrix [see
Figure 19.2]. From an accounting standpoint, secrecy and transparency refer to
the degree to which corporations disclose information to the public. Optimism
and conservatism refer to the degree of caution that companies exhibit in valuing
assets and recognizing income. Anglo-Saxon countries such as the United
Kingdom and the United States have accounting systems that tend to be
transparent and optimistic, while countries such as Germany, Switzerland, and
Japan, among others, tend to be secretive and conservative.
III. International Standards and Global Convergence
A. Mutual Recognition versus Reconciliation.
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Major approaches to dealing with accounting and reporting differences: (1)
Mutual recognition, (2) Reconciliation to local GAAP, and (3) Issue financial
statements according to IFRS. Despite the many differences in accounting
standards and practices around the world, a number of forces are leading to
convergence:
A movement to provide information compatible with the needs of
investors
The global integration of capital markets, which means easier and faster
access to investment opportunities around the world and, therefore, the
need for more comparable financial data
The need of MNEs to raise capital outside their home-country capital
markets while generating as few different financial statements as
possible
Regional political and economic harmonization, such as the efforts of the
EU, which affect accounting as well as trade and investment issues
Pressure from MNEs for more uniform standards to allow greater ease
and reduced costs in general reporting in each country
B. The First Steps in Establishing IFRS. The International Accounting
Standards Committee (IASC) has worked toward harmonizing accounting
standards by issuing a set of International Accounting Standards (IAS). The key
turning point in the significance of the IAS standards came in 1995 when the
International Organization of Securities Commissions (IOSCO) announced it
would endorse IASC core standards if a set were developed that both
organizations could agree upon. In May 2000, the IASC completed a core set of
standards acceptable to IOSCO, and securities market regulators began the
process of convincing their standard setters to adopt these standards, called
International Financial Reporting Standards (IFRS).
C. The International Accounting Standards Board
In March 2001, the IASC reorganized into the International Accounting
Standards Committee Foundation (now called the IFRS Foundation) and the
International Accounting Standards Board (IASB).
1.. International Financial Reporting Standards (IFRS). When the
IASB was organized, all of the old International Accounting Standards were
adopted, and the board began to issue new standards called International
Financial Reporting Standards (IFRS). As of 2016, 120 countries require the
use of IFRS for reporting by public companies, while most others permit
their use in some cases.
2. The Relationship between the FASB and the IASB. The FASB and
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IASB also decided to adopt a process of convergence of accounting standards.
Standard setting in the U.S. depends on the cooperation of the SEC. Convergence is
complicated because it is both technical in terms of the quality of the standards as
well as political.
3. The European Response to Convergence. The convergence process
has been very unsettling for some Europeans. Differences in opinions exist on
how IFRS should be applied and how the rules should be enforced.
POINT-COUNTERPOINT: Should U.S. Companies Be Allowed to Use IFRS?
POINT: Investors, as well as creditors and other users, need reliable, comparable
financial statement information to make well-informed decisions on a global basis. The
two standards–U.S. GAAP and IFRS–are becoming more alike and allowing U.S.
companies to use IFRS would make the U.S. more a part of the global economy, its
companies could also raise more capital because investors in countries that use it would
be more familiar and able to keep up with the single international set of standards.
U.S. investors would also benefit. They would become more familiar with the
international standards and would feel more apt to invest in international companies.
Many U.S. firms with international operations use IFRS abroad, so allowing IFRS to be
used for U.S. reporting would reduce the costs of accounting for and reporting
information to users. In addition, U.S. companies that acquire foreign companies that use
IFRS would find it easier to use IFRS for all operations rather than have to convert the
results of their acquired companies from IFRS to U.S. GAAP for reporting purposes.
COUNTERPOINT: The U.S. economy is the largest economy in the world and thus
needs the most stringent financial reporting standards in the world. The U.S. system has
historically used the most reliable standards in the world. Allowing U.S. companies to use
IFRS would impose tremendous costs on the nation’s economy. The differences between
IFRS and U.S. GAAP, though growing more insignificant, still exist. The standards are
not directly comparable, which could mean trouble for investors who may have difficulty
seeing the differences. In addition, sovereignty, even over accounting, is not something
the U.S. government would give up to an international organization
over which it has some influence but not control.
IV. TRANSACTIONS IN FOREIGN CURRENCIES
In addition to minimizing or eliminating foreign-exchange risk, firms must concern
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themselves with the proper recording and subsequent accounting of transactions
resulting from the purchase or sale of products and the borrowing or lending of
foreign currency.
A. Recording Transactions
When accounting for assets, liabilities, revenues and expenses, foreign-currency
receivables and payables result in gains and losses whenever the relevant
exchange rate changes. Such transaction gains and losses must be included on
the income statement in the accounting period in which they arise.
B. Correct Procedures for U.S. Companies
The FASB requires that U.S. companies report foreign currency transactions at
the original spot exchange rate and that subsequent gains and losses on
foreign-currency receivables or payables be put on the income statement. The
same procedure must be followed according to IFRS.
V. TRANSLATING FOREIGN-CURRENCY FINANCIAL STATEMENTS
An MNE must eventually develop one set of financial statements in its home-country
currency. Translation involves the process of restating foreign-currency financial
statements, and consolidation is the process of combining the translated financial
statements of a parent and its subsidiaries into a single set. In the United States,
translation is a two-step process: first, statements are recast according to U.S.
GAAPs; then all foreign currency amounts are translated into U.S. dollars.
A. Translation Methods
FASB No. 52 and IAS 21 are alike in that they require MNEs to translate their
foreign-currency financial statements into the currency of the parent’s country.
The two standards yield the same result.
1. Two Methods: Current-Rate and Temporal. The method the firm
chooses depends on the functional currency of the foreign operation,
which is the currency of the primary economic environment in which the
entity operates. If the functional currency is that of the local operating
environment, the firm must use the current-rate method, which provides
that all assets and liabilities be translated at the current exchange rate (the
spot exchange rate on the balance sheet date). All income statement items
are translated at the average exchange rate, and owner’s equity is translated
at the rates in effect when the firm issued capital stock and accumulated
retained earnings. If the functional currency is the parent’s currency, then
the firm must use the temporal method, which provides that only monetary
assets such as cash, marketable securities and receivables and liabilities be
translated at the current exchange rate. Inventory and property, plant, and
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equipment are all translated at the historical exchange rates in effect when
the assets were acquired. In general, income statement accounts are
translated at the average exchange rate, but cost of goods sold and
depreciation expenses are reported at the appropriate historical exchange
rates (not an average for the period).
a. The Translation Process [see Tables 19.1 and 19.2]
b. Disclosing Foreign-Exchange Gains and Losses. Under the
current-rate method of translating foreign-currency financial
statements, the gain or loss is called an accumulated translation
adjustment and is recognized in owners’ equity. Under the temporal
method, the gain or loss is taken directly to the income statement, thus
affecting earnings per share.
VI. INTERNATIONAL FINANCIAL ISSUES
A. Capital Budgeting in a Global Context
Capital budgeting is the process whereby MNEs determine which projects and
countries will receive capital investment funds.
1. Methods of Capital Budgeting
a. Payback Period. One method uses a payback period—the
number of years required to recover the initial investment made.
b. Net Present Value. Another method is to determine the net
present value (NPV) of a project, which is a function of the annual
free cash flow in a period, the required rate of return or cost of
capital, the initial outlay of cash, and the project’s expected life.
c. Internal Rate of Return. A third approach is to compute the
internal rate of return—the rate that equates the present value of
future cash flows with the present value of the initial investment.
2. Complications in Capital Budgeting
Several aspects of capital budgeting are unique to foreign project
assessment:
• Parent cash flows must be distinguished from project cash flows
• Remittance of funds to the parent (such as dividends, interest on loans,
and payment of intra-company receivables and payables) is affected by
differing tax systems, legal and political constraints on the movement
of funds, local business norms, and differences in how financial
markets and institutions function
• Differing rates of inflation
• Unanticipated exchange-rate changes
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• Political risk in the target market
• The terminal value of the project is difficult to estimate because
potential purchasers from host, home, or third countries may have
widely divergent views on the project’s value
Because of these complications, it is very difficult to estimate future cash
flows. There are two ways to deal with these variations: 1) determine
several different cash flow scenarios and 2) adjust the minimum required
rate of return that the project must achieve.
B. Internal Sources of Funds
Funds refer to working capital, i.e., the difference between current assets and current
liabilities. Internal sources of funds include loans, investment through equity capital,
interfirm receivables and payables, and dividends.
A. Cash Flows and the MNE. [see Figure 19.4]
Interfirm financial links become extremely important as MNEs grow in size and
complexity. Funds can flow from parent to subsidiary, subsidiary to parent,
and/or subsidiary to subsidiary. Goods, services, and funds all can move within
an MNE, thus creating receivables and payables. Entities may choose to pay
quickly (a leading strategy) or to defer payment (a lagging strategy). Transfer
pricing can be used to adjust the size of a payment. In addition, firms can
generate cash from normal operations. Whatever the means, international cash
management is complicated by differing inflation rates, fluctuating exchange
rates, and distinct national and regional bloc policies regarding the flow of
funds.
B. Global Cash Management [see Figure 19.5]
Global cash management strategy focuses on the flow of money to serve specific
operating objectives. Effective cash management hinges on the following
questions:
• What are the local and corporate system needs for cash?
• How can the cash be withdrawn from subsidiaries and centralized?
• Once the cash has been centralized, what should be done with it?
Cash budgets and forecasts are essential in assessing a firm’s cash needs. Cash
may be transferred within a firm via dividends, royalties, management fees, and
the repayment of principal and interest on loans.
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1. Multilateral Netting. Multilateral netting is the process of coordinating
cash inflows and outflows among subsidiaries so that only net cash is
transferred, reducing transaction costs. Multilateral netting allows
subsidiaries to transfer net intercompany flows to a clearing account, which
disburses cash to net receivers. Netting requires sophisticated software and
good banking relationships in different countries. [See Figure 19.6 and
Table 19.3]
VII. FOREIGN-EXCHANGE RISK MANAGEMENT
As illustrated earlier, global cash-management strategy focuses on the flow of money
for specific operating objectives. Another important objective of an MNEs financial
strategy is to protect against the foreign-exchange risks of investing abroad.
Strategies to protect against such risks may include the internal movement of funds,
as well as the use of foreign-exchange instruments such as options and forward
contracts.
A. Types of Exposure
The three types of foreign-exchange exposure include translation exposure,
transaction exposure, and economic exposure.
1. Translation Exposure. Translation exposure reflects the foreign-
exchange risk that occurs because a parent company must translate
foreign-currency financial statements into the reporting currency of the
parent, i.e., the value of the exposed asset or liability changes as the
exchange rate changes.
2. Transaction Exposure. Transaction exposure reflects the foreign-
exchange risk that arises because a firm has outstanding accounts receivable
or payable that are denominated in a foreign currency, i.e., the receivable or
payable changes in value as the relevant exchange rate changes.
3. Economic (or Operating) Exposure. Economic or operational
exposure arises from effects of exchange-rate changes on future cash flows,
the sourcing of parts and components, the location of investments, and the
competitive position of the company in different markets.
B. Exposure-Management Strategy
Management must do a number of things if it wishes to protect assets from
exchange-rate risk.
1. Define and Measure Exposure. An MNE must forecast the degree of
exposure in each major currency in which it operates and adopt appropriate
hedging strategies for each. A key aspect of measuring exposure is
forecasting exchange rates, where the major concerns are the direction,
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magnitude, and timing of exchange-rate fluctuations.
2. Organize and Implement a Reporting System. Once the company
has decided how to define and measure exposure and estimate future
exchange rates, it must create a reporting system that will assist in
protecting it against risk. To achieve this goal, substantial participation from
foreign operations must be combined with effective central control.
3. Formulate Hedging Strategies. A firm can hedge its position by
adopting operational and/or financial strategies, each with cost/benefit and
operational implications.
a. Operational Hedging Strategies. Firms may choose to balance
local assets with local debt by borrowing funds locally, because
that helps avoid the foreign-exchange risk associated with borrowing in
a foreign currency. They may also choose to take advantage of leads
and lags for interfirm payments.
b. Leads and Lags. A lead strategy means collecting foreign-
currency receivables before they are due when the currency is
expected to weaken, or paying foreign-currency payables before they
are due when a currency is expected to strengthen. A lag strategy means
delaying collection of foreign-currency receivables if the currency is
expected to strengthen, or delaying payment of foreign-currency
payables when the currency is expected to weaken. However, such
strategies may not be useful for the movement of large blocks of funds,
and they may also be subject to government restrictions.
c. Using Derivatives to Hedge Foreign-Exchange Risk. A firm
can also hedge exposure through forward contracts and options,
which establish fixed exchange rates for future transactions and
currency options, i.e., derivatives, which assure access to a foreign
currency at a fixed exchange rate for a specific period of time. A
foreign-currency option is more flexible than a forward contract
because it gives the purchaser the right, but does not impose the
obligation, to buy or sell a certain amount of foreign currency at a set
exchange rate within a specified amount of time.
LOOKING TO THE FUTURE:
Will IFRS Become the Global Accounting Standard?
The future of accounting is complicated. It is clear that more jurisdictions use IFRS than
U.S. GAAP for external financial reporting. However, the United States is no closer to
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allowing IFRS to be used for U.S. companies listing on U.S. stock exchanges. A major
reason is that GAAP is far more comprehensive than IFRS, both in depth and breadth.
Also, it responds more to the background, needs, and regulatory requirements of U.S.
capital markets than do IFRS. The major vote in favor of U.S. GAAP is that half
the world’s stock market capitalization is located in the United States, and companies that
want access to U.S. capital must play by U.S. rules. The convergence project between the
FASB and IASB may solve some of the concerns in the long run.
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