978-0134200057 Chapter 19 Lecture Notes

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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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