International Business: Competing in the Global Marketplace SIxth Edition

Chapter 19

Accounting in the International Business

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Learning objectives
• Describe differences in the accounting policies of different countries. Identify problems associated with these differences, and how international standards are trying to address these problems. Show how multinationals need to consolidate financial information across subsidiaries. Explore alternate approaches to currency translation for financial reporting and managerial control and evaluation. Emphasize the importance of separating the issue of subsidiary performance from managerial performance.

Accounting, the language of business, provides the means for firms to communicate their financial positions to investors, creditors, and the government. Financial information also is used in making resource allocations. International businesses are confronted with a number of accounting challenges that do not arise in the case of domestic businesses. They must prepare reports for international constituencies and translate and consolidate information across countries and currencies. The opening case, Adopting International Accounting Standards, and the closing case, China’s Evolving Accounting System, illustrate some of the issues accountants address in the international sphere.

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OUTLINE OF CHAPTER 19: ACCOUNTING IN INTERNATIONAL BUSINESS Opening Case: Adopting International Accounting Standards Introduction Country Differences in Accounting Standards Relationship between Business and Providers of Capital Political and Economic Ties with Other Countries Inflation Accounting Level of Development Culture Accounting Clusters National and International Standards Lack of Comparability Management Focus: The Consequences of Different Accounting Standards International Standards Management Focus: Novartis Joins the International Accounting Club Multinational Consolidation and Currency Translation Consolidated Financial Statement Currency Translation Current US Practice Accounting Aspects of Control Systems Exchange Rate Changes and Control Systems Transfer Pricing and Control Systems Separation of Subsidiary and Manager Performance Chapter Summary Critical Discussion Questions Closing Case: China’s Evolving Accounting System

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TEACHING SUGGESTIONS The basic idea of this chapter is to explore the need to reach a point where international accounting information is comparable: apples to apples. There is progress in this direction, but students will be fascinated by the basic idea that substantial differences in accounting methods still exist, and accountants need to be able to bridge them so that MNC consolidation can have some validity. TRANSITION The opening case on international accounting standards is an effective introduction for this chapter. You might explore with students why such differences exist and what the impediments to standardization might be, in their opinions. LECTURE OUTLINE FOR CHAPTER 19 This teaching outline follows the PowerPoint presentation provided along with this instructor’s manual. The PPT slides include extensive notes that are printable under view—notes page. What follows is a summary. Slide 19-3 Opening Case The opening case describes how and why many German firms are beginning to report their financial results under US and international accounting standards, in addition to German standards in order to be able to issue equity to foreign investors in foreign markets. In most situations the results reported under US GAAP show significantly lower profitability than under German standards. The following questions might be helpful in directing the discussion. What is the general effect on a German firm’s profitability when it reports its results under US GAAP compared to the reported profitability under German accounting regulations? Why? In most cases a firm shows significantly lower profitability under US GAAP than it would under German accounting standards. US regulations require a greater write-off against profits for items such as future liabilities (e.g., pensions) and previously booked goodwill. Why do US and German standards differ so significantly? (Most students will probably not have the background to answer this question, so the instructor may have to relay this information. Yet it is important for understanding the basic issues.) German firms have typically received most of their funding from banks, in debt and equity. As a general rule, banks are more interested in assets that can serve as collateral than they are in profits. Thus the accounting system has evolved to focus attention on assets. For example, in this setting, a brand name can be a valuable asset and may be reflected so on the books - it could be sold if needed. Under the US system a brand name is simply part of goodwill (if on the books at all), and must be written off over time. In summary, because the primary users of financial information differ (banks

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in Germany, shareholders in the US), the information system for presenting this data has evolved differently. It would seem that publishing financial statements in multiple formats is costly, and that most international standards lead to a reporting of lower profits. Given this, why would a German firm want to go through the trouble? The German equity market is relatively small and illiquid. Thus for German firms to raise additional capital, they want to appeal to investors in other countries. National regulations, however, usually require that foreign firms conform to local standards before they can issue stock on a local exchange to local investors. Thus while the conversion is expensive, if it leads to a lower cost of capital for German firms, it is worth it. Slide 19-4 Accounting Information and Capital Flows Accounting is shaped by the environment in which it operates. In each country the accounting system has evolved in response to the nature of the demands for accounting information. Slide 19-5 Determinants of National Accounting Standards Five main factors 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) levels of inflation, 4) the level of a country's development, and 5) the prevailing culture in a country. Slide 19-6 Relationship between Business and Providers of Capital Three main external sources of capital for business enterprises are: (1) individual investors, (2) banks, and (3) government. Slide 19-7 Political and Economic Ties with Other Countries Slide 19-8 Inflation Accounting Current cost accounting (adopted in Great Britain in 1980) adjusts all items in a financial statement—assets, liabilities, costs, and revenues—to factor out the effects of inflation by using a general price index to convert historic figures into current values. Slide 19-9 Level of Development Slide 19-10 Culture Slide 19-11 National and International Standards Slide 19-12 Lack of Comparability Slide 19-13 International Standards International Accounting Standards Board (IASB) Slide 19-14 Multinational Consolidation and Currency Translation

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Subsidiaries of multinationals are separate legal entities but not separate economic entities Slide 19-15 Currency Translation 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 firm. This can cause problems due to exchange rate fluctuations. The text has a good example. Under the temporal method, assets valued in a foreign currency are translated into the home currency using the exchange rate that existed when the assets were originally purchased. One problem with this approach is that the balance sheet of the multinational may no longer balance. Slide 19-16 Current US Practice Under US FASB regulations, a self-sustaining subsidiary is said to have its own local currency as its functional currency. The balance sheet for such subsidiaries is translated into the home currency using the exchange rate in effect at the end of the firm's financial year, while the income statement is translated using the average exchange rate in effect during the firm's financial year. On the other hand, an integral subsidiary has US dollars as its functional currency. Slide 19-17 Accounting Aspects of Control Systems Slide 19-18 Exchange Rate Combinations in the Control Process Slide 19-19 Accounting Aspects of Control Systems Lessard- Lorange Model Slide 19-20 Transfer Pricing and Control Systems. Transfer price can critically affect the performance of two subsidiaries that exchange goods or services and can also introduce significant distortions into the control process. Transfer price must be taken into account when setting budgets and evaluating a subsidiary's performance. Slide 19-21 Separation of Subsidiary and Manager Performance. Slide 19-22 Looking Ahead to Chapter 20 Financial Management in the International Business

ANOTHER PERSPECTIVE These are comments or illustrations of material in the text that build from unusual applications or other views of the major concepts. You may find them useful to stimulate discussion or to help bring a concept home to your students.

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Accounting Bodies Take the Heat Plans to combine the U.S. and international accounting standards have come under heavy attack in Europe and in the U.S. One area of special concern is a proposal to change the net income statement, a widely accepted measure of a company’s performance, into a broader measure, one that would capture all of a company’s gains and losses, including changes in the value of its assets on the balance sheet. Right now, for example, market real estate values do not appear. Threat to Highly Paid CEOs: Let’s Outsource! U.S. CEOs are the most expensive in the world. Their median income in 2004 was $2.3 million, salary plus bonus. That compares with $1.2 million in the UK, $857,000 in France, $386,000 in Sweden, and $88,117 in India. Sure, they are talented, but if we can outsource programming and other knowledge-based activities, we might want to give the CEO job a try.

ANSWERS TO CRITICAL THINKING AND DISCUSSION QUESTIONS FOR CHAPTER 19 QUESTION 1: Why do the accounting systems of different countries differ? Why do these differences matter? ANSWER 1: Accounting systems are shaped by the environment of the country, and have evolved to meet the nature of demands for accounting information in that country. Five factors seem to influence the type of accounting system with which a country ends up. These are 1) the relationship between business and the providers of capital, 2) political and economic ties with other countries, 3) levels of inflation, 4) the level of a country's development, and 5) the prevailing culture of a country. These differences matter because with increasing trade and the globalization of capital markets, we need to compare and evaluate firms across national borders. And in the case of multinational firms with operations in different countries, and hence different reporting requirements in different countries, differences in accounting systems can significantly impact the way a firm collects and reports information.

QUESTION 2: Why are transactions among members of a corporate family not included in consolidated financial statements? ANSWER 2: To outside investors, the transactions among members of a corporate family are of limited interest, as the main interest is in the overall economic viability of the combined enterprise. Internal transactions are typically not undertaken at a market rate (although firms may try to get as close to a true market rate as possible), and governmental regulations may induce firms to undertake internal transactions at unrealistic transfer prices. Beyond this, the internal transactions often just even out in any case (a profit in one subsidiary is removed by a loss in another from their

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transactions, an account payable is a liability in one subsidiary that is offset by an equal account receivable asset in another subsidiary). Consolidated financial statements exclude intra-firm transactions since these may be of limited use in understanding the overall financial situation of the corporate family and may include misleading or immaterial information. QUESTION 3: The following are selected amounts from the separate financial statements of a parent company (unconsolidated) and one of its subsidiaries: Parent $ 180 $ 380 $ 245 $ 790 $4,980 $ 0 $ 250 $4,160 Subsidiary $ 80 $ 200 $ 110 $ 680 $3,520 $ 200 $ 0 $2,960

Cash Receivables Accounts payable Retained Earnings Revenues Rent Income Dividend Income Expenses

Notes: (i) Parent owes subsidiary $70 (ii) Parent owns 100% of sub. During the year sub paid parent a dividend of $250. (iii) Subsidiary owns the building that parent rents for $200 (iv) During the year parent sold some inventory to subsidiary for $2,200. It had cost Parent $1,500. Subsidiary, in turn, sold the inventory to an unrelated party for $3,200. Given this information (a) What is the parent's (unconsolidated) net income? (b) What is the subsidiary's net income? (c) What is the consolidated profit on the inventory that the parent originally sold to the subsidiary? (d) What are the amounts of consolidated cash and receivables? ANSWER 3: (a) Parent's unconsolidated net income: Revenues (4980-2200) + Rent Income (0) + Dividend Income (250 - 250) - Expenses (4160 -1500-200) = 320 (b) Subsidiary's net income: Revenues (3520) + Rent Income (200) + Dividend Income (0) - Expenses (2960) = 490 (c) Consolidated profit on the inventory: 3200 - 1500 = 1700 (d) Cash: 180 + 80 = 260, Receivables: 380 - 70 +200 = 510

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QUESTION 4: Why might an accounting-based control system provide headquarters management with biased information about the performance of a foreign subsidiary? How can these biases be corrected? ANSWER 4: There are three primary reasons why accounting based control systems may provide headquarters management with biased information about the performance of a subsidiary: exchange rate changes, transfer prices, and general economic conditions. Because exchange rates can change over the course of a budget, translated financial data can be misleading - an increase in domestic sales could actually show up as a decrease after translation due to home currency appreciation. By using a common exchange rate for both budget setting and evaluation (i.e. the initial rate or a forecast rate), this problem can be addressed. Since multinational firms often have significant intra-firm transactions, prices have to be set on these transactions. Due both to the difficulty of setting such prices fairly, and the incentives to set prices in order to minimize tax or import duties, profitability of units can be distorted by unrealistic transfer prices. Since it can be impossible and inefficient to use only fair transfer prices, the effects of transfer prices have to be taken into consideration when evaluating the performance of a subsidiary. Lastly, different foreign subsidiaries may be operating in vastly different business environments. The subsidiary that is growing and barely showing a profit in an economy that is in recession is clearly doing better than one that is growing quickly and profitable, but in country where the GDP is growing twice as fast as the subsidiary. Thus when comparing the results of separate subsidiaries, the economic environment in which they are operating must be considered. TEACHING SUGGESTIONS FOR THE CLOSING CASE OF CHAPTER 19 CLOSING CASE: CHINA’S DEVELOPING ACCOUNTING SYSTEM The closing case describes the evolving nature of the accounting system in China, and the challenges that this creates for Western firms. Discussion of the case can be assisted by the following questions: QUESTION 1: What factors have shaped the accounting system currently in use in China? ANSWER 1: The legacy of communism is critical in understanding the Chinese accounting system. The primary role of the accounting system was to measure output and conformance to plan. Given that most large enterprises are still government owned, and that most assets are the property of the state, neither profitability nor financial strength were relevant attributes to measure. Although this is changing as Chinese enterprises come in contact (and enter joint ventures) with Western firms, it is changing in a Chinese fashion. QUESTION 2: What problems does the accounting system currently in use in China present to foreign investors in joint ventures with Chinese companies?

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ANSWER 2: The current accounting system in China presents many difficulties for foreign investors in joint ventures. Determining if a particular enterprise is appropriate for a joint venture becomes difficult, because the financial data reported is not always helpful in understanding the success and viability of the enterprise. After entering a joint venture, determining how successful the venture is, what additional funding may be required, or what proceeds there are that can be returned to the investors is also difficult. Likewise the exposure to future losses may be obscured. Also understanding performance may be difficult when the basis of its measure is unclear. This is significant when you may want to negotiate and provide incentives for superior performance. QUESTION 3: If the evolving Chinese system does not adhere to IASC standards, but instead to standards that the Chinese government deems appropriate to China’s “special situation,” how might this affect foreign firms with operations in China? ANSWER 3: Foreign firms with operations in China need to be able to provide investors with consolidated information on financial performance, including that of Chinese subsidiaries. If these subsidiaries do not provide data according to IASC standards, then the overall financial condition of the firm will not be accurately represented according to IASC standards. This can have significant consequences to a firm’s relations with investors, banks, and regulatory authorities. globalEDGE EXERCISES Use the globalEDGE™ site to complete the following exercises: Exercise 1 The globalEDGE™ site offers a country comparison tool that allows for comparing the countries based on statistical indicators. Utilize this tool to identify in which of the following countries the historic cost principle of accounting cannot provide accurate results: Argentina, Bulgaria, Ecuador, Indonesia, Latvia, Malaysia, Mexico, Romania, Russia, and Senegal. Utilize the “rank countries” tool to identify other countries in which the historic cost principle would not provide valid results. Exercise 2 Deloitte Touche Tohmatsu hosts an International Accounting Standards webpage that provides information and guidelines regarding the accounting procedures approved by IASC. Locate the website, the section on Standards, and prepare a short description of the international accounting standards of accounting for recording inventory levels.

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ANSWERS TO globalEDGE EXERCISES Chapter 19 – Exercise 1 The Country Comparison section is located under the country insights page in the resource desk. The countries specified in the exercise can be compared using the country comparison tool according to the inflation rate. In countries with high inflation rates the historic cost principle would not provide accurate results. Additionally, the “rank countries” tool can be used to identify the countries with the high inflation rates in the world. Resource Name: “Rank Countries” Website: http://globaledge.msu.edu/ibrd/countryindex.asp globalEDGE™ Location: “Country Insights” Chapter 19 – Exercise 2 The IAS website can be located by searching for the term “international accounting standards” at http://globaledge.msu.edu/ibrd/ibrd.asp. The resource is titled “IAS Plus” and is located under the globalEDGE™ Category “Money: Finance”. Search Phrase: “international accounting standards” Resource Name: IAS Plus Website: http://www.iasplus.com/standard/ias02.htm globalEDGE™ Category: “Money: Finance”

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