Exercise Solutions

EXERCISE SOLUTIONS
Chapter One
1. Based on the brief history of accounting and business provided in this chapter, list the
key historical events that have shaped the accounting profession so far. For each event,
briefly explain how that event affected the practice of accounting.
Answer: Some of the key historical events are:

1. The rise of the city states in Italy and the need to account for public finances.
2. The rise in international trade and the need to account for transactions crossing national
borders.
3. Foreign direct investment by public and private sector companies.
4. The industrial revolution and the rise of large-scale limited liability companies to pool
resources for the massive investments necessary for the mass production of products.
5. The reduction in barriers to foreign investment and eventually to trade after World War 2.
All of these trends in business required companies to account for transactions to provide
information to owners, whether sole proprietors or shareholders.
2. Make a list of the most important business, cultural, and political forces at work in your
own country. For each item you listed, answer the following questions:
a. How will this development affect the accounting profession in this country?
b. How will this development affect the accounting profession in other countries?
Answer: This will depend on the country selected. Use Figures 1.1 and 1.2 to make sure the
major forces are covered.
3. In chapter 7, you will learn more about the IASB (International Accounting Standards
Board). To familiarize yourself with this organization, do the following:
a. Go to the IASB’s website at www.iasb.org, find the purpose of the IASB and
summarize it in one paragraph.
Answer: The purpose of the IASB is to set high-quality financial reporting standards that can be
used worldwide. The IASB has the sole responsibility for setting reporting standards. It works
with standard setters in different countries to converge standards into one set of standards that
can be used by everyone.
b. Consider the economic, political, and cultural realities the world is facing today.
Based on these considerations, do you think the IASB will accomplish its
mission? What are the major threats this organization faces?
Answer: The EU wants greater control over the IASB, but the Board wants to remain
independent of any particular political body. The FASB is mandated in the U.S. to set
accounting standards there, and it would be difficult for the FASB to give up its standard-setting
authority to an international body. However, there is good will between the IASB and FASB to
develop a set of common acceptable standards.
4. As the text mentions, more and more companies are conducting business in foreign
countries. One of the distinguishing characteristics of MNEs is that they are listed on
foreign stock exchanges. Go to the website of the NYSE (New York Stock Exchange) at
www.nyse.com and find a list of all the foreign (non-US) companies listed on the
exchange. Answer the following questions:
a. Which foreign country has the most companies listed on the NYSE?
b. Which regions/continents are the most strongly represented on the NYSE?
Which are the least represented?
c. Why are some regions of the world less represented on the NYSE?
Answer: This depends on when you access the website. Under “International” “Non-U.S. Listed
Company Directory,” and “Overview,” the following number of companies was listed by region
in December 2006: Canada (86); Caribbean/Bermuda/Puerto Rico (55); Latin America (87);
Middle East/Africa (9); Europe (199); and Asia/Pacific (88). The countries with the most
listings are Canada (86), the United Kingdom (63), Bermuda (39), and Brazil (37). The region
least represented was Middle East/Africa due to the small number of large scale companies
headquartered there.
5. Now that you have found foreign companies listed on a US stock exchange, pick a stock
exchange in a different country and find a list of the foreign companies listed on that
country’s exchange. You can find a list of world stock exchanges at www.fibv.com.
Once you have Answer the following questions:
a. Which foreign country has the most companies listed on the exchange?
b. Which regions/continents are the most strongly represented on the exchange?
Which are the least represented?
c. Why are some regions of the world less represented on the exchange?
Answer: This depends on the country selected.
6. Find out what listing requirements must be met by foreign companies wishing to be
listed on your country’s stock exchange. If you country doesn’t have an exchange, you
can choose another countries exchange. You can find a list of world stock exchanges at
www.fibv.com.
Answer: This depends on the country that is selected. Go to the following link to find out what
the requirements are for foreign companies wishing to list on a U.S. exchange:
http://www.nyse.com/Frameset.html?displayPage=/listed/1022221392983.html
7. Choose one of the MNEs from exhibit 1.1. Find that company’s most recent annual
report on the web and answer the following questions:
a. What percentage of total revenues comes from foreign operations?
b. In what countries does the company operate? Why do you think it chose to
expand into those countries?
c. To gather and summarize all the data required to create its annual report, the
company you chose had to integrate financial information from various
countries. What challenges do you think the firm faced in trying to integrate
information from so many different origins?
Answer: This depends on the company selected.
8. The following statement is taken directly from the text:
“There are also a growing number of securities markets that have been termed “emerging”
markets (e.g., in China, Eastern Europe, and the developing countries of Africa). Indeed,
securities markets are seen to be fundamental elements of the transition to a market economy,
which necessarily involves the privatization of state-owned enterprises and the need to attract
foreign investment.”
a. Do you agree with the statement above? (Answer: depends on the position taken by
the student).
b. Why is the existence of a securities market fundamental to have a market
economy? (Answer: In the absence of a securities market, power tends to be
concentrated into the hands of a few people. Once more people become involved in
the economy through owning shares of stock in companies, the companies must
satisfy the demands of a broader range of stakeholders.
9. As mentioned in the text, the influence of culture (i.e., societal or national values) is an
important environmental influence on accounting traditions and practices. Religion has
a very strong influence on culture in some nations. For example, the laws and
organizations of Islamic nations are based on the Muslim faith. The International
Islamic University Malaysa has and Islamic accounting website fount at
http://www.iiu.edu.my/iaw/. Take some time to learn about Islamic accounting. How
has the Islamic culture and religion shaped accounting in predominantly Muslim
nations?
10. Toyota is a well-known Japanese auto maker with operations in several parts of the
world. At the end of this chapter is a case on Toyota’s Global Expansion. Understanding
the Japanese accounting environment will greatly aid you in preparing for the case at
the end of this chapter. Visit
http://marriottschool.byu.edu/teacher/Acc645/account/Japan.htm and read the article
on Japanese accounting.
11. Ahold is a food products MNE based in the Netherlands. At the end of this chapter is a
case on Ahold and the Challenges of Going Global. Understanding the Dutch accounting
environment will greatly aid you in preparing for the case at the end of this chapter. Go
to the web and learn about accounting practices in the The Netherlands. Answer the
following questions:
a. How do the legal system and culture influence accounting?
b. How does membership in the EU affect accounting practices?
c. How are accounting standards set?
d. What are some of the key accounting practices?
Answer: Most of the information to answer this question can be found in Chapter 3, pages 65-
66.
12. Consider the following statement:
“Globalization refers to the deepening relationships and broadening interdependence among

people from different countries… The growth of globalization creates both opportunities and
threats for individuals, companies, and countries.”
a. What are some of the opportunities created by globalization?
Answer: Globalization allows companies to invest abroad, sell abroad, and source abroad
through purchasing goods produced in lower-cost locations such as China. Its consumers and
producers are not confined to the domestic market.
b. What are some of the threat posed by globalization?
Answer: A concern with globalization is that the rich get richer and the poor get poorer.
Globalization gets blamed for just about everything that goes wrong in developing countries, but
globalization also lifts the economies of the world by allowing them to receive investment and to
export products to other countries.
13. Schering is a German in the medical industry. In its 2003 annual report, the company
disclosed the following information:
“We have spent substantial amounts on environmental protection and safety measures up to
now, and anticipate having to spend similar amounts in 2004 and subsequent years. In 2003, our
operating and maintenance costs in the field of environmental protection and safety totaled
€76m (2002: €74m). Our capital expenditure on environmental protection projects and other
ecologically beneficial projects totaled €15m (2002: €15m). We estimate that operating and
maintenance costs for safety and environmental measures will rise to between €76m and €80m
annually by 2008. We expect capital expenditure on environmental projects and other
ecologically beneficial projects to be between €5m and €15m annually over the same period.”
(Schering 2003 Annual Report)
a. Who would be most interested in this type of financial information?
Answer: Stakeholders who are interested in the environment would be interested in this. These
stakeholders tend to be environmental groups inside and outside of government as well as some
investors who have a strong environmental bent.
b. Would this kind of information be valuable in determining the future financial

performance of the company?
Answer: Not necessarily, unless it can be proven that a good environmental performance results
in lower costs and higher profits. However, environmental responsibility might attract a specific
call of investors less concerned about profits.
c. Why would Schering be interested in reporting about its environmental

protection and safety efforts?
Answer: Schering is a European company, and environmental compliance is a major issue in

Europe. This information is of special interest to European governments and investors.
14. StoraEnso is a multinational Swedish company in the paper, packaging, and forest
products industry. Along with its traditional annual report, the company publishes a
Sustainability report for shareholders and the public. Visit www.storaenso.com and
find the latest Sustainability report. Answer the following questions:
a. What is disclosed in the Sustainability report?
Answer: Information on the Environment and Corporate Social Responsibility, incljding

occupational health and safety and the socio-economic impacts of their investments.
b. Why do you think StoraEnso spends so much time and energy on disclosing that
kind of information?
Answer: It is a European company where an interest in sustainability is very high. In addition, it

is a company that uses natural resources, and it wants to demonstrate its commitment to
sustaining the environment.
c. Do you think disclosing that kind of information helps StoraEnso be more

profitable? Why?
Answer: By acting responsibly, StoraEnso is demonstrating to shareholders that it can be both

profitable and committed to sustaining the environment. Many of its environmentally sound
policies have helped to reduce costs as well as build good will at home and in the communities
where it operates.
15. A new trend in investing is to look for companies that are not only profitable, but show
a high degree of what is called “corporate sustainability”. Sustainability is a relatively
new concept, but one that is increasing in popularity amongst investors and the general
public. In response to this, Dow Jones created the Dow Jones Sustainability Indexes
(DJSI). Visit www.sustainability-index.com and answer the following questions:
a. What is corporate sustainability?
Answer: Sustainability involves meeting the needs of the present without compromising the
ability of future generations to meet their own needs, while taking into account what is best for
the people and the environment.
b. How does the concept of sustainability create a demand for nontraditional

financial information? How will this affect international accounting practices?
Answer: An interest in sustainability implies the disclosure of information that is normally not
part of the general purpose financial statements, such as production, waste disposal and
emissions. At the present time, international accounting standards do not involve this type of
disclosure. NGOs tend to be more concerned about companies reporting their impact on the
environment than do accounting standard setters.
c. What does the DJSI measure? Why would corporations want to be a part of this
index?
Answer: Launched in 1999, the Dow Jones Sustainability Indexes track the financial
performance of the leading sustainability-driven companies worldwide. Based on the cooperation
of Dow Jones Indexes, STOXX Limited and SAM Group the indexes provide asset managers
with reliable and objective benchmarks to manage sustainability portfolios. The DJSI family
currently comprises global, European, Eurozone, North American and US benchmarks.
Dow Jones Sustainability World Index

The Dow Jones Sustainability World Index (DJSI World) covers the top 10% of the biggest
2,500 companies in the Dow Jones World Index in terms of economic, environmental and social
criteria. This index was first published on 8 September, 1999.
d. Find a list of current DJSI members. Do you recognize any of the companies?
Answer: In order to answer this question, you will need to register with DJ. However, the
registration is free. The companies listed include some of the largest in the world as well as
some that you might not recognize.
e. Do you think firms will benefit from establishing sustainability strategies? How?
Answer: Given the increasing interest in sustainability, it will be helpful for companies to
improve in this area, as long as it does not impede their number one objective, which is to
maximize shareholder value.
Chapter 2
1. Form into small groups and have each group select two countries from different
culture areas (as defined by Hofstede). Identify and compare each country’s societal
and accounting values.
Answers will vary per student.
2. Locate each country in Gray’s ‘Authority and Enforcement” and “Measurement

and Disclosure” frameworks. How do the countries compare? Comment on the
relevance and reliability of your findings.
3. List six cultural traits that you think have impacted the accounting system in the
U.S. and your country.
4. Give an example of professionalism vs. statutory control within your country. How
does this example relate to the five societal values? Give concrete examples.
5. Give an example of uniformity vs. flexibility within your country. How does this
example relate to the five societal values? Give concrete examples.
6. Give an example of conservatism vs. optimism within your country. How does this
7. Give an example of secrecy vs. transparency within your country. How does this
8. Consider Parmalat’s accounting problems in 2003. What societal values and

accounting values most contributed to Parmalat’s falsified statements?
Societal Values: Large Power Distance, Collectivism, weak uncertainty avoidance
Accounting Values: Secrecy
9. Consider Enron’s accounting problems. What societal values and accounting values
most contributed to Enron’s collapse?
Societal Values: Masculinity, individualism, short-term orientation
Accounting Values: Professionalism, Optimism
10. Because of the accounting scandals of the early 21st century, new laws like
Sarbanes-Oxley have been enacted. What societal and accounting values do the
laws attempt to change?
Societal Values: Strong uncertainty avoidance, long-term orientation
Accounting Values: Statutory control, uniformity, conservatism
11. How has globalization impacted the viability of cultural accounting analysis? In
other words, has globalization increased the common development of accounting
values and decreased the importance of national societal values?
12. Using the accounting and societal values discussed in the chapter, construct a basic
ideal accounting system. Is there a country that uses your system? Is there a
country that closely approximates your system?
13. The chapter discusses how cultural and governmental influences impact accounting
and financial reporting standards. Do accounting and financial reporting standards
influence governmental or cultural standards? Support your answer.
According to Gray, accounting standards do influence culture to an extent.
14. Discuss the benefits and difficulties experienced by both a MNE and a host country
when the MNE enters the country.
Although the relationships between MNEs and host countries have become less antagonistic
and more pragmatic and business like in recent years, there are a number of areas of continuing
concern. Employment and consumption patterns are often significantly influenced by MNEs.
As a result, there is pressure for more accountability to employees and consumers and for some
consultation with the parties affected by the decision of MNEs.
The environmental impact of MNEs is also an area of major and growing importance in
terms of accountability. Whereas developed countries have a growing array of regulations,
developing countries tend to have lower standards, and are more concerned with improving
economic conditions. In this context, both the UN and OECD have been concerned with
providing guidelines to MNEs, including the disclosure of relevant information, to encourage
positive relationships with host countries.
15. How have the social values, accounting values, and accounting system traits in the
United States been impacted by recent globalization? What is a good measure of a
country’s accounting system inertia (the amount that a country’s accounting system
affects more than is affected by globalization of accounting systems and standards)?
Answers will vary by student. The United States accounting standards have changed far less
than other countries involved in globalization and accounting standardization. A good measure
of accounting system inertia may be a country’s GDP.
Chapter 3
Exercises 1-3: Form into small groups and have each group select two countries from
different culture areas (as defined by Hofstede).
1. Identify and compare each country’s societal and accounting values
2. Locate each country in Gray’s “Authority and Enforcement” and “Measurement

and Disclosure” frameworks. How do the countries compare?
3. Comment on the relevance and reliability of your findings.

Exercises 4 & 5: It may seem natural to think that your home country accounting
standards are better than other countries;
4. Discuss differences that exist and some of the explanations for those differences.
Answers will vary per student. Students should discuss differences relating to the values
emphasized by each country as compared to other countries.
5. Are these differences actually weaknesses in the other country’s system, or are they
justified?
Answers will vary per student. They should explore the possibility that other accounting
systems may have merit even if they prefer their own.
Exercised 6 – 8: Consider the four value dimensions identified by Hofstede and the four
accounting values identified by Gray;
6. What mix of accounting values would you argue produces an ideal accounting
system?
Answers will vary per student. They should go through each of Hofstede’s identified values
and determine which values they would emphasize and why.
7. How do those accounting values relate back to the four value dimensions? In other
words, which value dimensions lead to the ideal accounting values?
Answers will vary per student. They should connect Hofstede’s values to the four value
dimensions in order to determine the ideal focus of an accounting system.
8. What countries seem to fit those values identified as ideal?

Answers will vary per student. They should take the values they identified and go through
the country descriptions to determine which ones fit their description the closest.
9. Many of the countries discussed in this chapter have their own standard setting
bodies. Why should (or shouldn’t) a country have its own standard setting
organization?
National standard setting organizations are beneficial because they are more likely to
understand how the global rules should be adapted and/or applied locally than a global standard
setting organization would.
A global standard setting organization is beneficial because it increases the likelihood of
global standardization. If international accounting convergence is a good idea, a global standard
setting body is also probably a good idea. However, if international convergence is not the best
choice, then national standard setting bodies are probably better than one global organization.
Exercises 10 and 11: IFAC (the International Federation of Accounants) is a worldwide

organization of professional accounting bodies.
10. Visit IFAC’s website (www.ifac.org) and visit two of the accounting organizations
discussed in this chapter.
11. What is the purpose of IFAC? What educational and auditing resources are
available on the IFAC website?
According to the website, IFAC’s mission is “to serve the public interest … continue to
strengthen the worldwide accountancy profession and contribute to the development of strong
international economies by establishing and promoting adherence to high-quality professional
standards, furthering the international convergence of such standards and speaking out on public
interest issues where the profession's expertise is most relevant.
Education and auditing resources will vary over time.
12. Go to the website of one of the stock exchanges and find two companies that are
listed from another country. Find these companies’ annual reports and determine
which accounting system is used by each company. Websites are: the New York
Stock Exchange (www.nyse.com), NASDAQ (www.nasdaq.com), or the London
Stock Exchange (www.londonstockexchange.com).
13. The United States’, United Kingdom’s and Australian accounting systems are very
similar. What other developed countries have Anglo-American accounting systems?
Find the accounting standard setting body for one of these countries and determine
at least one difference in accounting principles as compared to the Anglo-American
countries studied in this chapter.
Possible countries include: Canada, Hong Kong, Ireland, New Zealand, Singapore, and South
Africa. Differences will vary per student.
14. If an accounting system is primarily concerned with collecting taxes, how will it
differ from an accounting system concerned with providing relevant and reliable
information to investors? Which countries covered in this chapter have
traditionally focused on tax?
An accounting system that is primarily concerned with collecting taxes will be more
conservative, less transparent, and controlled by statute rather than by a professional
organization. An accounting system focused on investors will be the opposite of the system
previously described. Sweden, Germany, Switzerland, France, Spain, Italy, and Japan tend to
focus more on tax than the other countries listed in the chapter. Some of the countries that have
historically focused on tax are shifting away from that focus (e.g. Sweden).
15. If the primary source of capital for a company is from banks and other lenders how
will that affect the type of accounting information provided? Compare this to
companies that get capital from shareholders.
If a company’s primary source of capital is debt, the company will focus its financial statements
on its ability to make regular payments on the debt.
If a company’s primary source of capital is equity, the company will focus its financial
statements on current and future growth.
Chapter 4
1. Consider the differences between developing countries and developed countries:

a. How are the accounting systems going to be different?
Developing countries accounting systems tend to be very new and simple. Many of these
countries also face the issue of high inflation and poor economies. As such, their standards may
differ in order to address these issues. Many developing countries do not have an independent
body to issue accounting standards. In these countries, the Ministry of Finance continues to
issue standards.
b. Why might these differences be justified?

As stated before, developing countries face different economic circumstances which may
require different accounting rules. Additionally, many developing countries lack the resources
and education to build an independent accounting body. Their best method may be to continue
using the Ministry of Finance to issue standards.
2. As a potential investor in one of the developing countries, list some requirements in

financial reporting you would want before investing in their stock market?
Answers will vary per student. Possible answers include: independent audits, reconciliation to a
familiar accounting system (e.g. IFRS), disclosure of pending liabilities, and comparative
financial statements of at least two years.
3. Imagine you are a developing country working to build up your accounting system.
a. Explain your standard setting process – what regulatory bodies should
be involved and what should their role be.
These answers will likely vary per student. They should include an institution in charge of
formulating accounting standards. Additionally, they should create a way for the system to be
regulated to ensure quality reporting. They should consider whether these bodies should be
independent of government and what their primary focus should be.
b. What would you do before you started creating standards (consider IFRS,
create a principle framework, etc…)?
These answers will vary per student. They should consider whether they want their
framework to be principle based or rules based. They should also determine what principles will
guide their system. Lastly, they should determine whether the country should create their
standards around existing IFRS.
c. What are some of the challenges you might face (speed of issuance vs. quality
of standards issued)?
In an emerging economy, it is difficult to get the standards issued fast enough without
hindering the quality of the individual standards. Countries need to determine which
characteristic is more important to them in the creation of their accounting system. They may
consider adopting IFRS is in the interim period so that they have standards in place to start from.
4. In Exhibit 4.2 several companies from each of the countries discussed in this chapter
list on the NYSE, NASDAQ, and/or London Stock Exchange.
a. Go to the website of each of these stock exchanges and find at least one
company from the developing countries on each exchange.
b. Find out in which year the company listed was listed on the exchange.
5. Mexico, Brazil and Argentina have a history of high inflation during periods of their
history. How does inflation impact accounting and financial reporting in these
countries? Compare this to countries that have not had high inflation.
Argentina allows companies to revalue their assets and liabilities to reflect purchasing power
rather than historical costs during hyperinflationary periods. In some countries where there has
not been recent or regular hyperinflation, no standard exists for accounting for hyperinflationary
periods.
6. Companies from each of the developing countries discussed in this chapter refer to
IFRS in their financial statements. Go to the International Accounting Standards
Board Web site (www.iasb.org) and identify 5 companies that refer to IFRS.
Answers will vary by student.
7. IFAC (the International Federation of Accounants) is a worldwide organization of

professional accounting bodies. Visit IFAC’s website (www.ifac.org). Find out if
the accounting organizations discussed in this chapter are members of IFAC.
All listed bodies are members, except for the following: CINIF, Accounting Society of
China, and ICAAT.
8. If an accounting system is primarily concerned with collecting taxes how will it

differ from an accounting system concerned with providing relevant and reliable
information to investors? Which countries covered in this chapter have
traditionally had a focus on tax?
An accounting system that is primarily concerned with collecting taxes will be more
conservative, less transparent, and controlled by statute rather than by a professional
organization. An accounting system focused on investors will be the opposite of the system
previously described. Sweden, Germany, Switzerland, France, Spain, Italy, and Japan tend to
focus more on tax than the other countries listed in the chapter. Some of the countries that have
historically focused on tax are shifting away from that focus (e.g. Sweden).
Exercises 9 and 10: Form into small groups and have each group select two countries
from different culture areas (as defined by Hofstede).
9. Identify and compare each country’s societal and accounting values.
10. Locate each country in Gray’s “Authority and Enforcement” and “Measurement
and Disclosure” frameworks. How do the countries compare? Comment on the
relevance and reliability of your findings.
11. Compare the strengths and weaknesses of accounting in the Eastern
European countries to those from Latin America.
Eastern European countries are emerging from socialist systems. As a result, Eastern
European countries tend to have less-developed accounting systems than Latin American
countries, who have had a free market longer. On the other hand, Eastern European countries
have the advantage of the European Union, which is motivating developing countries to adopt
IFRS. Adopting IFRS allows developing countries to bypass the difficulties of developing their
own accounting standards. Latin American countries have a unique accounting system because
hyperinflation problems have caused the standards to require valuations based on purchasing
power rather than historical cost. Like the Eastern European countries, Latin American countries
are working to converge with IFRS, but are doing so individually rather than as a union of
nations.
12. Exhibit 4.2 provides the number of companies from the developing countries
covered in this chapter that are listed on each of the three major worldwide stock
exchanges: NYSE, NASDAQ, and London Stock Exchange. Do you notice any
patterns in the listing behavior by country? What factors might explain the listing
patterns observed in the table?
The Latin American countries favor the NYSE, while European countries and former British
colonies favor the London Stock Exchange. Answers to the second question may vary per
student. It appears that geographic proximity is an important factor in picking a major foreign
exchange.
13. Refer to Exhibit 4.3. Discuss the factors that might explain the acceptance of IFRS
or not in the developing countries covered in this chapter.
It seems that countries in the process of entering the free market accept IFRS, while those that
have been in the free-market for longer do not. One possible reason is that new entrants don’t
have a former accounting system that works, but older free market countries have a national
accounting system that works in the free market.
14. Exhibit 4.4 provides information on the legal origin, income group, and accounting
rating. Do you notice any patterns? What is the correlation between these factors?
French and English legal systems tend to have higher accounting ratings. In contrast, Eastern
European countries have lower accounting ratings. German and Socialist legal origins have
lower accounting standards on average. Income group does not seem to have any observable
correlation with accounting standard rating.
15. Which of the countries covered in this chapter have private financial accounting
standard setting boards? What are the costs and benefits of a private vs.
governmental standard setting board?
The following countries have private financial accounting standards boards: India, Malaysia,
Argentina, Mexico, Indonesia, and Thailand (standards must be approved and enacted by
government). The benefit of a private standard setting board is that it understands better which
accounting standards make sense. The benefit of a governmental board is that the government
has a much greater power of enforcement. It is also much harder to overturn a decision made by
the government than a decision made by a private board.
Chapter 5
Volkswagen and GM (questions 1-7)

1. If you were to make a tender offer for Volkswagen, how would you decide much to
offer? What accounting differences between the U.S. and Germany should be taken
into account?
The offer should be equal to the present value of expected future cash flows due to
acquisition. The offer should take into account that the German accounting system uses
completed contract method, so there may be some revenue that will be recognized immediately.
In addition, the German accounting system is more tax-based and more conservative than the
U.S., so earnings presented by Volkswagen may be understated according to U.S. GAAP.
2. If Volkswagen were to sell bonds on the U.S. market, do you think its interest rate
would be greater or lesser than GM? Why?
The relative interest rate and bond rating of Volkswagen depend on its financial position after
being translated into U.S. GAAP. However, because German accounting is more conservative,
Volkswagen should have a lower interest rate than GM.
3. Compute the following ratios for both companies in 2003. What are some possible
reasons for the differences in ratios?
VW GM
o Current ratio 1.68 1.03 (need notes for accuracy)
o Asset Turnover .764 .454
o Times Interest Earned Do not know 1.315
o Debt-to-equity ratio 2.246 10.755
o Earnings Per Share (Basic/ Diluted) 2.84/ 2.84 7.24/ 7.14
Answers may vary per student. It appears that Volkswagen funds more of its activities
through equity financing. That explains the current ratio, the debt-to-equity ratio, and the lower
earnings per share. This seems to be contrary to the expected norm.
4. Which of the statements do you prefer? Why? Which of the statements is more
transparent?
Answers will vary per student. Notice that both companies have different things shown on
their balance sheet (e.g. GM does not split out current and non-current; Volkswagen does not
show how much it paid in interest).
5. What differences should you look for when adjusting Volkswagen’s results to GAAP
reporting standards? In other words, what are some of the major accounting
differences between Germany and the U.S. that are relevant to this industry?
After a business combination, deferred tax assets are used up against goodwill and intangible
assets in the U.S., but under IFRS the deferred tax asset is only used up against goodwill. IFRS
allows more borrowing costs to be capitalized as assets, which effects would have to be reversed
after the merger. Assets may not be worth what they appear to be worth because VW may have
already marked the assets to market value, and impairment tests are different between the two
systems.
6. If you were a bank, to whom would you rather lend money? Why?
Volkswagen. It appears to have the better ability to pay.
7. If you were an equity investor, in whom would you rather invest? Why?
GM, because they have a higher EPS ratio and are growing more. It should be noted that VW’s
statements are set up to be more appealing to creditors, and GM’s statements are set up to be
more appealing to equity investors. Thus, our views may be skewed by the presentation styles.
GENERAL MOTORS CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
Years Ended December 31,

------------------------
2003 2002 2001
---- ---- ----
(dollars in millions except
per share amounts)
Total net sales and revenues (Notes 1 and 24) $185,524 $177,324 $169,051
------- ------- -------
Cost of sales and other expenses (Note 5) 152,071 146,793 138,847
Selling, general, and administrative expenses 21,008 20,690 19,433
Interest expense (Note 16) 9,464 7,503 8,317
------- ------- -------
Total costs and expenses 182,543 174,986 166,597
------- ------- -------
Income from continuing operations before
income taxes, equity income
and minority interests 2,981 2,338 2,454
Income tax expense (Note 11) 731 644 1,094
Equity income (loss) and minority interests 612 281 (138)
----- ----- -----
Income from continuing operations 2,862 1,975 1,222
Loss from discontinued operations (Note 2) (219) (239) (621)
Gain on sale of discontinued operations 1,179 - -
----- ----- -----
Net income 3,822 1,736 601
Dividends on preference stocks - (46) (99)
----- ----- -----
Earnings attributable to common stocks
(Note 20) $3,822 $1,690 $502
===== ===== ===
Basic earnings (loss) per share attributable to

common stocks
$1-2/3 par value
Continuing operations $5.10 $3.53 $2.21
Discontinued operations $2.14 $(0.16) $(0.42)
---- ---- ----
Earnings per share attributable to
$1-2/3 par value $7.24 $3.37 $1.79
==== ==== ====
Losses per share from discontinued operations
attributable to Class H $(0.22) $(0.21) $(0.55)
==== ==== ====
Earnings (loss) per share attributable to

common stocks assuming dilution
$1-2/3 par value
Continuing operations $5.03 $3.51 $2.20
Discontinued operations $2.11 $(0.16) $(0.43)
---- ---- ----
Earnings per share attributable to $1-2/3
par value $7.14 $3.35 $1.77
==== ==== ====
Losses per share from discontinued operations
attributable to Class H $(0.22) $(0.21) $(0.55)
==== ==== ====
Reference should be made to the notes to consolidated financial statements.
CONSOLIDATED BALANCE SHEETS
December 31,
------------
2003 2002
ASSETS (dollars in millions)
Cash and cash equivalents (Note 1) $32,554 $20,320

Other marketable securities (Note 6) 22,215 16,825
------ ------
Total cash and marketable securities 54,769 37,145
Finance receivables - net (Note 8) 173,137 134,643
Loans held for sale 19,609 15,720
Accounts and notes receivable (less allowances) 20,532 16,337
Inventories (less allowances) (Note 9) 10,960 9,737
Assets of discontinued operations - 18,653
Deferred income taxes (Note 11) 27,190 39,767
Net equipment on operating leases
(less accumulated depreciation) (Note 10) 34,383 31,026
Equity in net assets of nonconsolidated affiliates 6,032 5,097
Property - net (Note 12) 38,211 35,956
Intangible assets - net (Notes 1 and 13) 4,760 10,796
Other assets (Note 14) 58,924 14,176
------- -------
Total assets $448,507 $369,053
======= =======
LIABILITIES AND STOCKHOLDERS' EQUITY
Accounts payable (principally trade) $25,422 $21,138

Notes and loans payable (Note 16) 271,756 200,168
Liabilities of discontinued operations - 7,956
Postretirement benefits other than pensions (Note 17) 36,292 38,152
Pensions (Note 17) 8,024 22,679
Deferred income taxes (Notes 11 and 15) 7,508 6,523
Accrued expenses and other liabilities (Note 15) 73,930 65,344
------- -------
Total liabilities 422,932 361,960
Minority interests 307 279
Stockholders' equity (Note 19)
$1-2/3 par value common stock (outstanding,
561,997,725 and 560,447,797 shares) 937 936
Class H common stock (outstanding,
958,284,272 shares in 2002) - 96
Capital surplus (principally additional paid-in capital) 15,185 21,583
Retained earnings 12,752 10,031
------ ------
Subtotal 28,874 32,646
Accumulated foreign currency translation adjustments (1,815) (2,784)
Net unrealized gains (losses) on derivatives 51 (205)
Net unrealized gains on securities 618 372
Minimum pension liability adjustment (2,460) (23,215)
----- ------
Accumulated other comprehensive loss (3,606) (25,832)
----- ------
Total stockholders' equity 25,268 6,814
------- -------
Total liabilities and stockholders' equity $448,507 $369,053
======= =======
Reference should be made to the notes to consolidated financial statements.

Volkswagen AG
Volkswagen AG
Daimler-Benz (questions 8-11)
8. Discuss the arguments for and against Daimler-Benz listing its shares in the United
States.
The arguments for Daimler-Benz listing its shares in the U.S. include: increasing the access
to capital, increasing the marketability and value of the company’s shares, increasing the
publicity about the company and its products, increasing the spread of foreign relative to
domestic investors, matching investments in the U.S. with financing raised in the U.S. thereby
eliminating exchange risk, and so on. Against these arguments are: the regulatory costs involved
including SEC filing costs, stock exchange listing costs, accounting and auditing costs of
reconciliation to U.S. GAAP, and the political and employee costs of reporting different
measures of profit and equity compared to those under German GAAP.
9. Identify and discuss the major differences between U.S. and German
accounting principles.
German GAAP tends to be more conservative than U.S. GAAP and has the potential to
“smooth” earnings rather more so. In the case of Daimler-Benz there are substantial differences
between German and U.S. GAAP despite the company’s move towards international conventions
generally and to U.S. GAAP in particular. The major areas of difference revealed by Daimler-
Benz are as follows:
1. Accruals for Provisions and Valuations
In Germany, extensive loss provisions are permitted including adjustments to
the valuation of inventories and receivables. The adjustments to U.S. GAAP
offset both equity and income. The term ‘appropriated retained earnings’ has
been used to refer to changes to earnings which are considered not available
for distribution as dividends. It is also suggested by Daimler-Benz that this is
a way of bridging the two accounting cultures.
2. Long-term Manufacturing
The completed contract method is used in Germany compared to the U.S.
percentage of completion method.
3. Goodwill
In Germany, goodwill can be written off immediately to shareholder equity or
capitalized and amortized over its expected useful economic life, normally
between 5 and 15 years. Under U.S. GAAP, goodwill is checked regularly for
impairment.
4. Disposal of Investments in Business
In Germany, the sale is recorded when the contract is signed, whereas in the
U.S. the gain or loss is not recognized until the monetary exchange is realized.
5. Pension Provisions
In the U.S., provisions include anticipated increases in wages and salaries and
also health care costs for retirees. This is an area where U.S. accounting tends
to be more cautious than German GAAP.
6. Currency Translation
Under German GAAP only unrealized losses are to be recorded whereas
under U.S. GAAP unrealized profits as well as losses must be recorded.
7. Deferred Taxes
Under German GAAP, deferred tax assets are established only for the
elimination processes in consolidation. Under U.S. accounting principles,
deferred tax assets can also be recorded for valuation adjustments and existing
tax loss carry forwards.
10. Calculate the “conservatism” index and returns on equity for 1992 and 1993 under
both German and U.S. GAAP.
1992 1993
Conservatism Index 1-[(1,350-1,451)/1,350] 1-[(-1,839-615)/1,839]
=1.07 =2.33
Return on Equity
German GAAP 1,451/19,719 615/18,145
=7.36% =3.39%
U.S. GAAP 1,350/27,604 -1,839/26281
=4.89% =-6.99%
11. Does it appear that German GAAP are more or less conservative than U.S. GAAP?
How can you explain your findings?
German GAAP would appear to be less conservative than when measured under U.S. GAAP.
This is contrary to expectations. However, German GAAP equity is much more conservative
than when measured under U.S. GAAP. The most important areas of difference have to do with
the treatment of provisions and reserves and the valuation of assets. These permit a very
conservative approach to income and asset measurement with the potential for smoothing
earnings. In the case of Daimler-Benz, the opportunity for smoothing earnings has been used in
1992 to reduce earnings by 774 (DM million) to 1,451 (DM million). These adjustments have to
be added back under U.S. GAAP, as do the accumulated provisions of 9,931 (DM million) to
equity. In 1993, in contrast, earnings have been increased by adjustments of 4,262 (DM million)
to increase earnings from a loss of 3,660 (DM million) to a profit of 615 (DM million). Under
U.S. GAAP, these adjustments have to be deducted from reported earnings. The accumulated
provisions of 5,770 (DM million) have to be added back to equity under U.S. GAAP, similar to
1992.
Matterhorn (questions 12-15)
Jack Stone is in a real quandary. He has only two weeks in which to make a final
recommendation on the acquisition of Matterhorn, a Swiss manufacturer of high-quality
mountain climbing equipment. Matterhorn is a Swiss corporation, with a large percentage
of the stock owned by Hans Groberg and his family. Hans started the business 30 years ago
and is anxious to sell so he can retire. He has two sons and a daughter who manage various
Matterhorn subsidiaries, but none of them is anxious to take over the business. Since
beginning the business, some of the stock has been sold to nonfamily members, so Hans’s
personal holdings are less than 15 percent. However, his control over Matterhorn has never
been questioned by other shareholders. The banks have provided substantial financing for
Matterhorn and control most of the proxy votes of other shareholders at the annual
meetings.
Part of Jack’s dilemma is that he has no idea what to offer Matterhorn shareholders for
their stock. The Swiss company law requires that financial statements be prepared, but the
information disclosed is rather limited. Jack computed a price-earnings ratio for
Matterhorn and discovered that it was four times that of a similar company in the United
States, and he suspects that Matterhorn’s earnings were understated in comparison with
U.S. GAAP. On the balance sheet, he noticed that certain fixed assets were carried at a
value of one Swiss franc, even though their insured value was several million Swiss francs.
In talking with a CPA who had experience in Switzerland, Jack found out that hidden
reserves, which tend to understate the value of assets and overstate expenses, were allowed.
Jack tried to get Matterhorn’s accountant to show him how the hidden reserves really
affected the books, but the accountant was hesitant to do so.
Another problem is trying to get a picture of the whole corporation. Matterhorn’s financial
statements—such as they are—contain the results of only the parent. Jack knows that at
least 10 subsidiaries controlled by Hans’s children were not consolidated with
Matterhorn’s operations. Jack has tried to get copies of the financial statements of the
subsidiaries and a summary of intercompany transactions but still has not received a
response.
12. What are the major problems Jack faces in trying to evaluate this investment
opportunity?
 Accounting standards are different in Switzerland, and since earnings cannot be
restated in terms of U.S. GAAP, Jack has no idea what the price of the stock
should be.
 Matterhorn’s accountant wasn’t too cooperative.
 The financial statements were parent company statements only, and little
information existed on the affiliated companies.
13. Why is the consolidation issue so tricky here?

Since the financial statements were only the parent results, it is difficult to know if there were
many intercompany transactions that could affect parent company results. Also, it is difficult to
know if overall the operations are operating at a profit or loss since the affiliate statements are
inaccessible.
14. What are some major differences in disclosure between Switzerland and the
United States as brought out in this case?
Some major differences in disclosure are: information relating to the value of and relationship
with subsidiaries, the use of hidden reserves, and expected future revenues and costs.
15. Why are the Swiss so conservative and secretive in their accounting?
Switzerland’s secrecy stems from a history of geographic and political isolation. Most
companies in Switzerland are small and family-owned and managed, which significantly limits
the number of information users. As a result, legal requirements relating to accounting and
disclosure have tended to be minimal.
Chapter 6
In groups of three or four students, select three major companies, listed on U.S. exchanges,
from different countries with operations in oil and gas or pharmaceuticals. Using
information from annual reports, Web sites, and other public sources, prepare a
comparative and critical analysis of their corporate disclosures. Each person should
choose one of the companies. Read the company’s latest annual report or 10-K
(www.edgar.sec.gov) and do exercises 1-4.
1. Identify which groups (government, trade unions, lay investors, analysts,
competitors, etc.) are most likely to use each of the items listed in the report’s table
of contents.
2. Do any of the items seem to be completely superfluous? Is there any information
that you think should be included that is not included in the annual report?
3. What information do you think is the most valuable to competitors? What
information is most valuable to investors?
4. Is the company an MNE? What disclosures does the report include to help foreign
investors? How much of the foreign disclosures is government mandated?
Compare your company’s latest annual report with the annual report from 1998 and do
exercises 5-7.
5. What has been added to the annual report? What has been deleted from the
disclosures?
6. Which of the two reports appears to have more future-focused, quantitative data?
Would you expect the more recent report to be more or less quantitative? Why?
7. From a disclosure point of view, discuss the advantages and disadvantages of
seeking international financing.
The advantage of seeking international financing is that the company has access to more
potential funds. It is also possible that increased disclosure will raise investor confidence in the
company, which will reduce the cost of external financing.
The disadvantage of seeking international financing is that the company must comply with
multiple sets of disclosure requirements. If the domestic market requires fewer disclosures, the
company may hesitate to expand into foreign capital markets.
8. Read IAS 14 (www.iasb.org). Compare and contrast the U.S. and IASB approaches
to segmental disclosure.
IAS requires disclosure for “primary” and “secondary” segments, but the U.S. only asks for
disclosure relating to one basis of segmentation. IAS defines a segment by line of business or
geographical area, but the U.S. requires segmentation by how the company is segmented for
internal management. The IAS requires that the segment information conform to IFRS, and the
U.S. requires that the information be presented the same way it is internally.
Use Electrolux’s 2003 Annual Report (April 5, 2004) to do exercises 9-11.

(http://ir.electrolux.com/html/annual2003en/)
9. Read the environmental disclosures. What indications are there that Electrolux is
doing well from an environmental standpoint? What indications are there that
Electrolux is doing poorly from an environmental standpoint?
A major indication that Electrolux is doing poorly from an environmental standpoint would
be pending litigation related to environmental factors. However, Electrolux has no pending
environmental litigation, except for asbestos cases. The company also shows how it is
complying with the EU’s new WEEE policy, which indicates that the company is doing well
environmentally. Especially note the graph showing waste during production.
10. Does the information provided in the environmental disclosures impact your desire
to invest in the company? Should it?
Answer will vary per student. The information provided in the environmental disclosures
should influence an investor’s decision, if for no other reason than risky environmental
procedures increase the chance of costly litigation.
11. Read the discussion on business areas. What does it tell you about the current
position and likely future position of the company?
The discussion on business areas reviews the market position of the company in each of its
product and geographical segments. The disclosure explains expansion during the past year,
which hints at future trends. For example, the company appears to be focusing more heavily on
the Eastern European market than it was previously.
Refer to figure 6.7, the 2005 forecast from the annual report of Schering AG
(www.Schering.de), to do exercises 12-15.
12. List the items forecasted, the forecast horizon of each item, and the amount
forecasted.
Net sales 1 year mid-single digits (5-8%)
Yasmin 1 year double digits
U.S. business 1 year double digits
Oper. Profit margin 2 years 18%
13. How might an analyst or investor use this information?

An analyst or investor might follow the news for changes in sales of Yasmin. The investor or
analyst also might check for filings or news releases about the approval of a new drug. The
company’s quarterly earnings can also be followed to see if the company is on target with its
operating profit margin estimate.
14. Compare and contrast Schering’s forecast disclosure with Electrolux’s 2004
outlook.
Electrolux’s outlook is more vague. It does not include any quantitative estimates. Also,
Electrolux includes negative information that results in an overall negative estimate for 2004.
15. Overall, how useful is the forecast statement? Why?

Overall, the forecast statement by itself is not very useful. This is because, as Gray, Radebaugh,
and Roberts point out, quantified forecasts are perceived as having major negative net costs.
Simply put, a clear forecast statement could hurt a company’s competitive position.
Figure 6.7 Excerpt from 2004 Annual Report of Schering AG.
Outlook 2005
For fiscal year 2005, we expect a currency adjusted net sales increase in the mid-single digit
range and a further increase in our profitability.
We expect a continuous strong double-digit growth of Yasmin®. In addition, we forecast
that net sales of Betaferon®, for which we expect promising new study results, will continue
to increase in local currencies.
Our U.S. business should increase in the double-digit range in local currency.
In 2005, we expect that the operating margin of 15.5% reached in 2004 will further
increase and that we will achieve our operating profit margin goal of 18% (based on a U.S.
dollar/euro exchange rate of 1.20) in 2006.
Chapter 7
Exercises 1-5: Form into groups of three or four students representing the various
participants in international accounting standard-setting, including the IASB, the IOSCO,
the United States, the European Union, developing countries, and MNEs. In particular,
discuss the following questions:
1. Should international accounting standards be set for the world or be restricted to
MNEs interested in raising finance from international investors?
Answers will vary.
2. Should international accounting standards be set on the basis of a philosophy of

“uniformity” or a philosophy of “mutual recognition,” where some differences are
tolerated?
Answers will vary.
3. If the goal is “uniformity,” how can the “right” answers be found?

Answers will vary.
4. Should the IASB have the authority to set international financial reporting
standards or should standards be the outcome of a more collaborative/consultative
exercise?
Answers will vary.
5. How can international financial reporting standards be enforced?

Answers will vary.
6. Harry Harrison does not understand why he should care about differences between
various countries international financial reporting standards because he only works
for domestic firms. He feels it is a huge waste of time and does not care about
differences from country to country.
a. Is there substance to his argument?
To an extent. If his domestic firm doesn’t interact with any MNEs and does not plan on
becoming an international corporation, then it is possible that international accounting standards
would not affect him.
b. Why might he be wrong? What would you tell him to get him to change his
attitude?
If his firm has any competitors that have subsidiaries abroad, or if his firm receives or sends
resources abroad, international accounting standards are important for his firm, even if his firm is
not an MNE. Without international accounting standards, it will be harder for him to compare
his firm to international competitors. Additionally, if his firm ever plans to expand
internationally, he should care about the differences between countries. Therefore, International
Accounting Standards are applicable to almost all firms, including domestic companies.
7. Germany’s accounting system is generally used to meet the needs of creditors and
tax authorities. In other words, there is little difference between their financial
books and their tax books. In 2005, Germany will be required to use IFRS for their
financial statements.
a. Discuss this issues faced by companies in Germany as they embrace an
accounting system different from their traditional tax-oriented
system.
One main issue faced by Germany will be the introduction of deferred tax assets and
deferred tax liabilities on their balance sheet. They will need to learn about how these arise and
how they account for them.
b. What might they do to ease the transition?

Answers will vary.
Exercises 8 and 9: Visit the International Accounting Standards Board website

(www.iasb.org).
8. What projects are currently being addressed by the IASB? Give a few examples
along with a description.
Answers will vary.
9. What news has recently been announced about the IASB?

Answers will vary.
Exercises 10 - 12: Visit the Financial Accounting Standards Board website (www.fasb.org).
Find information on the “Convergence Project.”
10. What has already been accomplished towards convergence?
Answers will vary.
11. What is on the current agenda?

Answers will vary.
12. What is the difference between short-term convergence and long-term convergence?
Short-term convergence includes projects that can be completed quickly, usually because
there is little difference between existing standards. Short-term convergence is beneficial as a
morale-booster for advocates of convergence. Long-term convergence includes projects that will
take more time. These projects are where the real value and the hard work of convergence are.
13. What are some of the major differences between U.S. GAAP and IFRS
as determined by the FASB and IASB?
Major areas of difference appear to be limited to property, plant and equipment revaluations,
deferred taxes (where partial rather than comprehensive allocation has been used), goodwill
(where goodwill has been charged to reserves contrary to U.S. requirements or different
amortization periods have been used), and capitalized borrowing costs (where borrowing costs
are expensed rather than capitalized).
14. On the IASB Web site are biographies of the current IASB board members. Where
are they from? What were their prior affiliations? Is this a fair international
representation?
15. Fourth and Seventh Directive: Your country is a member of the European Union and
you are preparing your year-end financial statements. According to the fourth and
seventh directive, you have a lot of different options/layouts to consider for the
presentation of your balance sheet and your profit/loss statement. The balance
sheet can be traditional, or can present the information in an analytical layout. The
profit/loss statement can be presented by analyzing costs on an operational basis or
on a type of expenditure basis. You want to determine what the best option is for
your company.
a. Compare and contrast the different presentation options. Does the best
option differ country to country? Why?
The Fourth Directive permits different layouts for the balance sheet and the income
statement. Costs cane analyzed on an operational basis or by type of expenditure. The
operational layout shows gross profit or loss and shows the accounts on an overall operational
basis. The Type of Expenditure layout does not show gross profit, but provides more detail on
individual expenses and where they came from.
The balance sheet can be presented in an analytical layout or as a modified balance sheet
showing account headings only, provided detailed information is given in the notes. The
analytical approach to the balance sheet shows net current assets in additional to total assets less
current liabilities. This approach would make the balance sheet more transparent, compared to
the modified layout, because it would have all of the details required in the actual balance sheet;
information in the notes is often passed over and not studied in detail. However, some
companies may find the disclosure sufficient and prefer the modified balance sheet over the
analytical.
b. Which presentation option do you think provides the most accurate

representation of a company?
Answers will vary per student. The answer should be supported with valid, logical
reasons.
Chapter 8
1. Simple Purchasing Problem: Mautz Company is considering buying S&H

enterprises, which has the following assets and liabilities. Make the Journal Entry to
record the purchase of S&H if the purchase price is $4,620,000.
S&H Cost Fair Market Value
Accounts Receivable 540,000 530,000
Inventory 1,420,000 1,500,000
Property, Plant and Equipment 2,030,000 4,000,000
Accounts Payable (630,000) (630,000)
Notes Payable (1,300,000) (1,300,000)
Net Assets 2,060,000 4,100,000
Under the Purchase Method, the business is recorded at fair market value
Accounts Receivable 530,000
Inventory 1,500,000
PPE 4,000,000
Goodwill 520,000
Cash 4,620,000
Accounts Payable 630,000
Notes Payable 1,300,000
2. Simple Pooling Problem: Assume Mautz Company and S&H want to merge companies,
and that the companies have the following assets and liabilities. Create the balance
sheet of the two newly merged companies under the pooling method.
S&H Cost Fair Market Value
Inventory 1,420,000 1,500,000
Notes Payable (1,300,000) (1,300,000)
Net Assets 2,060,000 4,100,000
Mautz Co, Cost Fair Market Value

Inventory 2,750,000 2,600,000
Notes Payable (2,500,000) (2,500,000)
Net Assets 3,460,000 6,030,000
Under the Pooling method, the balance sheets of both companies are added together (at cost)
Mautz S&H
Accounts Receivable 1,320,000
Inventory 4,170,000
Property, Plant and Equipment 5,280,000
Accounts Payable (1,450,000)
Notes Payable (3,800,000)
Net Assets 5,520,000
3. Simple Consolidation Problem: Walser Co has 80% ownership in Marit Inc. The
balance sheets and income statements for the two companies are below. Walser Co’s
ownership in Marit has been accounted for using the equity method. At the end of
2004, Marit owed $5 to Walser Co. Create the consolidated financial statements for
Walser Co.
80%
Walser Marit Consolidated
ASSETS
Cash 100 10 110
Accounts Receivable 350 50 395 (400 – 5)
Inventory 250 20 270
Plant and Equipment 1400 150 1550
Investment in Marit 88 - -
Totals Assets 2188 230 2325
LIABILITIES 1320 120 1435 (1440 – 5)

Minority Interest 22 (110 x 20%)
EQUITY 868 110 868 Same as parent equity
TOTAL LIABILITIES
AND EQUITY 2188 230 2325
===================================================
INCOME
Sales 1500 400 1900
Income from Sub1 64 -
EXPENSES 750 320 1070

Minority Interest Income - - 16 (80 x 20%)
Net Income 814 80 814 Same as parent NI
===================================================
4. Simple Joint Venture Consolidation: Cardon Co. and Farrell Inc. embarked on a joint
venture to bring technology to undeveloped countries. The venture was named TechCo
and each company had 50% ownership. Create the consolidated financial statements
for Cardon Company on a proportional basis.
50%
Cardon TechCo Consolidated
ASSETS
Cash 57 16 65 (57 + (16 x 50%))
Accounts Receivable 146 - 146
Inventory 350 220 460 (350 + (220 x 50%))
Plant and Equipment 875 170 960 (875 + (170 x 50%))
Investment in TechCo 88 - -
Totals Assets 1516 406 1631
LIABILITIES 1190 230 1305 (1190 + (230x50%))

Minority Interest - - -
EQUITY 326 176 326 Same as parent equity
TOTAL LIABILITIES
AND EQUITY 1516 406 1631
===================================================
INCOME
Sales 875 220 985 (875 + (220 x 50%))
Income from Sub1 15 - -
EXPENSES 630 190 725 (630 + (190 x 50%))

Minority Interest Income - - -
Net Income 260 30 260 Same as parent NI
===================================================
5. Perform an internet search to find an article relating to the issues concerning

consolidation.
a. How does the company/country account for the issue?
b. What are their arguments behind the treatment? Do you feel their argument is
valid?
6. Perform an internet search to find an article relating to issues concerning goodwill.

valid?
7. Perform an internet search to find an article relating to issues concerning joint

ventures.
valid?
8. Perform an internet search to find an article relating to issues concerning research and
development costs.
valid?
9. Bonanza Group acquired the Bargain Company at the beginning of 2004 for a purchase
price of $300 million. The book value of the net assets was stated at $200 million, but at
“fair value” this was restated at $220 million. Bonanza’s policy is to depreciate assets
subject to revaluation on a straight-line basis over a 10-year period. Bonanza Group’s
earnings before charging for any goodwill amortization or additional depreciation were
$50 million. Bonanza’s management was wondering whether a change of headquarters
might be a good idea from a reported earnings perspective and decided to consider the
position in Japan and the Netherlands compared to the United States. Prepare a
comparative schedule showing the net earnings after any goodwill or depreciation
adjustments in accordance with generally accepted accounting principles in each of the
following countries:
a. United States (assume goodwill impairment of 25% after 3 years and nothing
else)
b. Japan (assume goodwill amortization over 5 years)
c. Netherlands (assume immediate write-off of goodwill against reserves)
$300 million - $220 million (fair value) = $80 million GOODWILL

Schedule for Year 1:
United States Japan The Netherlands
Profit before Goodwill $50 $50 $50
and additional
depreciation
Less: Goodwill --- ($16) ---
amortization non-amortization, (80/5 years) Immediate write
subject to off against
impairment reserves
Less: additional ($2) ($2) ($2)
depreciation ($20
million/ 10 years)
Net Earnings $48 $32 $48
10. Refer to Exercise 9 above. Compare and contrast your findings across the three
countries and discuss the significance of the results from the perspective of both
Bonanza’s management and international financial analysts.
Earnings after depreciation and goodwill adjustments range from 96% to 64% of pre-adjusted
earnings. The U.S. is the least conservative. Although The Netherlands has earnings of $48,
they must also write-off $80 of reserves. Management’s preference would probably be to use the
Japanese method. Financial analysts shouldn’t care, as long as they can make adjustments to be
able to compare Bonanza with other companies.
Exercises 11-13: In Japan, the pooling method is still permitted in business combinations.
Unlike the United States and the United Kingdom, whose groups follow a hierarchical
structure, Japan’s groups are described as “headless combinations” or keiretsu and are
built around trust and loyalty. As such, it is difficult to distinguish a “parent” corporation
among the relationships.
11. What are some of the problems of using the majority shareholder rule to consolidate
Japanese financial statements?
Because of the decentralized nature of Japanese groups, the majority shareholder rules
does not necessarily reveal a parent corporation. Using the majority shareholder rule to
consolidate accounts is misleading because it does not reflect the true nature and structure of the
Japanese group.
12. What are the reasons behind using a pooling method over a purchase method?
Using the pooling method in Japan is a more accurate reflection of the economic nature
of business combination in Japan because the purchases reflect a cooperation rather than control.
13. What effect do these different treatments have on the financial statements?
Both earnings and assets may be understated. Because their assets are not market to
market every time a purchase is made, the values remain substantially lower than companies in
the U.S. and the United Kingdom. As such, consolidated accounts are not very comparable.
Exercises 14–15: Hambert company, located in the United Kingdom, researches different
diseases in order to develop medicine to combat them. During the year, Hambert spent
over $2.4 million researching various conditions such as cancer, diabetes, and depression.
It also spent $1.2 million to determine the effects of different chemicals on improving
diabetes. From this information, Hambert spent $500,000 in effort to introduce a drug for
improving diabetes. At the end of the year, Hambert had also spent $3.2 million in attempt
to learn more about a specific aspect of depression, which might be treatable.
14. Separate the costs into the categories of pure research, applied research, and
development.According to United Kingdom law, which costs should be capitalized, if
any, and which should be expensed? What are the arguments behind this treatment?
Pure Research: $2.4 million spent on researching various conditions
Applied Research: $1.2 million spend to determine effects of different chemicals on
improving diabetes; the $3.2 million spent in attempt to learn more about a specific aspect of
depression
15. Now assume your company is located in Italy. How do you treat the various costs?
What are the arguments behind this treatment?
All research and development costs are capitalized and amortized over five years.
If research did not provide future benefit, no one would research. Although not all research leads
to a breakthrough, research in general provides future benefit and should thus be expense.
Chapter 9
Compare the 2004 segment disclosures of Altria (www.altria.com) and Reynolds American
(www.reynoldsmaerican.com) for exercises 1-5.
1. What do the segment disclosures reveal about the companies strategic emphases?
Altria Group, Inc. is the parent company of Kraft Foods, Philip Morris USA, Philip Morris
International and Philip Morris Capital Corporation. Footnote #15 in the 2004 Annual Report
provides information on net revenues and earnings for Domestic Tobacco, International
Tobacco, North American Food, International Food, Beer, and Financial Services. It’s strategy
is oriented around its business groups.
Reynolds American Inc., on the other hand, is basically a tobacco company. It is the parent
company of R.J. Reynolds Tobacco Company, Santa Fe Natural Tobacco Company, Inc., and
Lane Limited. It provides segment data on two different segments: R.J. Reynolds Tobacco
(89.5% of total revenues) and All Other. No geographic segment data is provided. It’s strategy
is based solely on the tobacco business.
2. How do the companies domestic tobacco segments compare?
That information is not provided for Reynolds in its segment operations, but elsewhere in form
10-K for 2004, it discloses that 95.8 percent of its income is from domestic operations. In the
case of Altria, only 30.7 percent of its revenue is from domestic operations.
3. What do the disclosures have in common? How are they different?
Both companies provide the information required for segment disclosures for U.S.-based MNEs,
but Altria Group provides separate domestic and international information for each line of
business. Reynolds doesn’t provide any geographic segment information in its segment
disclosures since most of its revenues are generated domestically.
4. How much of the difference can be attributed to Altria’s international status?
The differences are two fold. Part of the difference is the fact that Altria is a multi-product
company resulting from acquisitions, whereas Reynolds is a single product company, even
though they also grew by acquisition. A second difference is that Altria generates significant
revenues internationally and this provides information by domestic and international, whereas
Reynolds generates very little revenues abroad and thus does not have to provide international
information.
5. Which company would you rather have invested in before reading the segment
disclosure? Does reading the segment disclosure of both companies influence your
investment inclinations?
Students should address the fact that without reading the annual report and looking at the
segment disclosures, they probably didn’t know how different the two companies are. In fact,
they probably heard of Reynolds but might never have heard of Altria. After learning more
about the companies, they might have been more positive about Altria due to its line of business
and geographic diversification.
Compare and contrast Altria’s 2004 segment disclosure with the 2004 segment disclosure of
British American Tobacco (www.bat.com). Use the information to do exercises 6-7.
6. How different are the segment disclosure requirements for the two companies?
What information does each company provide beyond the requirements?
BAT is clearly a single-industry (tobacco) MNE which generates its revenues in more than 180
markets. It is the world’s second largest quoted tobacco group by global market share, with
brands sold in 180 markets. BAT’s total revenues in British pounds are slightly greater than
Altria’s tobacco revenues but significantly smaller that Altria’s consolidated revenues. Also,
BAT does not provide information split into domestic and international as does Altria. Instead, it
provides revenue and profit information according to the following five geographic segments:
Americas-Pacific, Asia-Pacific, Latin America, Europe, and Africa/Middle East. BAT’s
segment information is generated according to IFRS but with some exceptions, and the
information is unaudited. Altria provides its information according to U.S. GAAP, and the
information is included in the audited footnotes.
7. Do the segment disclosures help in comparing the performance of the two

companies? Which segments of Altria related to British Tobacco segments?
Because Altria aggregates its geographic information into domestic and international, there is not
enough information to compare with BAT’s segments. However, Altria provides revenue and
profit information for its tobacco segment, so it is possible to compare their tobacco segment
with BAT’s tobacco business on a consolidated basis.
Look at the segment disclosures in BOC’s annual report (www.boc.com) for exercises 8-12.
8. What generated the increase in turnover (sales revenue) during 2004?
All of BOC’s business units reported an increase from 2003-2004, but the largest increase came
from the BOC Edwards division.
9. Who will likely use the geographically segmented data? Who will likely use the
LOB segmented data?
BOC provides a matix of information about revenues but not profits with business segments
across the top and geographic segments (Europe, Americas, Africa, and Asia/Pacific) down the
sides. It only provides profit information by line of business. In addition, BOC uses the British
approach to segment disclosures by providing total information according to both origin and
destination. Governments, investors, creditors, and employees would likely be interested in the
geographically segmented data. Investors and creditors would be interested in the LOB
segmented data.
10. If you could buy one LOB or region of the company, which one would you choose?
Why? What concerns, if any, do you have about the segmented data misleading you in your
decision?
I might recommend buying BOC Edwards because of its revenue growth from 2003-2004.
However, the process gas solutions LOB is bigger and thus has a lot of potential. In addition, the
process gas solutions LOB is three times as profitable as is BOC Edwards. The Asia/Pacific and
Europe groups seem to be growing faster than Americas, but there is no profit information. You
could assume that the lack of information means that all segments are equally profitable, but that
is a large assumption.
11. What application does exercise 10 have for creditors?
Creditors are interested in free cash flow generated by operations to protect their loans. By
looking at profitability by segment, a creditor can determine the degree to which operations are
spinning of cash. Of course, operating profit is not the same as free cash flow, so there isn’t
enough information to determine how much cash is being generated. On a geographic side,
some areas of the world are risky than others, so geographic segment data can help a creditor
determine how much exposure it has.
12. How might competitors use the segmented data to their advantage?
Profitability by LOB segment can be a benchmark on profitability for your segment as well.
Changes in revenues by geographic segment can tell you where your competitor is expanding in
the world.
13. Based on the organizational chart provided in Figure 9.2, create a possible
segmentation of the company by LOB segments. Create a possible segmentation of the
company by geographic segments.
BOC - LOB
Process Gas Solutions

Industrial and Special BOC Afrox Hospitals Gist
Products Edwards
BOC – Geographic Area
Europe Americas Africa Asia/Pacific
BOC - Matrix
Process Gas Solutions

Industrial and Special Products BOC Edwards Afrox Hospitals Gist
Europe Europe Europe Africa Europe
Americas Americas Americas
Africa Africa Asia/Pacific
Asia/Pacific Asia/Pacific
14. CurAll Corp. sells bandages of various types to both medical institutions and to retail
stores. For internal reporting purposes, the company is divided into two profit centers:
retail sales and medical institution sales. The medical institution division makes 40% of its
sales to the retail division, which uses the larger bandages in pre-packaged first-aid kits.
The retail division makes 20% of its sales to the medical institution division. Assume that
both of the profit centers are consistent with SIC. According to the dual-yardstick
proposal, how could the LOB segments be divided for external reporting purposes?
According to the dual yardstick approach, an organizational unit is a segment for reporting
purposes if all of the following apply: (1) more than 50 percent of the physical sales volume is
sold externally, (2) revenue and profitability information is accumulated regularly for this unit,
and (3) responsibility for the unit’s operating performance resides with the immediate manager
of the unit. Both the retail sales and medical institutional sales divisions are segments since they
meet all three of the above criteria. Since the profit centers are consistent with the SIC, CurAll
can use its internal profit centers as segments for external reporting.
15. CurAll Corp (see exercise 13) has operations in the United States, Canada, and
Mexico. The United States operations are concerned mostly with corporate affairs,
although there is a production plant in Tennessee. Mexico houses two large production
plants that handle the majority of the retail product manufacturing and a portion of the
medical institution production. Canada has a small plant dedicated to retail products. In
addition, each country has its own marketing division, and Mexico sells the majority of its
products to the United States and Canada marketing divisions for sale in the U.S and
Canada. Divide the company into geographical segments according to the dual-yardstick
model.
From an external sales standpoint, you could argue that there should not be a Mexico division
since all of its sales are made to the retail sales and institutional medical sales divisions in the
U.S. and Canada.
CurAll Corporation
Retail Sales Institutional Medical Sales
U.S. U.S.
Canada Canada
Chapter Ten
1. Exchange Rate Relationships. Below are the exchange rates between the U.S. dollar
and five different currencies. The rates are quoted in terms of the number of units of
the foreign currency to the dollar.
December 31, 2003 December 31, 2004

Euro .79670 .73310
British pound .56250 .51920
Swiss franc 1.2423 1.1318
Chinese yuan 8.2867 8.2865
Brazilian real 2.9030 2.6615
a. Against which currencies did the U.S. dollar weaken in 2004? Strengthen?
The U.S. dollar weakened against all the currencies, although the change against the yuan
was practically zero.
b. What is the exchange rate of each currency on December 31, 2004 in terms of
dollars per unit of the foreign currency?
1.3641 USD/euro .1207 USD/yuan

1.9260 USD/pound .3757 USD/real
.8835 USD/franc
c. Which currency changed the most against the dollar in 2004? The least?
In 2004, the Swiss franc changed the most against the dollar—it strengthened by 8.9%. The
Chinese yuan changed the least (0%) against the dollar.
2. Exchange Rate Relationships. Below are the exchange rates between the U.S. dollar
and five different currencies. The rates are quoted in terms of the number of dollars
per unit of the foreign currency.
December 31, 2003 December 31, 2004

Mexican peso .08911 .089654
Argentine peso .3441 .3366
Thai baht .02526 .02568
S. Korean won .0008372 .0009751
Indian rupee .0220 .02289
a. Against which currencies did the U.S. dollar weaken in 2004? Strengthen?
The U.S. dollar strengthened against the Argentine peso and weakened against the other
currencies. Since a peso could get you fewer dollars in 2004, it weakened against the dollar,
which means that the dollar strengthened against the peso. The opposite would be true of the
other currencies.
b. What is the exchange rate of each currency on December 31, 2004 in terms of units
of foreign currency per dollar?
11.154 USD/M. peso 1,025.54 USD/won

2.971 USD/A. peso 43.687 USD/rupee
38.941 USD/baht
c. Which currency changed the most against the dollar in 2004? The least?
The won strengthened by 16.5% against the dollar, and the Mexican peso hardly changed at
all.
3. Assume the following spot exchange rates between the U.S. dollar and the British pound
sterling:
March 1 $1.8685
March 31 $1.8258
April 30 $1.7740
On March 1, XYZ, a U.S. company, sells goods to a British importer for £1,000,000.
Payment is to be received on April 30, and XYZ adjusts its financial statements quarterly.
What are the journal entries for XYZ on March 1, March 31, and April 30? Was the
dollar strengthening or weakening over the period of the contract?
March 1 Accounts Receivable 1,868,500
Sales Revenue 1,868,500
£1,000,000 * $1.8685 = 1,868,500
March 31 Foreign exchange loss 42,700

($1.8685 - $1.8258) * £1,000,000 = 42,700
April 30 Cash 1,774,000

Foreign exchange loss 51,800
£1,000,000 * $1.7740 = 1,774,000
($1.8258 - $1.7740) * £1,000,000 = 51,800
The dollar was strengthening over the period of the contract.
sterling:
March 1 $1.8685
March 31 $1.8258
April 30 $1.7740
On March 1, XYZ, a U.S. company, sells goods to a British importer for $1,868,500 at the
spot rate and denominates the sale in dollars. Payment is to be received on April 30, and
XYZ adjusts its financial statements quarterly. What are the journal entries on March 1,
March 31, and April 30? Was the dollar strengthening or weakening over the period of the
contract?
March 1 Accounts Receivable 1,868,500

Sales Revenue 1,868,500
March 31 no entry
April 1 Cash 1,868,500

sterling:
March 1 $1.8685
March 31 $1.8258
April 30 $1.7740
On March 1, XYZ, a U.S. company, buys goods from a British exporter for £1,000,000.
Payment is to be made on April 30, and XYZ adjusts its financial statements quarterly.
What are the journal entries on March 1, March 31, and April 30? Was the dollar
strengthening or weakening over the period of the contract?
March 1 Purchases 1,868,500

Accounts Payable 1,868,500
£1,000,000 * $1.8685 = 1,868,500
March 31 Accounts Payable 42,700

Gain on foreign exchange 42,700
($1.8685 - $1.8258) * £1,000,000 = 42,700
April 30 Accounts Payable 1,825,800

Cash 1,774,000
£1,000,000 * $1.7740 = 1,774,000
($1.8258 - $1.7740) * £1,000,000 = 51,800

6. Assume the following spot exchange rates between the U.S. dollar and the Japanese
yen:
March 1 ¥107.40
March 31 ¥105.64
April 30 ¥109.82
On March 1, XYZ, a U.S. company, sells goods to a Japanese importer for ¥10 million.
Payment is to be received on April 30, and XYZ adjusts its financial statements quarterly.
What are the journal entries for XYZ on March 1, March 31, and April 30? Was the
dollar strengthening or weakening over the period of the contract?
March 1 Accounts receivable 93,110

Sales revenues 93,110
¥10 million / ¥107.40 = 93,110
March 31 Accounts receivable 1,551

¥10 million / (107.40 – 105.64) = 1,551
April 30 Cash 91,058

Loss on foreign exchange 3,603
Accounts receivable 94,661
¥10 million / ¥109.82 = 91,058
¥10 million / (105.64 – 109.82) = 3,603
Initially, the dollar fell against the yen, but then it rose again and finished up over the March 1 to
April 30 period.
7. Assume the following spot exchange rates between the U.S. dollar and the Japanese
yen:
March 1 ¥107.40
March 31 ¥105.64
April 30 ¥109.82
On March 1, XYZ, a U.S. company, buys goods from a Japanese importer for ¥10 million.
Payment is to be made on April 30, and XYZ adjusts its financial statements quarterly.
What are the journal entries for XYZ on March 1, March 31, and April 30? Was the dollar
strengthening or weakening over the period of the contract?
March 1 Purchases 93,110

Accounts payable 93,110
¥10 million / ¥107.40 = 93,110
March 31 Loss on foreign exchange 1,551

¥10 million / (107.40 – 105.64) = 1,551
April 1 Accounts Payable 94,661

Cash 91,058
¥10 million / ¥109.82 = 91,058
¥10 million / (105.64 – 109.82) = 3,603
Initially, the dollar fell against the yen, but then it rose again and finished up over the March 1 to
April 30 period.
8. On January 1, XYZ, a U.S. firm, borrows €1,000,000 from a German bank for five
years at 6 percent interest paid semiannually in euros. Principal does not have to be
paid until the end of the loan. The principal is adjusted for any exchange rate changes
every six months. Assume the following exchange rates for the first year of the loan:
January 1 $1.2575
June 30 $1.2082
December 31 $1.3640
Assume that the average exchange rate for each six-month period is the simple average
for that period. What are the journal entries for January 1, June 30, and December 31?
Was the dollar strengthening or weakening over the period of the contract?
January 1 Cash 1,257,500

Notes payable 1,257,500
€1,000,000 * $1.2575 = $1,257,500
June 30 Notes payable 49,300

($1.2575-$1.2082) * €1,000,000 = 49,300
Interest expense 36,987

Gain on foreign exchange 741
Cash 36,246
€1,000,000 * (.06/2) = €30,000 * $1.2329 = $36,987
€30,000 * $1.2082 = $36,246
December 31 Loss on foreign exchange 155,800

Notes payable 155,800
($1.2082 - $1.3640) * €1,000,000
Interest expense 38,583

Loss on foreign exchange 2,337
Cash 40,920
583 €1,000,000 * (.06/2) = €30,000 * $1.2861 = $38,
€30,000 * $1.3640 = $40,920
9. Rouse Company, a developer of major shopping centers, built two shopping centers in
Canada and financed more than 90 percent of the cost with a loan from Canadian
lenders. The loan would be paid off with rental income from the shopping centers with
no recourse to Rouse Company.
a. Assume that Rouse treated the U.S. dollar as the functional currency for translation
purposes and that the Canadian dollar was weakening against the U.S. dollar.
What do you think would have been the impact of that situation on the income
statement?
Rouse would have used the temporal method, resulting in a net liability position – especially
since the assets were 90 percent financed by debt. A weak Canadian dollar would have
generated translation gains, which would have shown up on the income statement. However,
income would have been translated at lower U.S. dollar value terms do the weak Canadian
dollar, so that would have depressed earnings somewhat.
b. Rouse argued to the FASB that its operations in Canada constituted a natural hedge
and that it should not have to reflect any translation gains or losses in income. What
do you think they meant by a “natural hedge,” and what is your opinion about their
contention?
A natural hedge means that fixed assets purchased by the debt will generate earnings that can
offset any loss on the foreign currency long-term debt.
c. How would your answer in question “a” differ if Rouse treated the Canadian
dollar rather than the U.S. dollar as the functional currency?
First, Rouse would have a small net asset position. If the Canadian dollar is the functional
currency and is weakening, Rouse would pick up translation losses that would be shown in
equity. Earnings would still be lower due to the weaker Canadian dollar.
d. Given the assumptions in the case, which currency should be the functional
currency?
Since 90 percent of the cost of building the Canadian shopping centers is financed by a
Canadian loan and cash flows from earnings are also in Canadian dollars, the Canadian dollar
should be the functional currency.
The following is an example of a U.S. company with a U.K. subsidiary:
Fourth Quarter 2003 Fourth Quarter 2004

U.S. Dollar U.S. Dollar
Pound Equivalent U.S. Pound Equivalent U.S.
Sterling per Pound Dollars Sterling per Pound Dollars
Net sales £5,020 1.723 $8,649 £5,390 1.863 $10,042
Cost of sales 3,320 1.67 5,544 3,465 1.798 6,230
Gross profit 1,700 3,105 1,925 3,812
Operating expenses 1,170 1.723 2,016 1,315 1.863 2,450
Pretax results 530 1,089 610 1,362
Income taxes 310 1.723 534 315 1.863 587
Net earnings £220 $555 £295 $775
Was the U.S. dollar strengthening or weakening against the pound from the third quarter
of 2003 to the fourth quarter of 2003? From the third quarter of 2004 to the fourth
quarter of 2004?
The U.S. dollar weakened against the pound from the fourth quarter of 2003 to the fourth
quarter of 2004.
c.Was the temporal method or the current rate method used to translate this
income statement?
The temporal method was used to translate this income statement (revenues and expenses are
translated at the average rate of exchange during the year, and cost of sales is translated at the
exchange rate in effect when the assets were originally purchased).
Analyze the effect of translation on reported sales and earnings from one year to the next
and compare the dollar and pound changes.
Sales increased by 7.4% in pounds and by 16.1% when translated into dollars. Earnings
likewise increased by more when translated into dollars. This is due to a weakening of the
U.S. dollar in relation to the pound.
If the income statements had been translated at the average exchange rate, what would
have been the impact on your answer for question c?
Sales and earnings still would have risen by more when translated into dollars but not by as
much (the average exchange rate is 1.793, which is quite a bit smaller).
RadCo International is a U.S. firm with a wholly owned subsidiary in France. The basic
assumptions involved in the French subsidiary and its interaction with the parent
company are as follows (see page 280 in the text):
a. The functional currency of the subsidiary is the euro, and the financial statements
have been recast in U.S. GAAP to assist in the translation process.
b. Capital stock was issued and fixed assets acquired when the exchange rate was €1.05
per dollar; dividends are paid at a rate of $1.3644 per euro.
c. Inventories were all acquired in the previous quarter.
d. Purchases, sales, and other expenses occurred evenly throughout the year.
e. There is a zero beginning balance in the accumulated translation adjustment
account.
f. Inflation in France has been in the single digits in recent years.
Exercise: Translate the financial statements into U.S. dollars.
Balance Sheet (in € in thousands)

12/31/2003 12/31/2004
Cash 1,000 1,256 2,000 2,729
Accounts receivable 3,900 4,897 4,725 6,447
Inventories 3,600 4,521 4,700 6,413
Fixed assets 27,500 34,532 27,500 37,521
Accumulated depreciation (2,750) (3,453) (5,500) (7,504)
Total 33,250 41,752 33,425 45,605
Accounts payable 6,500 8,162 6,000 8,186

Long-term debt 12,500 15,696 10,800 14,736
Capital stock 6,200 6,510 6,200 6,510
Retained earnings 8,050 11,384 10,425 14,366
Accumulated translation adjustment 1,807
Total 33,250 41,752 33,425 45,605
Income Statement (in €, thousands)

Sales 31,500 41,268
Expenses
Cost of goods sold (18,000) (23,582)
Depreciation (2,750) (3,603)
Other (4,500) (5,895)
Taxes (1,500) (1,965)
Net income 4,750 6,223
Dividends 2,375 3,240
Note: No value is given for the retained earnings balance for 12/31/2003. Since the ATA is zero
on that date, the dollar value of retained earnings is the dollar value of total assets minus
liabilities and capital stock. The retained earnings balance for 12/31/04 is the beginning retained
earnings balance plus net income minus dividends. The ATA is total assets minus liabilities,
capital stock, and retained earnings. It is a plug figure.
RadCo International is a U.S. firm with a wholly owned subsidiary in Mexico that uses the
dollar as its functional currency. The relevant facts in the case are as follows (see p. 281 in
the text):
a. Most of the transactions take place in Mexican pesos, although the subsidiary
borrowed money in U.S. dollars. The financial statements have been recast into U.S.
GAAP to facilitate the translation process.
b. Capital stock was issued, fixed assets acquired, and long-term dollar debt incurred
when the exchange rate was 5.0000 pesos per dollar.
c. Inventories are acquired during the previous quarter.
d. Purchases, sales, and other expenses occurred evenly throughout the year.
e. Fixed assets are being depreciated on a straight-line basis over 10 years.
Exercise: Translate the peso financial statements into dollars.

Relevant Exchange Rates (Pesos/US$)
Cap stock, fixed assets, LT
Historical Rate 5.000 5.000 debt
December 31, 2003 8.500
December 31, 2004 9.490
Average during 2004 9.000
Average fourth quarter 2003 8.450
Average fourth quarter 2004 9.200
Balance Sheet (in Mexican pesos in thousands)
12/31/03 USD 12/31/2004 USD

Cash 20,000 2,353 14,000 1,475
Accounts receivable 40,000 4,706 110,000 11,591
Inventories 40,000 4,734 30,000 3,261
Fixed assets 100,000 20,000 100,000 20,000
Accumulated depreciation (20,000) (4,000) (30,000) (6,000)
Total 180,000 27,793 224,000 30,327
Accounts payable 30,000 3,529 50,000 5,269

Long-term debt (U.S.$120) 1,020 120 1,139 120
Long-term peso debt 44,000 5,176 44,000 4,636
Capital stock 60,000 12,000 60,000 12,000
Retained earnings 44,980 6,967 68,861 8,302
Total 180,000 27,793 224,000 30,327
Income Statement
(in Mexican pesos in thousands) USD
Sales 230,000 25,556
Expenses
Cost of goods sold (110,000) (12,584)
Depreciation (10,000) (2,000)
Other (80,000) (8,889)
Taxes (6,000) (667)
Foreign exchange loss/gain (119) 15
Translation Gain (Loss) (67)
Net income 32,881 1,335
Beginning inventory 40,000 4,734
Purchases 100,000 11,111
140,000 15,845
Ending inventory 30,000 3,261
Cost of goods sold 110,000 12,584
Note: Since the 12/31/03 retained earnings balance is not given, it is a plug figure to make the
balance sheet balance. Since the LT debt in dollars doesn’t change the peso value changes,
which gives rise to a foreign exchange loss that is translated into dollars at the average exchange
rate for the year. Net income is the ending retained earnings balance (which is a plug figure)
minus the beginning retained earnings balance. The translation loss is a plug figure to make the
income statement balance.
Chapter Eleven
Company ABZ invested $200,000 cash in new equipment at the beginning of 2005. The
equipment was depreciated evenly over ten years with an expected salvage value of
$10,000. In 2008, inflation hit the economy hard, raising the CPI from 200 to 245. It is
estimated that it would cost $400,000 to replace the machine.
1. According to the GPP theory, how should the company represent the equipment on
its balance sheet at the end of 2008? How much depreciation expense will ABZ
recognize in 2009 for the equipment? What are the corresponding journal entries
for the change in value?
ABZ should record its equipment at a cost of $245,000 less accumulated depreciation. ABZ
should recognize $23,275 in depreciation expense in 2009. The appropriate journal entries
are below:
Depreciation expense 17,100

Accumulated depreciation 17,100
To restate accumulated depreciation to December 31, 2008 purchasing power
Equipment 45,000
GPP adjustment on equipment 45,000
To adjust equipment to December 31, 2008 purchasing power amounts
The calculations are as follows:

(245-200)/200 = 22.5% increase in price level
200,000 + (200,000 * .225) = $245,000 adjusted cost of equipment
200,000 – 10,000 = 190,000/10 years = $19,000 unadjusted depreciation expense
19,000 + (19,000 * .225) = $23,275 adjusted depreciation expense
(23,275 – 19,000) x 4 = accumulated depreciation adjustment
2. According to current cost accounting, how should the company represent the
equipment on its balance sheet at the end of 2008? How much depreciation expense
will ABZ recognize in 2009 for the equipment? What are the corresponding journal
entries for the change in value?
ABZ should record the equipment at its replacement cost of $400,000 less accumulated
depreciation. This would increase the depreciation expense to $39,000/year ([400,000 –
10,000]/10). The journal entries would be as follows:
Depreciation expenses 80,000
Accumulated depreciation 80,000
To adjust equipment to December 31, 2008 replacement cost amounts
Equipment 200,000
Holding gain 200,000
To adjust equipment to new replacement cost
3. According to current exit price accounting, how should the company represent the
equipment on its balance sheet at the end of 2008? How much depreciation expense
will ABZ recognize in 2009 for the equipment?
ABZ should record its equipment at a value of $400,000. This represents the current value of
$400,000 and an unrealized holding gain of $200,000 since 2005. No depreciation expense
is charged.
4. According to the real value accounting system, how should the company represent
the equipment on its balance sheet at the end of 2008? How much depreciation
expense will ABZ recognize in 2009 for the equipment?
ABZ should record the equipment at a cost of $400,000 less accumulated depreciation.
There will be a real holding gain of $155,000 ($400,000 market value - $245,000 GPP value)
and a GPP adjustment of $45,000. Depreciation expense in 2009 will be $39,000 to reflect
the equipment’s new current value.
5. How is the company’s financial position different if the equipment is purchased with
debt instead of cash?
ABZ’s financial position is better if the equipment is purchased with debt because it can pay
its debt with cash whose purchasing power has fallen. It would enjoy a gain in its purchasing
power due to its net liability position.
6. Now assume that ABZ is a subsidiary of ZBA, which is based in Brazil. If Brazil has
inflation of 15% in 2005, and 25% in 2006-2008, how much would the book value of
the equipment be in reals? What if Brazil had inflation of 35% in 2006-2008?
1. $287,500 (200,000 x 1.5 x 1.25) – 109,250 (19,000 x 1.5 x 1.25) = $178,250

2. $310,500 (200,000 x 1.15 x 1.35) – 117, 990 (19,000 x 1.15 x 1.25) - $192,510
7. If the company sells the equipment at the beginning of 2009 for $325,000, how much
gain or loss is recognized under each of the three accounting treatments?
Under GPP theory, ABZ would recognize a $173,100 gain ($325,000 - [$245,000 – (23,275 x
4)].
Under current cost accounting, ABZ would recognize an $81,000 realized holding gain
($325,000 – [$400,000 – 156,000]).
Under current exit value accounting, ABZ would recognize a $125,000 realized holding gain.
8. If ABZ does sell the equipment for $325,000, what are the potential benefits and
dangers in the current high-inflation economy?
While gains will be realized under each method, the costs of asset replacement have
increased and so maintaining operating capacity will likely require reinvestment of these
gains.
The effect of inflation on the financial position and performance of a corporation can result in
inefficient operating decisions by managers who do not understand its impact. Holding
financial liabilities is beneficial because the business will pay its obligations in the future
with cash that has lost some of its purchasing power. The caveat here is that financial
liabilities, such as short-and-long-term bank loans, often carry very high interest rates in
inflationary economies.
Exercises 9-11
You are the controller of a medium-sized, publicly-held phone company. The year has
not been good, and inflation has hit the telecommunications industry. The industry saw
an average price increase of 10%, while the rest of the economy had inflation of 3%.
OnCall, the company you work for, is confident that the rest of the economy will catch
up to the inflation of the telecommunications industry within the next two years.
9. How should inflation impact the balance sheet and income statement of OnCall in
the current year?
As stated in the chapter, financial assets such as cash lose value during inflation because of
their purchasing power diminishes. Conversely, holding financial liabilities is beneficial in
an inflationary period because the business will pay its obligations in the future with cash
that has lost some of its purchasing power. The caveat here is that financial liabilities, such
as short-and-long-term bank loans, often carry very high interest rates in inflationary
economies.
The effect of inflation on nonmonetary assets is reflected in both the income statement and
the balance sheet. During a period of rising prices, current sales revenues are matched
against inventory that may have been purchased several months earlier and against
depreciation computed on the historical cost of property, plant, and equipment that may have
been purchased several years ago, despite the fact that replacing inventory and fixed assets
has become more expensive.
Thus, OnCall’s balance sheet will probably be more heavily weighted toward liabilities. Its
income statement will show a higher profit margin due to revenues that are matched against
inventory with a low historical cost.
10. Assuming that in two years the rest of the economy does catch up to the price level
in the telecommunications industry, how should OnCall’s balance sheet and income
statement look at that point in time with regard to inflationary accounting?
OnCall’s assets will gain value but the cost of its inventory will be higher relative to sales
revenues, resulting in a lower profit margin. Financial liabilities will become less
burdensome but interest rates will likely be much higher.
11. Under IAS 29, how much would a gallon of gasoline have to cost before the U.S.
dollar were considered hyperinflationary? Assume that the price of gas is
representative of the rest of the economy, and a gallon of gas costs $2.00.
IAS 29 states that hyperinflationary economies are those in which 100% inflation occurs over
three years. Thus, before the U.S. dollar would be considered hyperinflationary, a gallon of
gas would cost $4.00 ($2 + [$2 * 100%]).
Exercises 12-15
White Light Electric, Inc. sells light fixtures in the United States. In 2010 the company
began operations, with total equity investments of $50 million (all cash). White Light
used the money to purchase and outfit a manufacturing plant for $30 million. The
plant, comprising 80% of the purchase price (the balance was for the land), is to be
amortized straight-line over 25 years with no expected salvage value. The plant
revenues (and thus the total company revenues) in 2010 were $70 million, with 7% gross
profit and $1.9 million in SG&A. By the end of 2010, the CPI had risen from 210 to
350.
12. Prepare a basic balance sheet and income statement for White Light Inc. for 2010
under the general purchasing power accounting approach.
12a. Historical Cost Approach
Balance Sheet
Useful
Assets Liabilities life 25
-
Cash 23,000,000 Plant HC 24,000,000
Plant 23,040,000 Equity 50,000,000

Land 6,000,000 Retained earnings 2,040,000
Total Assets 52,040,000 Total Liabilities and Equity 52,040,000
Income Statement
Revenues 70,000,000
COGS (65,100,000)
Gross profit 4,900,000
SG&A (1,900,000)
Depreciation (960,000)
Pretax profit 2,040,000
12b. General Purchasing Power Approach
Balance Sheet
Adj for infl
Assets Adj for infl Liabilities - - Useful life 25

Change in price
Cash 23,000,000 23,000,000 index 0.667
Plant 24,000,000 40,000,000 Equity 50,000,000 50,000,000 Plant HC 24,000,000
Less deprec (960,000) (1,600,000) GPP Adj. Reserve 18,000,000
Land 6,000,000 10,000,000 Retained earnings 2,040,000 3,400,000

Total Liab and
Total Assets 52,040,000 71,400,000 equity 52,040,000 71,400,000
Income Statement
Revenues 70,000,000 116,666,667
COGS (65,100,000) (108,500,000)
Gross profit 4,900,000 8,166,667
SG&A (1,900,000) (3,166,667)
Depreciation (960,000) (1,600,000)
Pretax profit 2,040,000 3,400,000
13. Prepare a basic balance sheet and income statement for White Light Inc. for 2010
under the current cost accounting approach.
13. Current Cost Accounting
Approach Balance Sheet

Adj for infl
Assets Adj for infl Liabilities - Useful life 25
Cash 23,000,000 23,000,000 Equity 50,000,000 50,000,000 Plant HC 24,000,000

Retained Change in price
Plant 24,000,000 40,000,000 earnings - (42,000,000) index 0.667
Beginning price
Less deprec (960,000) (1,600,000) Holding gains 2,040,000 index 210
Land 6,000,000 10,000,000 Plant 16,000,000 Ending price index 350
Total Assets 52,040,000 71,400,000 Land 4,000,000
Inventory 43,400,000
63,400,000
Income Statement Total liab and equity 52,040,000 71,400,000
Revenues 70,000,000 70,000,000
COGS (65,100,000) (108,500,000)
Gross profit 4,900,000 (38,500,000)
SG&A (1,900,000) 1,900,000
Depreciation (960,000) (1,600,000)
Pretax profit 2,040,000 (42,000,000)
14. Compare the two sets of financials using rate-of-return ratios.
14.Financial Ratios
Pre-tax Profit/Sales:
GPP Approach 2.90%
Current Cost
Approach -60%
Pre-tax Profit/Equity (total):

GPP Approach 4.80%
Current Cost
Approach -59%
15. Has White Light increased its net financial position or its net financial liability
position? Is that good or bad?
The net financial position has similarly increased under both approaches, given the stated assumptions.
However, the components of equity are significantly different with retained earnings greatly impacted by
the current cost approach.
Chapter 12
1. In October 2004, General Motors announced a change in its practices regarding new
model development. The following excerpt from The Wall Street Journal explains the
change:
“General Motors Corp. is the biggest car company in the world. The company was created, as its
name suggests, by bringing together many smaller motor-car makers in the early decades of the
20th century…In the U.S., Cadillac, Chevrolet, Buick and Oldsmobile all functioned as separate
entities with their own manufacturing plants. That philosophy applied overseas as well. GM
bought Britain's Vauxhall Motors in 1925, Germany's Adam Opel in 1929, and Australia's
Holden in 1931. Each of these and many other overseas units had their own manufacturing and
product-development divisions…In the mid-1980s, as pressure rose from Japanese rivals in the
mass market and German makers in luxury cars, [the formula stopped working]. Now GM has
[centralized the design and production of new models]… By tapping engineers in far-flung units
[such as India, South Korea, and China] who previously would have worked only on local
models, GM is hoping to speed up development of U.S. models without spending more. [One
executive] stresses that GM's goal isn't to offer cars that look the same in every market: “We want
to have all of these variations, but we want these variations to be plug-and-play.” GM's struggle
to find the balance between local autonomy and central control is a familiar one for global
corporations. Mr. Wagoner [CEO] says he wants GM to be the winner in what he calls "a race to
the middle" in the centralization vs. decentralization debate.” (New Driver: Reversing 80 Years of
History, GM Is Reining In Global Fiefs; Wall Street Journal, 10/6/2004)
a. What was GM’s traditional global strategy? What is its new strategy?
At first, GM had a multidomestic strategy, in which each subsidiary functioned as a
separate entity. Now, GM has centralized some of its operations and is trying to balance
a global vs. multidomestic strategy.
b. What were the advantages of the old strategy? What are the advantages of the
new strategy? Which one do you think is best for an auto manufacturer?
The advantages of the multidomestic strategy included the ability to manufacture cars
according the specifications and consumer wants in each country. The advantages of
centralizing design include minimizing design costs and hopefully purchasing and
assembly costs.
The second part of this question depends on the student’s opinion.
c. Recall the discussion on forces for global, forces for local differentiation, and
forces for worldwide innovation. How have these forces affected GM’s strategy
and structure?
GM has an increased need for efficiency and economies of scale, especially since it is
competing against the Japanese. However, GM also sells cars in a number of countries,
and these consumers each demand a different style of car, forcing GM to be responsive to
consumers’ preferences. GM wants to gather new ideas from each subsidiary but also
diffuse innovation throughout the company in order to leverage its knowledge. Each of
these factors has led GM to seek a balance between a global and a multidomestic
strategy.
d. What type of information transfer does the new structure foster: routine, non-
routine, sequential, or reciprocal?
This new structure seems to foster a reciprocal transfer of information between both
subsidiaries and the central office. The central office is using engineers from its
subsidiaries to get information about consumer preferences and tap design knowledge.
Then the central office will send back information to the subsidiaries in the form of new
models that can be customized to individual countries’ needs.
2. Hoeschst is a German chemical company operating in different product lines and

different geographic areas. Its major business areas are chemicals (23 percent of sales),
fibers (15 percent), polymers (17 percent), health (24 percent), engineering and
technology (15 percent), and agriculture (6 percent). Across these product lines,
Hoeschst produces products as diverse as phosphorus and phosphates used in
detergents, textile dyes, polyester auto tire cords, cellulose acetate fibers for cigarette
filters, polyvinyl chloride (PVC), automotive paints, pharmaceuticals, cosmetics, offset
printing plates, engineering ceramics, herbicides, and animal vaccines. Most of
Hoeschst’s product lines face significant global competition. On the geographic side,
Hoeschst sells products in the European Union (51 percent of total sales); other
European countries (7 percent); North America (21 percent); Latin America (7
percent); and Africa, Asia, and Australasia (14 percent).
a. What type of an organizational structure makes the most sense for Hoeschst?
A product line makes the most sense for Hoeschst since its products are so diverse.
b. What would be some of the major international accounting problems Hoeschst

might face?
If the organizational structure is highly centralized, Hoeschst may want to keep a main
set of books according to German GAAP or IAS. However, the subsidiaries may also
need to keep a separate set of books in order to comply with local laws. Reconciling
these needs, along with differences in foreign exchange and local laws, may complicate
Hoeschst’s international accounting function.
c. Given its size and geographical dispersion, what information transfer challenges
might Hoeschst face? How can IT ease those challenges?
As an MNE becomes larger and enters more countries, it faces the challenge of
compatibility of information from various divisions. During the late 1980’s and early
1990’s, most companies had separate information systems for each functional area and
division. One way to overcome this problem is by using an Enterprise Resource
Planning (ERP) system. The purpose of ERP is to integrate all departments and
functions under one computer system. In other words, all companywide data is stored in
one place and can be extracted and manipulated in any way to fit the needs of the
different functions and departments of a firm. Even with the new software, the cultural
issues involving management from different countries needs to be solved. Also,
Hoeschst needs to standardize hardware and software to reduce costs and allow
information to be transferred easily.
3. Procter & Gamble (P&G) is a well-known MNE based in the U.S. At the end of this
chapter is a case on P&G’s restructuring efforts. To prepare for the issues discussed in
the case, go to www.pg.com and answer the following questions. (The following link
goes directly to the Annual Reports page:
http://www.pg.com/investors/annualreports.jhtml)
a. Read about P&G’s product lines and geographical operations. What kind of
organizational structure would you guess the company has currently?
P&G is organized according to product lines. There are U.S. product lines and then
global product lines.
b. In the section on corporate governance and responsibility, learn about the board
of directors. What percentage of outside directors does P&G have? Are the
roles of chairman and CEO split? What are the different committees on the
board of directors?
P&G’s board of directors is comprised of about 80% outside directors. The chairman of
the board, A.G. Lafley, is also the CEO. The board has six committees: audit;
compensation and leadership development; executive; finance; governance and public
responsibility; and innovation and technology.
c. What challenges would P&G face in designing an effective management control

system?
One of the challenges P&G would face is the fact that its CEO is also Chairman of the
Board. This means that he can determine internal control procedures, and he is
responsible both for the daily operations of the firm as well as to represent shareholders’
interests. Having the CEO and the Chairman of the Board be one person may impair the
Board’s independence and/or weaken its resolve to contradict management if it acts
against shareholders’ interests.
d. Learn about the audit committee of the board of directors. Who heads the audit
committee, and what is his background? How important is the internal audit
function at P&G?
The head of the audit committee is John F. Smith, Jr. He is the Chairman of the Board at
Delta Air Lines and was previously the Chairman of the Board and CEO at General
Motors. He has been the audit committee director since 1995. The internal audit
function at P&G is very important because P&G produces a diverse range of products
and operates in many different countries. This provides opportunities for mistakes and
fraud.
4. Varig is an airline company based in Brazil. The company is 55.67% owned by FRB-
Par Investimentos, a local holding company. The rest of Varig’s shares are owned as
follows: Brazilian Government (30.68%); Interunion Capitalização, a private firm
(7.4%); Instituto Aerus de Seguridade Social, a pension fund (5.19%); Estado do
Rio Grande do Sul, a state in southern Brazil (0.44%); Varig's employees (0.29%);
Foreigners (0.34%). Varig lists its shares on several Brazilian stock exchanges.
a. Based on Varig’s ownership structure, what can you predict about the property
rights, financial system, and the prevalence of interfirm networks in Brazil?
Property rights: Property rights in Brazil probably favor the government and large
institutions rather than employees and smaller investors.
Financial system: Brazil’s financial system is probably a market-based financial system,
but the wealth is concentrated in large institutions rather than in broadly-based ownership
from individual investors.
Interfirm networks: It is hard to say, but financial institutions and the government appear
to have the greatest voice.
b. Based on your predictions, how do capital holders exercise control over Varig?
(Hint: Review this chapter’s discussion on the cross-national diversity of
corporate governance.)
Varig’s owners are primarily domestic, even though the airline flies internationally. Thus
Varig is more concerned about big institutions, both public and private.
5. Now that you have considered Varig’s ownership structure, consider Bayer, the
German pharmaceutical firm. Bayer’s ownership structure is as follows: Banks and
insurance companies (55%), individuals (24%), investment funds (12%), trade and
industry (3%), others (6%).
a. What differences do you notice between Bayer’s and Varig’s ownership
structures?
Bayer is owned mostly by banks and insurance companies, followed by individuals.
Varig is owned mostly by a holding company and the Brazilian government.
b. What does Bayer’s structure tell you about the property rights, financial
system, and the prevalence of interfirm networks in Germany?
Property rights: In Germany, property rights favor large shareholders.
Financial system: The financial system is predominantly bank-based.
Interfirm networks: Interfirm networks contain a high degree of multiplexity.
6. As mentioned in the text, informal controls are becoming a key aspect of managing an
organization. One of those controls is organizational culture. IKEA, the Swedish giant,
has managed to become the world’s largest furniture retailer with more than 200 stores
in more than 20 countries. Despite its international growth, IKEA has kept its strong
Scandinavian roots and philosophy in all its locations. To learn more about the
company’s culture, do the following activities:
a. Visit www.ikea.com and learn more about what the firm calls “the IKEA
concept”. What is the IKEA concept? How does the IKEA concept translate into
its products and stores?
The IKEA vision is “To create a better everyday life for the many people.” The company
fulfills this vision by offering a wide range of well-designed, functional home furnishing
products at prices so low that as many people as possible will be able to afford them. The
company targets young, new families and prices accordingly.
b. Now go to www.ikea.com/corporate/work, where you will find a link to IKEA’s

culture and values. How does the firm’s culture reflect the IKEA concept? How
does the culture as an informal control allow different people to do things in a
consistent manner?
IKEA extends its corporate vision of creating a better everyday life to its employees. It
does this by investing in its employees and giving them sufficient opportunities and
responsibilities to learn and develop. IKEA aligns its company culture with its corporate
vision by attracting diverse people who share similar values and beliefs, including
togetherness and enthusiasm; humbleness; willpower; and simplicity. It also uses
Swedish values and tries to instill them through using Swedish top management in its
locations around the world.
7. Companies worldwide are coming to realize that good governance structures and
policies alone are not sufficient to gain the public’s trust. Firms must convince potential
investors that management is ethical, competent, and trustworthy. Thus, many firms
have established written codes of ethics. One of those companies is Shell, the giant
Dutch oil company. Go to www.shell.com and find Shell’s code of ethics. Answer the
a. What are the key requirements of the code?
Each Executive Director shall:
 act in accordance with the highest standards of honesty, integrity and fairness and
expect the same in their relationships with others;
 adhere to the Statement of General Business Principles and any applicable code of
conduct on dealing in securities;
 excuse himself from making any decision about an issue at hand in which a conflict
of interests arises or could arise and in such event;
 avoid having any financial interest in works of or contracts awarded by a
Shell company or a company associated with a Shell company
 not seek or accept from third parties to his own advantage any favor in whatsoever
form or howsoever described in connection with the business of any Shell company
or his duties
 not hold positions or jobs or engage in outside businesses or other interests that
adversely impact the performance of duties owed to any Shell company;
 avoid any relationship with a contractor or supplier that could compromise the ability
to transact business on a professional, impartial and competitive basis
 consistent with the scope of his job responsibilities, ensure full, fair, accurate, timely,
and understandable disclosure in regulatory filings and in other public
communications made by Royal Dutch Shell.
b. To whom does the code apply?
The code applies to
 the Executive Directors of Royal Dutch Shell
 the Chief Financial Officer
 the Executive Vice President – Controller
 the Executive Vice President – Treasury and Corporate Finance
 the Chief Internal Auditor
 the Executive Vice President – Taxation
 the Executive Vice President - Investor Relations
 Executive Vice Presidents - Finance of Exploration and Production, Downstream
and Gas and Power
 any person or job holder designated by the Chief Financial Officer
These people are also known as COE (code of ethics) addressees.
c. Who is responsible for enforcing the code?

Each COE Addressee is held accountable for the full compliance with the code of ethics
with respect to any issues within his control.
d. At the end of this chapter you will find a case on The Royal Dutch/Shell Scandal.
What aspect of the code did management fail to follow?
Management failed to act in accordance with the highest standards of honesty, integrity
and fairness when it loosened its reserve booking policy.
8. In the U.S., public companies are required to file a Proxy Statement, which includes a
report on executive compensation. This report contains the compensation structure of
top management and the directors. Find and compare the reports on executive
compensation for IBM and Intel, two U.S. MNEs in the same industry. (Proxy
statements can be found at
ftp://ftp.software.ibm.com/annualreport/2004/2005_ibm_proxy.pdf and
http://download.intel.com/intel/annualreports/Proxy_2005.pdf).
a. What percentage of each CEO’s compensation is made of salary, bonus, stock
options, and stock grants?
IBM: Samuel J. Palmisano receives 18% salary, 57% bonus, 18% LTIP payouts, and 6%
other compensation/underlying securities.
Intel: Craig R. Barrett receives 21% salary, 62% bonus, 12% options, and 6% other
compensation.
b. In your opinion, which firm’s compensation structure best aligns top

management’s interests with those of the shareholders?
IBM’s compensation structures best aligns top management’s interests with those of the
shardholders because less of Mr. Palmisano’s compensation is fixed.
9. DaimlerChrysler is a well-known German-American MNE that produces automobiles
such as Mercedes, Chrysler, and Jeep. Pretend DaimlerChrysler has hired you to
evaluate their compliance with the German code of best practice. Use the Scorecard
for German Corporate Governance questions presented in this chapter (Exhibit 12.1) to
perform your evaluation. Visit the “investor relations” section of
www.daimlerchrysler.com to gather the necessary information. Once you have
answered all the questions in the scorecard, write a one page memo to the Chairman of
DaimlerChrysler’s board of directors outlining the strengths and weaknesses in the
firm’s compliance with the German code.
DaimlerChrysler does not have a link in its annual report to corporate governance, so it is hard
to find the material and make a good evaluation. One recommendation would be for the
company to have a separate link in its side menu under corporate relations for corporate
governance as many other companies do. Given the importance of corporate governance, it
makes sense to bring these issues out into the open rather than burying them in the report
somewhere.
10. Most codes of best practice on corporate governance are available to the general public.
Go to an Internet search engine and find the code of best practice for your country. If
your country doesn’t have one, choose a country of your interest and look up its code of
best practice.
a. What does the code suggest on the role and composition of the board of
directors?
b. Does the code suggest any specific committees for the board of directors?
c. Does it require the roles of chairman of the board and CEO to be separate?
d. What other areas of governance does the code cover?
The answer to this question depends on the student’s choice of country.
11. Choose one company from two or more different regions in the world, preferably in the
same industry. Learn about the ownership structure and the board of directors of your
chosen companies, and then compare your findings across companies.
a. What similarities and differences do you notice?
b. What do your findings suggest about the differences in the legal, financial, and
cultural aspects of the regions in which these firms operate?
c. Do your findings support the research findings on international corporate
governance presented in this chapter?
The answer to this question depends on the student’s choice of countries.
12. At the end of this chapter you will find a case on The Royal Dutch/Shell Scandal.
Interestingly, Shell was on the 2004 CalPERS Focus List. After you have read the case,
download the recommendations for improvement for Shell made by CalPERS from
the 2004 Focus List.
a. What problems does CalPERS identify in Shell’s governance and business
practices?
Performance:
 Stock has underperformed for the last 1, 3, and 5 years relative to peers.
 Concerns over apparent inadequacy of management and board controls.
 Concerns over Shell’s disclosure that its reserve accounting was flawed.
Governance:
 Dominant position of Royal Dutch within the context of its joint venture with Shell
Transport
 The exclusive right of incumbent Royal Dutch supervisory and management board
member representatives at Royal Dutch and to reject nominations by shareholders.
 Apparent absence of external competition to fill executive vacancies at the highest
level that is perpetuated by this mechanism – with no shareholder involvement.
 Large multi-national group being run by committee without a group chief executive.
b. What recommendations for improvement does CalPERS make?

 Establish a Board-level Committee comprised of independent directors from Royal
Dutch & Shell Transport to undertake a rigorous and wide-ranging re-examination of
the Group and how it is managed. This Board level Committee should address the (1)
role of a Group CEO, (2) management succession, (3) nomination of independent
directors and succession process of the Board, and (4) composition of the Group’s
boards.
 Establish a policy that allows shareholders open access and nominations to the Board.
 Remove reserves from compensation “Scorecards.” Reinforce the necessity for
compliant reserves bookings.
 Group Disclosure Committee should be enhanced with Group Legal Director and
quarterly access to the Committee of Managing Directors.
 Develop and foster a culture of compliance, ethics and appropriate conduct.
c. If you were a Shell shareholder, would you make any

additional recommendations?
This answer depends on the student’s opinion.
13. When it comes to shareholder activism as a means of corporate control, CalPERS is one
of the most active institutional shareholders in monitoring management performance
and financial performance. CalPERS is the largest public pension plan in the United
States and the third largest in the world. It serves more than 1,050,000 state, local
government and school district employees. The fund’s activism is well known and has
caused large companies to amend their governance practices. Visit www.calpers.com
and find the “Shareowner Action” section (This can be found at http://www.calpers-
governance.org/alert/default.asp). Answer the following questions:
a. What policies does CalPERS have with regards to executive compensation?
 Executive compensation programs should be designed and implemented to ensure
alignment of interest with the long-term interest of shareowners.
 Executive compensation should be comprised of a combination of cash and equity-
based compensation. Direct ownership should be strongly encouraged.
 Executive compensation policies should be transparent to shareowners. The policies
should contain, at a minimum, compensation philosophy , the targeted mix of base
compensation and "at risk" compensation, key methodologies for alignment of
interest, and parameters for guidance of employment contract provisions, including
severance packages. These policies should be submitted to shareowners for
approval on a periodic basis.
 Executive contracts should be fully disclosed, with adequate information to judge the
"drivers" of incentive components of compensation packages.
b. The CalPERS Focus List contains a set of companies in the CalPERS fund that,
in the fund’s opinion, need to make improvements in their governance and
business practices. What companies are on the most recent Focus List? Choose a
company from the list. What does CalPERS want that company to modify?
The 2005 Focus List includes American International Group, AT&T, Delphi, Novell,
and Weyerhauser Company.
CalPER seeks to amend Novell’s bylaws to require that at least 50 percent of

senior executive equity compensation be performance-based and that performance
metrics be fully disclosed to shareowners.
c. CalPERS also has a Monitoring List to recognize firms that have made
improvement to their governance practices “without undue publicity from being
named to the Focus List”. What companies are on the most recent Monitoring
List? Choose a company from the list and learn about the improvements it
made.
The companies on the most recent Monitoring List are E*Trade Financial and Nextel
Communications.
E*Trade Financial has made the following improvements:

 Appointing Mitch Caplan as CEO and renewing the Company’s commitment to
good corporate governance.
 Addressing shareholder concerns over excessive compensation to the prior CEO
 Separating the function of Chairman and CEO
 Adding three new independent directors
 Formalizing an executive session at every board meeting that includes only non-
management directors.
d. Why does CalPERS have the power to make companies change? Do individual
investors have the same power?
CalPERS is the largest public retirement system in the U.S. It uses the collective
force of its members to persuade corporations to change. Individual investors are not
as powerful as a large group of investors.
14. Effective November 15, 2004, management of public companies in the U.S. is required
by the Sarbanes-Oxley Act to report on the effectiveness of internal controls. In
addition, auditors must provide an independent assessment of management’s report.
Find the annual report for a public U.S. firm issued after the effective date and read the
reports of management and the independent auditors.
This answer depends on the company chosen by the student.
15. United Airlines entered into a strategic alliance with Thai Airways to develop and
market airline services.
a. Would you characterize this strategic alliance as a global innovator, an
integrated player, a local innovator, or an implementer from the standpoint of
United? What is your logic for your choice?
One possible answer is that this strategic alliance is an integrated player. It seems that
information will be shared between both United Airlines and Thai Airways in an effort to
improve both companies.
b. What are some of the problems that United might face in establishing
appropriate informal and subtle control mechanisms for the strategic alliance?
One potential problem United may face in establishing informal and subtle control
mechanisms are forming task forces comprised of employees from two separate
companies and cultures (forming lateral relations). Another challenge would be to create
an organizational culture, in which things will be done by different people in similar or
consistent ways.
Chapter 13
1. Nissan announced that it was closing some factories in Japan and shifting production to
the United States to shelter itself from foreign exchange risks that it faces when
exporting cars to the United States. Describe the risk that Nissan is concerned about.
Describe the pros and cons of using forward contracts to hedge Nissan sales to the
United States and whether or not they are a better solution than moving production to
the United States.
Nissan is concerned about economic risk—the potential for change in expected cash flows. It
arises from the pricing of products, the sourcing and cost of inputs, and the location of
investments.
Nissan could enter into a forward contract to deliver foreign currency at the same time the
company is expected to collect foreign currency from the foreign customer. That way a gain
on the foreign currency receivable would be offset by a loss in the foreign currency payable,
thus netting the gain and loss. This is simpler and less expensive than an operating hedge
(moving production to the United States). However, forward contracts are usually only used
to hedge specific financial transactions. If Nissan expected possible trade barriers or long-
term changes in the exchange rate, investing money in U.S. production may be the better way
to offset long-term political and/or economic barriers.
2. Pick a foreign currency of your choice and graph the value of that currency against the
U.S. dollar over the past 12 months. Based on what has happened to that exchange rate,
describe the financial challenges facing an exporter from the country or an exporter to
that country.
This answer depends on the student’s choice of foreign currency.
3. In the chapter, we discussed how companies can use derivative financial instruments to
hedge against a potential loss on a foreign currency receivable or payable. If there are
possible losses from denominating receivables and payables in a foreign currency, why
don’t firms insist that receivables and payables always be in their own currency instead
of a foreign currency?
Part of being a global company is dealing in foreign exchange. A company that insisted that
payables and receivables always be in its own currency would not be in business very long,
because customers would go to suppliers that offer payment in the buyer’s currency. The
solution depends on the market position of the company.
4. Siemens is a German company that generates its revenues in energy, industry,

information and communications, and health care. It has operations all over the
world. In the notes to its financial statements, Siemens states:
“Due to the weakness of the German mark relative to the British pound, the U.S. dollar and several
Asian currencies, total assets increased DM2.7 billion upon translation of foreign currency accounts.
As a result, the negative translation adjustment in shareholders’ equity was substantially reduced. Net
sales decreased DM1.5 billion, due to the opposite impact of annual average exchange rates on the
related statement of income accounts.”
Explain what this means in terms of exposure and the impact of exchange rates on
reported results.
Siemens is explaining that it is subject to translation exposure. It has an exposed assets
position because the value of its assets rises as other currencies rise against the mark.
5. On January 1, XYZ, a U.S. company, purchased inventory from a Japanese supplier

for ¥100,000,000, with payment to be made on February 28. At the same time, it decided
to enter into a forward contract to hedge the yen liability. Assume the following
exchange rates relative to the transaction:
¥110 per $ January 1 spot rate
¥108 forward rate quoted on January 1 for delivery on
February 28
¥109 spot rate on January 31
February 28
¥112 spot rate on February 28
How many dollars would XYZ have to pay the Japanese supplier, and what would be
the dollar value of the purchase?
XYZ would pay $925,926, which is ¥100,000,000 converted at the forward rate of ¥108
quoted on January 1 for delivery on February 28.
The dollar value of the purchase is $909,091, which is ¥100,000,000 translated at the spot
rate of ¥110 per dollar on January 1. Any changes in the exchange rate at subsequent dates
are taken to income.
6. On January 1, XYZ, a U.S. company, sold inventory to a Japanese supplier for

¥100,000,000, with payment to be received on February 28. At the same time, it decided
to enter into a forward contract to hedge the yen receivable. Assume the following
exchange rates relative to the transaction:
¥108per $ January 1 spot rate
February 28
¥108.5 spot rate on January 31
February 28
¥112 spot rate on February 28
How many dollars would XYZ receive after converting the proceeds from the Japanese
customer, and what would be the dollar value of the purchase?
XYZ will receive $925,926, which is ¥100,000,000 at the forward rate of ¥110 per dollar quoted
on January 1 for February 28 delivery.
The dollar value of the sale is $909,091, which is ¥100,000,000 translated at the spot rate of
¥110 per dollar on January 1. Any changes in the exchange rate at subsequent dates are taken
to income.
7. On March 1, QRS, a U.S. company, purchased inventory from a German supplier for
€100,000. At the same time, QRS entered into a forward contract to hedge the euro
liability which must be settled on May 31. Assume the following exchange rates:
€0.7705 March 1 spot rate

€0.7600 forward rate quoted on March 1 for delivery on May 31
€0.7700 spot rate on March 31
€0.7620 forward rate quoted on March 31 for delivery on May 31
€0.7600 spot rate on May 31
a. Assuming that no forward contract is entered into and that the books are closed at
the end of the quarter, what would be the journal entries for the exporter on March
1, March 31, and May 31?
€100,000/€0.7705
March 31 Foreign exchange loss 84

Accounts payable 84
€100,000/€0.7700
May 31 Accounts payable 129,870

Cash 131,578
The cash value represents €100,000 at the spot rate of €0.7600.
b. Assuming that a forward contract is entered into and that the discount rate is 6
percent, what would be the journal entries on March 1, March 31, and May 31?
€100,000/€0.7705
Memorandum entry made to record commitment to receive €100,000 at the forward rate of
€0.7600 (131,579).
March 31 Foreign exchange loss 84

Accounts payable 84
€100,000/€0.7700
Foreign exchange loss 345

Forward contract 345
€100,000/€0.7600 - €100,000/€0.7620 = -$345
May 31 Accounts payable 129,870

Cash 131,578
The cash value represents €100,000 at the spot rate of €0.7600.

Gain on forward contract 345
€100,000/€0.7620 - €100,000/€0.7600 = $345
Given the short time period and small amount, we did not make an adjustment on March 31
for the time value of money. QRS pays $131,578 to get €100,000 to pay the German
supplier. Since the future spot rate is the same as the forward rate quoted on March 1, you
might think that QRS is indifferent between entering into a forward contract and just waiting
until the date it had to make payment. But the forward contract gave QRS certainty. The
future spot rate could have been greater than or less than the forward rate.
8. On January 1, XYZ, a U.S. exporter, sold merchandise to a German supplier for

€100,000. At the same time, it decided to enter into a forward contract to hedge the
euro receivable. Assume the following exchange rates relative to the transaction.
$1.3000/euro January 1 spot rate

$1.2800 forward rate quoted on Jan 1 for delivery on Feb 28
$1.3500 spot rate on January 31
$1.3300 forward rate quoted on January 31 for delivery on Feb. 28
$1.3100 spot rate on February 28
a. How many dollars would XYZ receive from the sale, and what would be the
dollar value of the sale?
XYZ would receive $128,000 from the sale, and the value of the sale would be $130,000.
(See following entries.)
b. Assuming that no forward contract is entered into and that the books are closed at
the end of the each month, what would be the journal entries for the exporter on
January 1, January 31, and February 28?
January 1 Accounts receivable 130,000

Sales revenue 130,000
€100,000*1.3000

Foreign exchange gain 5,000
€100,000*(1.3500-1.3000)
February 28 Cash 131,000

The cash value represents €100,000 at the spot rate of $1.3100.
c. Assuming that a forward contract is entered into and that the discount rate is 6
percent, what would be the journal entries on January 1, January 31, and February
28?
€100,000*1.3000
Memorandum entry made to record commitment to receive €100,000 at the forward rate of
$1.2800 (128,000).

€100,000*(1.3500-1.3000)

Forward contract 5,000
€100,000*(1.3300-1.2800) = $5,000

The cash value represents €100,000 at the spot rate of $1.3100.

€100,000*(1.3100-1.3300) = $2,000

Cash 3,000
If we had taken into account the time value of money, the value of the forward contract on
January 31 would have been $4,975. $5,000/(1+.06/12)
9. On January 1, ABC, an Australian exporter sold wool to a British importer for

£500,000 at an exchange rate of £2.4405 per Australian dollar. At the same time, they
entered into a forward contract to hedge the receivable. Assume the following exchange
rates relative to the transaction.
£2.4405 January 1 spot rate

£2.5000 forward rate quoted on Jan 1 for Feb 28 delivery
£2.4800 spot rate on January 31
£2.4900 forward rate quoted on Jan 31 for Feb 28 delivery
£2.4950 spot rate on February 28
a. How many A$ would the exporter receive from the sale, and what would be the
The exporter would receive A$200,000 from the sale if the forward contract is entered into,
and the dollar value of the sale will be A$204,876.
the end of each month, what would be the journal entries for the exporter on
January 1, January 31, and February 28?
January 31 Foreign exchange loss 3,263

£500,000/£2.4800 - £500,000/£2.4405

The cash value represents £500,000 at the spot rate of £2.4950.
percent, what would be the journal entries on January 1, January 31, and February
28?
Memorandum entry made to record commitment to receive £500,000 at the forward rate of
£2.5000 (A$200,000).
January 31 Foreign exchange loss 3,263

£500,000/£2.4800 - £500,000/£2.4405
Foreign exchange loss 803

£500,000/£2.4900 - £500,000/£2.5000 = A$803


Foreign exchange gain 402
£500,000/£2.4950 - £500,000/£2.4800

Cash 401
If ABC had taken into consideration the time value of money, the amount of the forward
contract on January 31 would have been A$799, which is A$803/(1+.06/12)
10. On January 1, ABC, an Australian exporter entered into a firm commitment to sell
wool to a British importer for £500,000. Delivery will be made on February 28, and
payment will be made on March 30. At the same time, they entered into a forward
contract to hedge the receivable. Assume the following exchange rates relative to the
transaction and that the books are closed at the end of each month.

£2.5000 forward rate quoted on Jan 1 for March 30 delivery
£2.4800 forward rate quoted on February 28 for March 30 delivery
£2.4950 spot rate on March 30
a. How many A$ would the exporter receive from the sale, and what would be the
The exporter would receive A$200,000 from the sale if they entered into the forward
contract, and the dollar value of the sale would be A$200,407 (see entries in part c).
January 1, January 31, February 28, and March 30?
January 1 no entry
January 31 Firm Commitment 803

Gain on firm commitment 803
February 28 Firm commitment 810

Gain on firm commitment 810

Firm commitment 1,613
Sales 200,407
March 30 Cash 200,401

percent, what would be the journal entries on January 1, January 31, February 28,
and March 30?
January 1 No entry
Memorandum entry made to record commitment to receive £500,000 at the forward rate of
£2.5000 (A$200,000).
January 31 Foreign exchange loss 803

£500,000/£2.4900 - £500,000/£2.5000 = A$803
Firm commitment 803

February 28 Foreign exchange loss 810

Firm commitment 810


Sales 200,407
Firm Commitment 1,613
March 30 Forward Contract 1,212

Gain on Forward Contract 1,212


Cash 200,000
If ABC had taken into account the time value of money, the amount of the forward contract
on January 31 would have been A$803/(1+.06/6) = A$ 795 and the amount of the forward
contract on February 28 would have been A$810/(1+2*.06/12) = A$806
11. On January 1, ABC, an Australian importer entered into a firm commitment to buy
cloth from a British exporter for £500,000. Delivery will be made on February 28, and
payment will be made on March 30. At the same time, they entered into a forward
contract to hedge the liability. Assume the following exchange rates relative to the
transaction and that the books are closed at the end of each month.

£2.4800 forward rate quoted on February 28 for March 30 delivery
£2.4950 spot rate on March 30
a. How many A$ would the importer pay, and what would be the dollar value of the
purchase?
The importer must pay $200,000, and the dollar value of the purchase is $200,407. (See
following entries.)
January 1, January 31, February 28, and March 30?
January 1 No entry
January 31 Loss on Firm Commitment 803

Firm Commitment 803
February 28 Loss on Firm Commitment 810

Firm Commitment 810
Inventory/purchases 200,407
Firm purchase commitment 1,613
March 30 Accounts payable 202,020

Cash 200,401
percent, what would be the journal entries on January 1, January 31, February 28,
and March 30?
January 1 No entry
January 31 Forward Contract 803

£500,000/£2.4900 - £500,000/£2.5000
Loss on firm commitment 803

Firm commitment 803
February 28 Forward contract 810

£500,000/£2.4800 - £500,000/£2.4900
Loss on firm commitment 810

Firm commitment 810
Inventory/Purchases 200,407
Purchase commitment 1,613
£500,000/£2.4750
March 30 Loss on forward contract 1,212

£500,000/£2.4950 - £500,000/£2.4800


Cash 200,000
If you had adjusted the forward contract to reflect the time value of money, the forward contract
on January 31 would have been $795, and the contract on February 28 would have been worth
$806.
d. Would the importer have been better off not entering into the contract? Explain.
Yes, but not by very much. The importer received cloth worth $204,876 and paid $200,000
for it. However, had he/she not entered into the contract, he/she would have only had to pay
$200,401 for the cloth.
12. DEF Inc., a U.S. exporter, has been selling merchandise to its Japanese importer for
over ten years. They have a good idea how much merchandise they will deliver each
month, even though they have not yet booked the sales. On March 1, the President of
DEF Inc. asked the CFO to provide an estimate of sales revenues for April in dollar
terms, even though DEF Inc. invoices the sales in yen to cater to the customer. The
CFO’s estimate is that they will sell ¥1,000,000 in April and will book the sale at the end
of the month. After researching exchange rates, the CFO found the following:
Date Spot Exchange Rate Forward Rate for April 30 delivery
March 1 ¥105 ¥103
March 31 ¥104 ¥102.5
April 30 ¥101 ¥101
a. What are the nominal values, fair values, and period gains or losses for March 1,
March 31, and April 30? Assume a discount rate of 6 percent.
Date Nominal Value Fair Value Gain or Loss for the Period
March 1 0 0 0
March 31 $47 $47 $47
April 30 $145 $145 $145
b. What are the journal entries on March 1, March 31, and April 11?
March 1 No entry
March 31 Loss-other comprehensive income 47

Forward contract 47
April 30 Loss-other comprehensive income 145

Foreign currency 9,901

Sales revenue 9,901
Cash 9,709
c. Would the exporter have been better off not entering into the forward contract?
Explain.
No. The exporter received more cash under the forward contract than it would have if it
converted at the spot rate on April 30. But the forward contract gave DEF Inc. certainty.
13. DEF Inc., a U.S. importer, has been buying merchandise from its British importer for
over ten years. They have a good idea how much merchandise they will purchase each
month, even though they have not yet booked the purchases. On March 1, the
President of DEF Inc. asked the CFO to provide an estimate of purchases for April in
dollar terms, even though DEF Inc. has to pay in British pounds. The CFO’s estimate
is that they will buy £100,000 in April and will book the purchases at the end of the
month. After researching exchange rates, the CFO found the following:
Date Spot Exchange Rate Forward Rate for April 30 delivery

March 1 £1.7000 £1.7800
March 31 £1.7500 £1.7900
April 30 £1.8000 £1.8000
a. What are the nominal values, fair values, and period gains or losses for March 1,
March 31, and April 30? Assume a discount rate of 6 percent.
Date Nominal Value Fair Value Gain or Loss for the Period
March 1 0 0 0
March 31 $314 $314 ($314)
April 30 $310 $310 ($310)
b. What are the journal entries on March 1, March 31, and April 11?
March 1 No entry
March 31 Loss – other comprehensive income 314

April 30 Loss – other comprehensive income 310

Purchases 55,556

Cash 56,180
c. Would DEF Inc. have been better off not entering into the forward contract?
Explain.
No. By entering into the forward contract, DEF had to pay $56,180 for the inventory. If it
had not entered into the contract, they would have paid $55,556 at the spot rate on April 30.
However, the contract gave them certainty.
14. Assume that Apex Inc., a U.S.-based company, sells merchandise to Products plc, a
British customer, and has to denominate the sale in British pounds with payment to be
received in 90 days. Apex will receive £500,000 from the importer. In order to hedge
the receivable, Apex decides to borrow British pounds for 90 days at 12 percent and
deposit the pounds in an interest-bearing account.
a. How much will Apex have to borrow to cover its receivable?

Apex will have to borrow £485,437 (FV=500,000; n=3 months; i=12%/year)
b. If Apex deposits the money in an interest-bearing accounting yielding 8 percent,

what will be the cash received from the sale, assuming no tax effect? The spot rate
at the beginning of the transaction is $1.8500 per pound, and the rate 90 days later
is $1.8000.
Apex will receive £511,347. (£485,437 * $1.8500 = $898,058 invested at 8% for 3 months =
$916,018/$1.8000 = £508,899
15. Assume that Apex Inc., a U.S.-based company, sells merchandise to Quigley Inc., an
Australian importer, and has to denominate the sale in Australian dollars with
payment to be received in 90 days. Apex will receive A$500,000 from Quigley. In order
to hedge the receivable, Apex decides to borrow Australian dollars for 90 days at 10
percent and deposit the Australian dollars in an interest bearing account.
a. How much will Apex have to borrow to cover its receivable?

Apex will have to borrow A$487,805. (FV=500,000; n=3 months; i=10%/year)
b. If Apex deposits the money in an interest-bearing accounting yielding 8 percent,

what will be the cash received from the sale, assuming no tax effect? The spot rate
at the beginning of the transaction is A$1.2907 per U.S. dollar, and the rate 90 days
later is $1.3500.
The cash received will be A$521,675. (A$487,805/A$1.2907 = $377,938 invested at 8% for
3 months = $385,497 * A$1.3500 = A$520,421)
Chapter 14
1. The following table shows performance measures for a Korean subsidiary of a large
Dutch MNE:
2005 2006
% %
Performance Measure Budgeted Actual Difference Budgeted Actual Difference
Sales Revenue $ 1,500,000 $ 1,600,000 6.67% $ 1,700,000 $ 1,650,000 -2.94%
Variable Costs 700,000 750,000 7.14% 800,000 800,000 0.00%
Fixed Costs 500,000 500,000 0.00% 530,000 530,000 0.00%
Income Tax Expense 90,000 175,000 94.44% 185,000 128,000 -30.81%
Net Income $ 210,000 $ 175,000 -16.67% $ 185,000 $ 192,000 3.78%
Market Share % 35.00% 39.00% 4.00% 40.00% 41.00% 1.00%
Return on Investment (ROI) 11.00% 10.00% -9.09% 10.50% 11.50% 9.52%
In addition, you know the following facts:

 The Korean subsidiary receives finished goods from an Indian subsidiary. The transfer
price is negotiated between the Korean and Indian subsidiary. The Korean subsidiary
sells the goods in its home country and other neighboring countries.
 The budget is prepared by the Dutch parent company based on past performance and
corporate earnings targets.
 The budgeted tax rate for 2005 was 30%. However, new legislation increased the tax rate
to 50% for 2005. Thus, the budgeted tax rate for 2006 was 50%. The actual tax rate for
2006 was 40%.
 The parent company evaluates all subsidiaries based on ROI. ROI is calculated based on
the price paid for the subsidiary and yearly net income.
Based on this information, answer the following questions:

a. Do you agree with headquarters’ use of ROI to evaluate its Korean subsidiary?
Why?
As noted in the chapter, ROI is not a good measure to use if intercorporate transfers are
significant and are not at arm’s-length prices. ROI also should not be used for some foreign
operations, such as when sales subsidiaries buy all their products from other subsidiaries.
b. If not ROI, which performance base should be used to evaluate the

Korean subsidiary? Why?
As stated in the book, sales or market share are appropriate evaluation targets for subsidiaries
who have no control over their input costs and whose primary purpose is to sell the goods of
some other unit.
c. Based on your answer to the previous question, would you give the subsidiary a
good or bad evaluation in 2005? How about in 2006?
If the Korean subsidiary were evaluated on sales, it should receive a good evaluation in 2005
and a bad evaluation in 2006. If the subsidiary were evaluated on market share, it would
receive a good evaluation in both 2005 and 2006.
d. If the Korean subsidiary prepared its own budget, would you use a different
base? What if it also manufactured its own finished goods?
If the Korean subsidiary’s managers were involved in budget-setting, it is appropriate to
evaluate the subsidiary on a budget-to-actual base. If the Korean subsidiary manufactured its
own finished goods, then profitability would be an appropriate performance measure.
2. Consider the different performance evaluation criteria listed in the table in Exercise 1.
a. If the parent company in Exercise 1 were Anglo-American, which would most likely
be the preferred measure used to evaluate its Korean subsidiary?
According to the text, most foreign subsidiaries of U.S. MNEs were evaluated using ROI as
the main performance objective.
b. What if the parent were based in Asia?

As stated in the chapter, Asian MNEs, especially those in Japan, tend to use sales as the main
criterion in evaluating subsidiaries.
c. What do these preferences reveal about the management style and orientation of
these different cultures?
Asian nations, which are which are less individualistic and more long-term oriented, tend to
pick objectives that less directly reflect immediate returns, choosing those objectives that fit
a longer-term market dominance profile.
3. Lucas Inc. is the Mexican subsidiary of a U.S.-based multinational. In December 2004,

Lucas established the following budget for February 2005:
Number of units sold 23,000

Selling Price per unit 125 pesos
Variable Costs per unit 110 pesos
Fixed Costs 150,000 pesos
At the end of February 2005, Lucas actually sold 24,500 units at the budgeted price, but
at a variable cost of 112 pesos per unit. Fixed costs were as budgeted. Headquarters
uses A-1 to deal with foreign exchange budget planning and performance. The relevant
exchange rates for the February 2005 budget are the following:
Exchange rate when budget was established 0.08931 pesos

Projected exchange rate when budget was established 0.09034 pesos
Actual exchange rate at the end of February 2005 0.08971 pesos
a. Translate Lucas’s budget into U.S. Dollars and determine the sales volume and
flexible budget variances. [Suggestion: use a spreadsheet to organize the data as
in Exhibit 14.6]
Flexible Sales
Actual Flexible Static Budget Volume
Results Budget Budget Variances Variance
Budget and Actual Translated into Dollars (A-1)
Units Sold 24,500 24,500 23,000 - 1,500
Sales Revenues 273,512 273,512 256,766 - 16,746
Variable Costs 245,067 240,690 225,954 4,376 14,736
Contribution Margin 28,445 32,821 30,812 (4,376) 2,009
Fixed Costs 13,397 13,397 13,397 - -
Operating Income 15,049 19,425 17,415 (4,376) U 2,009 F
b. Now translate Lucas’s budget using P-2 and E-3.

Flexible Sales
Budget and Actual Translated into Dollars (P-2)
Units Sold 24,500 24,500 23,000 - 1,500
Sales Revenues 276,666 276,666 259,728 - 16,939
Variable Costs 247,893 243,466 228,560 4,427 14,906
Fixed Costs 13,551 13,551 13,551 - -
Flexible Sales
Budget and Actual Translated into Dollars (E-3)
Units Sold 24,500 24,500 23,000 - 1,500
Sales Revenues 274,737 274,737 257,916 - 16,821
Variable Costs 246,164 241,768 226,966 4,396 14,802
Fixed Costs 13,457 13,457 13,457 - -
c. Do you agree with headquarters’ use of A-1 in the budgeting process? Explain your
answer.
As stated in the chapter, using A-1 to monitor performance eliminates any exchange rate
variances. This method never takes into account what the exchange rate will be, and it does
not attempt to reconcile the budget from the original rate with that of the actual rate.
However, it uses an actual exchange established by the market and eliminates currency in the
evaluation process, focusing more on performance in the local currency as translated into
dollars.
4. Use the same information as in Exercise 3, but assume that management uses A-3 to
deal with foreign exchange budget planning and performance.
a. Translate Lucas’s budget into U.S. Dollars and determine the sales volume, flexible
budget, and foreign exchange variances.
Flexible Sales Actual Exchange

Actual Flexible Static Budget Volume Results at Rate
Budget
Results Budget Budget Variances Variance Rate Variance
Units Sold 24,500 24,500 23,000 - 1,500
Sales Revenues 274,737 273,512 256,766 1,225 16,746 273,512 1,225
Variable Costs 246,164 240,690 225,954 5,474 14,736 245,067 1,098
Contribution Margin 28,573 32,821 30,812 (4,249) 2,009 28,445 127
Fixed Costs 13,457 13,397 13,397 60 - 13,397 60
Operating Income 15,116 19,425 17,415 (4,309) U 2,009 F 15,049 67 F
b. Why does a foreign exchange variance arise when using A-3?

Using A-3 results in a foreign exchange variance because the actual exchange rate at the end of
the period is used to translate the actual results, whereas the budget is based on the actual
exchange rate at the beginning of the period.
5. Use the same information as in Exercise 3, but assume that management uses P-3 to
deal with foreign exchange budget planning and performance.
a. Translate Lucas’s budget into U.S. Dollars and determine the sales volume, flexible
budget, and foreign exchange variances.

Budget
Units Sold 24,500 24,500 23,000 - 1,500
Sales Revenues 274,737 276,666 259,728 (1,929) 16,939 276,666 (1,929)
Variable Costs 246,164 243,466 228,560 2,698 14,906 247,893 (1,729)
Contribution Margin 28,573 33,200 31,167 (4,627) 2,033 28,773 (201)
Fixed Costs 13,457 13,551 13,551 (95) - 13,551 (95)
Operating Income 15,116 19,649 17,616 (4,533) U 2,033 F 15,222 (106) U

b. Now that you have used five different rate combinations, which one do you think is
most useful in preparing the budget? Which rate is most useful in evaluating the
performance of Lucas Inc.? Which combination is the best in your opinion?
6. MultiCorp is a French-based company with operations in China. In determining the

budget for 2005, MultiCorp looks at its historical performance in the China and notes
that for March 2004, its operations were as follows:
Number of units sold 5,000
Direct cost of materials and labor € 400,000
Fixed manufacturing costs € 350,000
Selling price € 100 per unit
In trying to establish the budget in Chinese yuan for March 2005, MultiCorp does not
anticipate a change in fixed costs, but its direct cost of materials and labor is expected
to rise 10 percent, and its selling price is expected to rise by 15 percent. Sales are
expected to increase by 2%.
On October 1, 2004, when the budget is established, the spot rate is € 0.09727 per yuan,
and the projected average exchange rate for March 2005 is € 0.09558 per yuan. At the
end of March 2005, MultiCorp’s management looked at actual results and discovered
the following: the actual average exchange rate was € 0.09458, the selling price € 112,
and the cost per unit of direct materials and labor was € 90 per unit. A total of 4,800
units were sold.
Determine the sales volume variances, the flexible budget variances, and the foreign
exchange variances in Euros for the following budget translation techniques according
to the Lessard and Lorange model:
A-1
A-3
P-2
P-3
E-3
[Suggestion: use a spreadsheet to organize the data as in Exhibit 14.6] A-1
Flexible Sales
Budget and Actual Translated into Dollars
(A-1) Results Budget Budget Variances Variance
(1) (2) (3) (1)-(2) (2)-(3)
Units Sold 4,800 4,800 5,100 - (300)
Sales Revenues 52,292 53,693 57,049 (1,401) (3,356)
Variable Costs 42,021 41,087 43,655 934 (2,568)
Contribution Margin 10,272 12,606 13,394 (2,334) (788)

Fixed Costs 34,045 34,045 34,045 - -
Operating Income (23,773) (21,438) (20,650) (2,334) U (788) U

A-3
Budget
(1) (2) (3) (1)-(2) (2)-(3) (1)-(6)
Units Sold 4,800 4,800 5,100 - (300)
Sales Revenues 50,846 53,693 57,049 (2,847) (3,356) 52,292 (1,446)
Variable Costs 40,859 41,087 43,655 (228) (2,568) 42,021 (1,162)
Contribution Margin 9,988 12,606 13,394 (2,619) (788) 10,272 (284)
Fixed Costs 33,103 34,045 34,045 (942) - 34,045 (942)
Operating Income (23,115) (21,438) (20,650) (1,677) U (788) U (23,773) 657 F
P-2
Flexible Sales
(1) (2) (3) (1)-(2) (2)-(3)
Units Sold 4,800 4,800 5,100 - (300)
Sales Revenues 51,384 52,760 56,058 (1,376) (3,298)
Variable Costs 41,291 40,373 42,896 918 (2,523)
Fixed Costs 33,453 33,453 33,453 - -
P-3
Budget
(1) (2) (3) (1)-(2) (2)-(3) (1)-(6)
Units Sold 4,800 4,800 5,100 - (300)
Sales Revenues 50,846 52,760 56,058 (1,914) (3,298) 51,384 (538)
Variable Costs 40,859 40,373 42,896 486 (2,523) 41,291 (432)
Contribution Margin 9,988 12,387 13,161 (2,400) (774) 10,093 (106)
Fixed Costs 33,103 33,453 33,453 (350) - 33,453 (350)

Operating Income (2,050) 244 F
(23,115) (21,066) (20,292) U (774) U (23,360)
E-3
Flexible Sales
(1) (2) (3) (1)-(2) (2)-(3)
Units Sold 4,800 4,800 5,100 - (300)
Sales Revenues 50,846 52,208 55,471 (1,362) (3,263)
Variable Costs 40,859 39,951 42,448 908 (2,497)
Fixed Costs 33,103 33,103 33,103 - -
7. Use the data and questions in Exercise 6, but modify the following:
Exchange rate when the budget was established € 0.09727

Projected exchange rate € 0.09448
Actual exchange rate during March 2001 € 0.09883
Units actually sold 5,200
A-1
Flexible Sales
(1) (2) (3) (1)-(2) (2)-(3)
Budget and Actual Translated
into Dollars (A-1)
Units Sold 5,200 5,200 5,100 - 100
Sales Revenues 56,650 58,167 57,049 (1,517) 1,119
Variable Costs 45,522 44,511 43,655 1,012 856
Contribution Margin 11,128 13,657 13,394 (2,529) 263
Fixed Costs 34,045 34,045 34,045 - -
Operating Income (22,917) (20,388) (20,650) (2,529) U 263 F
A-3
Results Budget Budget Variances Variance Budget Rate Variance
(1) (2) (3) (1)-(2) (2)-(3) (1)-(6)
Units Sold 5,200 5,200 5,100 - 100
Sales Revenues 57,559 58,167 57,049 (609) 1,119 56,650 909

Variable Costs 46,252 44,511 43,655 1,742 856 45,522 730
Contribution Margin 11,306 13,657 13,394 (2,351) 263 11,128 178
Fixed Costs 34,591 34,045 34,045 546 - 34,045 546
Operating Income (23,284) (20,388) (20,650) (2,897) U 263 F (22,917) (368)
P-2
Flexible Sales
(1) (2) (3) (1)-(2) (2)-(3)
Units Sold 5,200 5,200 5,100 - 100
Sales Revenues 55,025 56,499 55,413 (1,474) 1,087
Variable Costs 44,217 43,234 42,403 983 831
Fixed Costs 33,068 33,068 33,068 - -
P-3
Results Budget Budget Variances Variance Budget Rate Variance
(1) (2) (3) (1)-(2) (2)-(3) (1)-(6)
Units Sold 5,200 5,200 5,100 - - 100
Sales Revenues 57,559 56,499 55,413 1,060 1,087 55,025 2,533
Variable Costs 46,252 43,234 42,403 3,018 831 44,217 2,036
Contribution Margin 11,306 13,265 13,010 (1,959) 255 10,809 498
Fixed Costs 34,591 33,068 33,068 1,523 - 33,068 1,523
Operating Income (23,284) (19,803) (20,058) (3,481) U 255 F (22,259) (1,025)
E-3
Flexible Sales
(1) (2) (3) (1)-(2) (2)-(3)
Units Sold 5,200 5,200 5,100 - 100
Sales Revenues 57,559 59,100 57,964 (1,542) 1,137
Variable Costs 46,252 45,225 44,355 1,028 870

Fixed Costs -
34,591 34,591 34,591 -
8. Suppose you are a manager for a large MNE. You have recently been assigned to
supervise several foreign subsidiaries in a politically and economically unstable region.
One of your responsibilities is to help establish the budget for the subsidiaries and
evaluate their performance at the end of the budget period. Budgets are prepared in the
local currency of each subsidiary and then translated into the parent currency.
Following is the exchange rate history for a particularly unstable country:
Exchange History
Date Local to Parent
January 1, 2001 2.1340290
July 1, 2001 0.0003201
January 1, 2002 0.0003401
July 1, 2002 0.0003391
January 1, 2003 1.0032410
July 1, 2003 3.3583000
January 1, 2004 3.3510000
July 1, 2004 0.0007037
January 1, 2005 0.0006841
July 1, 2005 0.0007141
The average exchange rate for the period was 1.09177021, and the high was 3.3672471.
After reviewing the trend in the table, you are troubled about which combination of
exchange rates to use for preparing the budget and for performance evaluation
purposes.
a. Recall the exchange rates from Exhibit 14.4. What combination of rates would you
use to prepare the budget and evaluate the subsidiary in question (e.g. A-1, P-2,
etc.)? Justify your answer.
According to the text, using the actual exchange rate at the time of budget may be
meaningless in an unstable foreign exchange environment. Using a projected exchange rate
may also be difficult in such an unstable environment, but it may be better than the other
alternatives. E-3 does not force management to be forward-thinking during the budget
process. The decision depends on the student’s decision.
b. Using A-1, P-2, or E-3 would be different than A-3 or P-3. Why are they different?
A-3 and P-3 result in a variance that is a function of operating results and exchange rate
changes. Under A-3, the budget is established at the initial exchange rate, but actual
performance is translated at the actual exchange rate. Thus, there is an exchange rate variance
that is the difference between the original and the actual rate. P-3 results in a variance that is
the difference between what management thought the exchange rate would be and what it
actually was at the end of the operating period. If management’s forecast was reasonably
accurate, P-3 should result in a very small foreign exchange variance. If the exchange rate
between the parent and local currency is relatively stable, A-3 should also result in a
relatively small foreign exchange variance.
c. How can hedging be a useful alternative in this situation?
By entering into a forward contract, futures contract, or an option, the company can offset
foreign currency translation losses by gains in a derivative contract (or vice versa).
Additionally a company can use foreign-currency debt as a hedge.
9. Assume the same information as in Exercise 8. Besides being involved in the regular
budgeting process, you are responsible for making capital budgeting decisions. For
example, you make decisions regarding the acquisition of entire companies and large
assets in the countries you supervise. To aid you in your decisions, you use NPV,
discount rates, and other financial tools. Consider the following questions:
a. When making a capital budgeting decision, how does political and financial risk
in unstable regions affect the discount rate used to get the NPV?
As stated in the chapter, long-range planning or capital budgeting must take into
consideration anticipated exchange rate movements for discounting cash flows. This
becomes part of the risk factor involved in discounting future cash flows, along with any
environmental uncertainty. Environmental uncertainty can be mild, such as the risk of
unexpected heavier taxation, or severe, such as the risk of expropriation. In general, the risk
effect is greater in less developed countries than in wealthier countries
b. Suppose a project shows a positive NPV after using the best financial analysis
possible. What extra qualitative factors would you consider before making a final
decision?
Qualitative factors to consider include the current political situation in the country,
governmental policies and attitudes regarding MNEs, current competitive advantages of the
firm, and previous exchange rate movements.
c. Suppose you decide, along with the local managers, to invest in a project that
ultimately proves unprofitable due to unexpected conditions in the local economy.
Who should be held responsible for the outcome?
10. Uplift International Ltd. is a multinational forklift manufacturer based in the U.K. The
forklift engines are designed and manufactured in its Manchester plant and then
shipped to a subsidiary in Brazil, where the forklift bodies are made. Recently, Uplift
introduced a line of forklifts featuring a new engine, which it had spent several years
and millions of dollars developing. To spread out and recapture the R&D costs of the
new engine, Uplift increased the transfer price of the engines sold to its Brazilian
subsidiary.
The Brazilian government stated that the new transfer price included, in effect, a
hidden royalty payment from the subsidiary to the parent. Such payments are illegal
by Brazilian law, and hence the new transfer price was unacceptable. In addition, the
Brazilian taxing authority pointed out that the new transfer price would result in
higher expenses and lower taxes for the Brazilian subsidiary. Finally, the government
felt that Uplift wasn’t justified in charging its subsidiary for overhead that didn’t
benefit the subsidiary.
As a result, Uplift lowered its transfer prices on engines shipped to Brazil (eliminating
the R&D allocation) to comply with the Brazilian government’s ruling. At that point,
the British government became upset because it felt that Uplift should have been
collecting R&D fees from its subsidiaries (which were obviously benefiting from it).
Furthermore, by not collecting R&D fees, Uplift was shifting taxable income out of the
United Kingdom and into Brazil. Meanwhile, the Brazilian customs authority became
upset because, as a result of the lower transfer prices, it was receiving less duty (tariffs)
than before. In sum, Uplift seemed to be in a position in which it could please no one.
a. Was Uplift justified in attempting to allocate to its subsidiaries, through increased

transfer prices, the development costs of the new engines?
As stated in the chapter, the allocation of corporate overhead directly reduces operating
profit, which reduces return on capital. Additionally, if it were not for differences in tax
rates worldwide, companies could allocate corporate overhead based on sales revenues in
each subsidiary or on some other basis. However, different tax rates complicate the situation.
For companies headquartered in high tax countries, there is an incentive to charge as many
expenses as possible against parent company income. However, this practice tends to
overstate expenses, understate income, and understate taxes in the parent country. Thus,
companies continually struggle with the general concept of allocating overhead and the ways
that affects both product costs and taxation.
b. If a company is justified in allocating overhead, R&D, and other similar expenses to

its subsidiaries, what would be the most equitable method of doing so?
One way to allocate overhead and other expenses to subsidiaries is to use tax law. However,
this eliminates any possibility for the firm to select an allocation basis that is consistent with
its manufacturing strategy. When tax implications are ignored, overhead is allocated
differently. Thus, each company must decide which method will be most advantageous to its
individual situation.
c. In situations in which some countries will not allow subsidiaries to pay the
parents for such allocations, how should a parent handle these “debts”?
In situations where a government will not allow such allocation, the parent can enter the
debt” of the subsidiary in the corporate headquarters’ ledger and base its evaluation of the
subsidiary on that ledger rather than the subsidiary’s ledger (which would not show the
expense). By U.S. tax law this “loss” is not deductible, however, in computing the taxable
income of the multinational.
d. What can Uplift International Ltd. do to resolve the intra-Brazilian government

conflict between the tax and customs authorities?
In handling the complaints of governments which permit the allocation but object to the
nonuniformity in pricing policy (allocations or other aspects), the firm can only seek to
justify its method on some fair and reasonable basis, assuming such a basis exists. If it
doesn’t exist, the multinational cannot expect the government to be fair and reasonable. In
terms of the intra-Brazilian governments conflict, the multinational can seek an inter-agency
meeting in which the two conflicting agencies get together with the multinational to work out
a solution acceptable to all parties. Failing this, the multinational can seek a higher
government authority to decide the issue.
11. Diverse Corporation is a holding company with varied product lines in different
geographic areas. Its major business areas are restaurants (27% of sales), food
processing (23%), dairy products (15%), and snack foods (19%). All other businesses
account for the rest of its sales. On the geographic side, Diverse sells products in Europe
(51 % of sales), North America (21 %); Latin America (18 %); and Africa, Asia, and
Australasia (10 %). Because the nature of its businesses requires a profound
understanding of local tastes and preferences, Diverse has adopted a multi-domestic
strategy, as described in Chapter 12.
Simple Corporation operates fast food franchises in all major cities across the world.
Simple’s world famous meals are sold in North America (33% of sales), Asia (21%),
Europe (20%), Latin America (15%), and other parts of the world (11%). While local
tastes require some minor adaptations to its menu, Simple has been very successful with
a core of similar products that have a broad appeal among children and teenagers in
most countries. Thus, Diverse has adopted a global strategy, as described in Chapter 12.
a. Assume you are a regional manager responsible for several subsidiaries of Diverse
Corporation. Should you use the same or different evaluation criteria for each
subsidiary? How about for the managers of each subsidiary?
According to the text, there are many possible criteria against which to judge performance,
and no single basis is equally appropriate for all units of an MNE or for each manager of a
subsidiary.
b. How would your answer be different for Simple Corporation?

Since Simple’s subsidiaries and divisions are all very similar and produce the same products,
using the same evaluation criteria would be more appropriate than for Diverse.
c. How do the different strategies affect the performance evaluation decisions

of Diverse and Simple?
For MNEs which employ a multidomestic strategy and have different kinds of operations
in different countries, using multiple performance criteria is more desirable and advisable.
However, this decision must be based on a cost-benefit analysis. For companies that use a
global approach to strategy and whose subsidiaries have a similar purpose, using the same
performance criteria is more appropriate.
12. Use the following selected financial data to calculate EVA for KZH Enterprises for
2006:
31-Dec-2005 31-Dec-2006
Sales Revenue $11,000,000 $11,500,000
Cost of Good Sold 7,000,000 7,800,000
Other Expenses 1,100,000 1,250,000
Cash Taxes Paid 760,000 800,000
Stockholder’s Equity 3,000,000 3,500,000
Total Liabilities 5,500,000 6,000,000
Cost of Debt (After Tax) 6.00% 6.00%
Cost of Equity 11.00% 12.00%
a. Explain in your own words what the 2006 EVA for KZH means.
AIC 9,000,000
ROIC 18.3%
WACC 8.22%
EVA 910,200
A positive EVA means that a company earned a return on its assets that exceeds the cost of
debt and equity, thus adding to shareholder value.
b. What would a negative EVA mean?

A negative EVA means that a company earned a return that was less than its cost of capital
and thus reduced its shareholder value.
13. The EVA Statement for InfoSys Technologies in Exhibit 14.9 contains the following
explanation:
“Economic value-added measures the profitability of a company after taking into account the cost
of all capital including equity. It is the post-tax return on capital employed minus the cost of
capital employed. It is those companies which earn higher returns than cost of capital that create
value. Those companies which earn lower returns than cost of capital are deemed destroyers of
shareholder value.”
a. Explain why “companies which earn higher returns than cost of capital create
value.”
In order to make products or run its business, a company must raise capital. It then sells its
products at an operating profit, out of which it pays for the cost of its capital. The
shareholders then receive whatever is left.
b. Why does a return lower than the cost of capital destroy shareholder value?
If a company cannot pay for the cost of its capital out of its operating income, it must do so
by using money that shareholders would otherwise receive. Thus, a return less than the cost
of capital reduces shareholder value.
c. Computing EVA requires accurate estimates of the cost of debt and cost of equity.
What should MNEs consider when computing cost of debt and equity for their
foreign subsidiaries?
MNEs should consider risks inherent to international investing, such as foreign exchange
rates, tax rates, and other environmental factors that could drive up the cost of raising capital.
14. Royal Philips Electronics of the Netherlands is Europe’s biggest electronics company
and one of the largest in the world. With sales of € 30.3 Billion in 2004, Philips operates
in over 60 countries and employs over 160,000 people. The company is a market leader
in medical products, color television sets, electric shavers, lighting, and silicon system
solutions. Around the turn of the century, Philips began a program named Business
Excellence through Speed and Teamwork (BEST) to achieve world-class excellence in
every aspect of the business. One of the main tools used to drive change and
communicate the new strategy was the Balanced Scorecard (BSC).
The initiative to use the BSC was a top-down directive from the Board of Management
to all divisions worldwide. Philips’ BSC was organized along four “critical success
factors” (CSF): Competence (knowledge, technology, leadership, and teamwork),
Processes (drivers for performance), Customers (value propositions), and Financial
(value, growth, and productivity). Each CSF connected to the others: as competence
increases, processes are improved, which leads to providing value to customers, which
makes the company financially stronger. First, top-level goals were set for each of the
CSFs. Then managers at each subsequent level of the organization set goals for each
CSF based on the top-level goals. Each goal had to be accompanied by a measurable
objective and logically connected to goals of upper- and lower-level divisions. Thus,
goals at all levels of the BSC were aligned with each other. As an example, a division
might set goals based on the four CSFs as follows:
 Financial: Economic profit realized, Income from operations, working capital,

etc.
 Customers: Rank in customer survey market share, repeat order rate
complaints, etc.
 Processes: Percentage reduction in process cycle time, capacity utilization, etc.
 Competence: Leadership competence, training days per employee, etc.
According to a manager in charge of the BSC, “In this process, employees have
analyzed what makes the business successful and gained a greater understanding of the
business enterprise.” In addition, the BSC acted as a tool to facilitate communication,
sharing of best practices, and overall cultural change. Overall, satisfaction with the
BSC at Philips has been high.
[Sources: Gumbus & Lyons, “The balanced scorecard at Philips electronics”, Strategic Finance,
November 2002; www.philips.com]
a. What are the advantages of the BSC goal-setting process over the traditional
budgeting process? What are the disadvantages of the BSC over the traditional
budgeting process?
The BSC approach takes a broader view of business performance by identifying the drivers
of long-term competitive performance and linking them to financial performance. However,
the cultural, geographical, and financial complexity of an MNE makes it challenging to
establish a set of interrelated, cause-and-effect performance measures.
b. How can the BSC be useful in solving the problem of choosing the “right”
performance base to evaluate managers and subsidiaries?
Adequate use of the BSC helps managers avoid using only one measure of performance
(such as ROI or sales growth), and forces them to link financial measures with the non-
financial factors that drive them. In addition, subsidiaries are evaluated based on a coherent
set of performance bases instead of just one base that may or may not be directly controlled
by that subsidiary.
c. How did the BSC help Philips integrate its geographically dispersed
employees, divisions, and product lines?
Philips’ four critical success factors included measures that are applicable to each division,
no matter where it is located. Additionally, lower-level managers were responsible to set
goals that corresponded to management’s overall goals. This ensured that goals at different
levels of the company were aligned, yet it allowed managers to set individual goals based on
their own subsidiary’s position and needs.
d. Notice that the ultimate focus of the BSC is still on financial performance. What is
the purpose of the other three focus areas (customer, process, learning and growth)?
The other areas in the balanced scorecard approach reveal the drivers of long-term
competitive performance. In simple terms, learning and growth help create more efficient
business processes, which create value for customers, who reward the firm financially. The
significant aspect about this measurement approach, however, is that it also creates a focus
for the future because the measures used communicate to managers what is important.
15. Read the Niessen Apparel case at the end of this chapter. After reviewing the situation,
Chuck Niessen hires you as a consultant to create a new control and evaluation system
for Niessen. During your initial meetings with Chuck, he expressed interest in creating
a Balanced Scorecard for Niessen Apparel. Since he has very little knowledge about the
BSC, he has asked you to prepare a brief memo containing the following information:
a. A concise explanation of the BSC and its basic components.

This section of the memo should include the following:
 The BSC approach endeavors to more closely link the strategic and financial
perspectives of a business. This approach takes a broader view of business
performance and provides a framework to look at the strategies giving rise to
value creation from the following perspectives:
o Financial
o Customer
o Internal business processes
o Learning and growth
b. A list of areas in which the BSC can be useful to Niessen Apparel. Chuck is
especially interested in how the BSC can help him evaluate and control foreign
subsidiaries like the Peruvian assembly plant.
The BSC approach reveals the drivers of long-term competitive performance. Another
advantage of the BSC is that it may help solve many control and evaluation dilemmas by
avoiding only one measure of performance. Thus, subsidiaries are evaluated based on a
coherent set of performance bases instead of just one base that may or may not be directly
controlled by that subsidiary.
c. An example of a possible BSC for Niessen Apparel at the corporate level and at the
subsidiary level.
(This is only an example of a possible BSC—students may submit different ideas.)
Niessen’s management should start by identifying broad goals that reflect each of the basic
BSC components. Then subsidiary managers could set goals for each subsidiary that are in
alignment with management’s goals. This will ensure that each subsidiary is contributing to
the achievement of Niessen’s goals but not being compared unfairly with other divisions.
Chapter Fifteen
1. The certification process for auditors varies significantly by country. Learn about the
certification requirements in your own country and answer the following questions:
a. What is the name of the organization responsible for certifying auditors? Is it a

government agency or a private agency?
b. What steps must a person follow to become a certified auditor in your country? Are
there minimum education requirements? Is a formal exam required to become
certified?
c. In your opinion, do these requirements help ensure that auditors are competent?
What, if anything, would you improve about the certification process?
This depends on the country selected.
2. As was mentioned in the chapter, reciprocity is the ability of an accountant to practice

in a different country. For this to be possible, the foreign country must recognize the
qualifications of the accountant. The General Agreement on Trade in Services
(GATS), sponsored by the WTO, was established in 1995 to promote the cross-border
transfer of services, including accounting. Go to www.wto.org and find the section on
services. Answer the following questions:
a. What is the main purpose of GATS?

The creation of the GATS was one of the landmark achievements of the Uruguay Round,
whose results entered into force in January 1995. The GATS was inspired by the following
objectives: creating a credible and reliable system of international trade rules; ensuring fair
and equitable treatment of all participants (principle of non-discrimination); stimulating
economic activity through guaranteed policy bindings; and promoting trade and development
through progressive liberalization.
b. What are the basic obligations for members of GATS?

Obligations contained in the GATS may be categorized into two broad groups: General
obligations and specific commitments. Under general obligations, Members are held to
extend immediately and unconditionally to services or services suppliers of all other
Members “treatment no less favorable than that accorded to like services and services
suppliers of any other country.” Under specific commitments, a commitment to national
treatment implies that the Member concerned does not operate discriminatory measures
benefiting domestic services or service suppliers.
c. Find the section on “accountancy services”. From time to time, committees from
different countries post proposals on how to foster reciprocity in accounting
services. Find a recent proposal and read it. What does the proposal suggest? Do
you think the ideas in the proposal are beneficial for the profession worldwide?
The answer depends on whether or not there is a proposal posted on the site.
3. The following article reports on one of the many challenges faced by auditors in
serving MNEs:
“Worried about partner defections, Big Five accounting and consulting firm KPMG International said it
will spend $100 million to more fully tie together its world-wide computer systems. Dubbed "KWORLD,"
KPMG's attempt to develop a new, global "digital nervous system" marks the first time the firm has
devoted such a large amount of money to a computer overhaul. Currently, KPMG's computers aren't fully
integrated world-wide. KPMG typically spends $50 million a year on upgrading its computers. Last month,
top partners at KPMG Canada threatened to defect to Arthur Andersen, citing as one of their reasons the
difficulty in serving multinational clients due to KPMG's unintegrated systems. KPMG hopes a more
integrated system will calm some nerves. KPMG's new system, which the firm will begin rolling out next
month will come with a new global online-messaging and "knowledge sharing" platform in which partners
can access corporate client information from anywhere in the world, says Michael J. Turillo, KPMG's
international chief knowledge officer.” (“KPMG to Fully Integrate Its Global Computer System,” Wall
Street Journal (Eastern edition), New York, May 27, 1999. pg. 1)
a. What difficulties might KPMG’s partners have had in serving multinational clients
without an integrated system?
Difficulties in serving multinational clients without an integrated system include problems in
transferring information from one country to another, coordinating plans and schedules, and
communicating between countries.
b. How can IT help solve some of the coordination and communication issues of
auditing an MNE?
IT can make it easier for auditors in different countries to communicate with each other, and
it can ease the transfer of financial information from one country to another.
c. IT can only go so far to solve the international auditor’s communications issues.

How do culture, language, and differences in local audit practices affect the
effectiveness of communications in an international audit engagement?
When trying to audit a foreign firm, auditors may have trouble understanding the firm’s
culture and audit practices, which will impede their understanding of why the foreign firm
engages in certain practices. Also, language barriers may prevent auditors from completely
understanding their foreign counterparts.
4. As mentioned in the text, as of the writing of this chapter an agreement between the
United States and the European Union on auditor reciprocity and regulation was
pending approval by members of the EU and by the European Parliament. Visit
www.europa.eu.int to learn more about the proposal and its progress in the approval
process.
This depends on whether or not students can find something on the site.
5. Although the Sarbanes-Oxley Act (SOX) is a United States law, Section 404 of SOX
requires the auditors of publicly listed companies in the U.S., including foreign firms,
to audit the internal controls of the company and issue an opinion on the effectiveness
of controls in addition to the traditional opinion of the financial statements. Suppose
you are the engagement partner for the audit of Morgan Inc., a U.S.-based MNE with
a subsidiary in Argentina. In the past, you have relied on the work of local auditors for
the Argentine subsidiary. This year you are unsure about how much to rely on the
work of local auditors to comply with Section 404. After all, Argentina isn’t subject to
SOX and auditors their have little experience auditing internal controls in such a
rigorous manner. You are also concerned that management of the Argentine
subsidiary is unaware of SOX and its requirements under Section 404. Based on this
scenario, answer the following questions:
a. Should you rely on the work of the local auditors to comply with Section 404?
Justify your answer.
This answer depends on the student’s opinion, but a firm has to set in place some mechanism
to ensure that local firms understand and can implement Section 404 audits. If not, they
could open themselves up to liability.
b. How can you make up for the lack of training of the local auditors?
One solution for the global firm is to concentrate on developing a stronger human capital
base through common global training and internship or foreign residency programs.
c. How would you coordinate the internal controls audit in the Argentine subsidiary?
6. The following report was published on December 18, 2004:
“On December 15th [2004] Air China joined the growing ranks of Chinese companies listed on western
stock exchanges. Unlike several other big Chinese firms, the national airline chose to land at the London
Stock Exchange rather than in New York. One reason is thought to be that listing in America has become
increasingly burdensome since Congress passed the Sarbanes-Oxley act in 2002…Several European firms
have said that they would consider delisting from American exchanges, given the cost of compliance with
the law. The most onerous part of the act is Section 404, [which] requires…public companies (and their
external auditors) to appraise the internal controls over financial transactions and to report any
weaknesses…The number of controls that big companies must test and document can run into the tens of
thousands, down to limiting who can sign company checks. Not surprisingly, this is expensive. Sarbanes-
Oxley (mostly Section 404) cost General Electric about $30m in extra payments to its auditor in 2003. J.P.
Morgan Chase says that it has 130 employees working full-time on compliance with the rule. And
according to a study by Ernst & Young, an audit firm, half of America's large public companies estimated
that they would devote more than 100,000 man-hours to compliance with Section 404 in its first year. The
load should ease thereafter…Some audit firms are so overloaded that they have been dumping less
profitable clients, usually smaller companies.
“Foreign firms…listed on an American exchange must comply with Section 404…Several might consider
delisting—but they cannot deregister from the SEC if they have more than 300 American investors. All this
may be harming American exchanges' ability to compete with European rivals for new listings….Of
course, against the expense and lost business must be weighed the benefits of better auditing and more
trustworthy accounts. "There is something to be said for listing on the exchange with the highest
standards," says Christian Brakman of the NYSE. The NYSE thinks that European corporate governance
regulation is already tightening too, thus reducing the competitive gap. For listed companies, there may be
no escaping the paperwork.” (“404 Tonnes of Paper,” The Economist, London, Vol. 373, Issue 8406: 142)
a. What challenges does Section 404 present to the auditors of foreign MNEs wishing
to list in U.S. exchanges?
Implementing Section 404 is extremely expensive and time-consuming. It may also be more
difficult to audit the internal controls of foreign firms, especially if those countries’ standards
are not as stringent as those in the United States.
b. Training staff on how to audit internal controls has been a major expense for audit
firms. How can international audit firms train staff located in countries not subject
to the Sarbanes-Oxley Act?
Most international audit firms will probably wait to train staff located in countries not subject
to Sarbanes-Oxley until they are more familiar with the procedures necessary to implement
Sarbanes-Oxley. When firms do begin training foreign staff, they may give them only a brief
overview of the new procedures necessary under Section 404 and not a detailed training.
c. Despite the challenges you just listed, do you see any opportunities for auditors in
helping MNEs comply with Section 404?
Auditors can use this new standard as a way to improve their own auditing skills and help on
the road to international harmonization of accounting/auditing standards.
7. The fall of Arthur Andersen in 2002, one of the world’s most renowned professional
services firms, rocked the auditing industry. The story of Andersen’s demise is
important to understand the current situation of the audit profession. Find the article
“Sad Account: Andersen's Fall From Grace Is a Tale of Greed and Miscues—Pushed to
Boost Revenue, Auditors Acted as Sellers, Warred With Consultants—Three Pebbles
and a Boulder'” by Ken Brown and Ianthe Jeanne Dugan in the Wall Street Journal
(Eastern edition) dated June 7, 2002. After reading it, answer the following questions:
a. Summarize the events that lead to Andersen’s indictment. In your opinion, what
caused the fall of Arthur Andersen?
Andersen's descent from conscience of the accounting industry to accused felon didn't
happen overnight. Rather, it stemmed from a series of management miscues and
compromises over the decades. As the firm grew from a close-knit partnership to a globe-
spanning behemoth, pressure to boost profits became intense. Andersen leaders responded by
pushing partners to become salesmen -- upsetting the delicate balancing act any auditor must
perform between pleasing a client and looking out for the public investor.
The fall of Arthur Andersen came about as the firm’s managements slowly moved away from
the founder’s original idea that reputation is more important than profit. Greed is the major
factor in Andersen’s fall.
b. In 1913, founder Arthur Andersen said, “We want to measure our contribution
more by the quality of the service rendered than by whether we are making a good
living out of it.” How did Andersen go from its founder’s mentality to being guilty of
fraud?
The seeds for Arthur Andersen's eventual demise were sown in 1950, when the firm
introduced its first computer. This ushered in an entirely new business. Rather than just audit
the books, Andersen would set up the computers clients needed to keep the books. It wasn't
long before Andersen boasted by far the largest technology practice of any accounting firm,
raking in huge profits.
To make sure auditors weren't just auditing, they began to be judged on how much new
business they brought in. Andersen began requiring partners to retire at 56 years of age in
order to cut costs. This made way for less expensive and less experienced partners. It created
more revenue per partner but left fewer partners overseeing audits. "Though most auditors at
Arthur Andersen are competent and honest," a longtime audit partner says, "a whole new
breed was not steeped in new training and was far more focused on selling."
The auditors and the consultants competed fiercely, turning the annual race for profits into a
devilish sport. Andersen started implementing a strategy to sell more audit work by handling
far more than the traditional, once-a-year external audit of the public books. Now, it was
pitching clients to outsource their internal bookkeeping operations.
Critics such as Arthur Levitt, at the time the chairman of the SEC, worried that the practice
would hurt the quality of the audit, because it removed a separate function that served as a
second opinion. In effect, accounting firms would be checking their own work.
c. How has the disappearance of Andersen affected the international audit industry?
It has decreased the amount of competition between international audit firms. Additionally,
audit firms are now limited in the amount of consulting work they may perform for their
clients.
8. PricewaterhouseCoopers (PwC) is one of the “Big Four” audit firms. Visit www.pwc.com
to learn more about this firm.
a. Where does the firm have offices? What are the benefits of having a presence in so
many locations? What are the challenges of providing accounting services in such a
dispersed set of locations?
PwC has offices in 148 countries around the world. The benefits of operating globally
include the ability to meet the needs of multinational clients and increasing global exposure.
Distance is the main challenge in providing audit services to so many locations. Other
challenges include diversity and training of auditors, home vs. local laws, and cultural
differences.
b. What industries does PwC cover?
Aerospace & Defense Energy, Utilities & Mining

Automotive Engineering & Construction
Banking & Capital Markets Entertainment & Media
Chemicals Financial Services Forest, Paper &
Education & Nonprofit Packaging
Government/Public Services
Healthcare
Hospitality & Leisure
Industrial Manufacturing
Insurance
Investment Management
Metals
Pharmaceuticals
Real Estate
Retail & Consumer
Technology
Telecommunications
Transportation & Logistics
c. Learn about one important issue faced by the audit profession today. What is the
issue? How is it affecting the profession? [Hint: look for a section on current events
or a press release link]
An example of an issue faced by the audit profession is the increase in economic crime and
how to detect it.
d. Find PwC’s most recent Annual Review. What does the review contain? Choose an
area that interests you and learn more about it.
PwC’s Annual Review contains items such as Connections, Value, Trust and Quality, People,
Governance & Reporting, and Annual Reviews for various countries.
e. If available, find the PwC website for your own country and learn about the firm’s
activities there.
This answer depends on the student’s choice of country.
9. The following announcement was published in March 2001:
“Ernst & Young Inc. (EY) has announced that it is merging its China division with leading mainland China
accounting firm Da Hua. The merger will create the firm Ernst & Young Da Hua, and is driven by the need
of EY to enhance its domestic presence in mainland China. Da Hua will benefit from the international
exposure and the technical backup and resources associated with big five firms. Da Hua is rated as the
number one audit firm on mainland China by the Chinese Securities Regulatory Commission (CSRC), in
terms of the number of listed companies it audits and the asset base of listed client companies. The new
union will be a fully-fledged merger according to EY, with seven senior managers of Da Hua joining as
partners of the new firm. Anthony T Y Wu, chairman of Ernst & Young Inc.'s operations in China, will
serve as chairman of the new firm. Wu predicted that the removal of the quota of CSRC on listings would
lead to "an explosion" in the number of companies seeking a listing on the mainland China and Hong
Kong, China bourses.” (“E&Y announces merger in China,” Accountancy, March 2001, Vol. 127 Issue
1291: 10)
a. How did the merger benefit both Ernst & Young and Da Hua?
Ernst & Young will enhance its domestic presence in mainland China, and Da Hua will
benefit from the international exposure and technical backup and resources offered by Ernst
& Young.
b. What kind of clients do you predict Ernst & Young Da Hua will attract? How will
those clients benefit from having an internationally known auditor?
Potential clients include companies seeking to enter the Chinese market. Having E&Y as an
auditor will add credibility to these firms’ financial statements, allowing these companies to
obtain international financing and to list in foreign exchange markets.
c. What challenges do you predict these two firms will have in trying to integrate their
practices and personnel?
Some of the potential challenges include foreign currency, language and culture, and
interaction of home country and local law.
10. Learn more about the audit function, ethical standards, and audit reports of your own
country.
a. Is there an organization responsible for setting audit standards? Is it a private or a

government organization? Describe the process by which audit standards are
created.
The answers to this and the following questions depend on the country chosen by the student.
b. Does the profession have a written code of ethics? If so, describe the independence
requirement for auditors in your country.
c. Who is required to be audited by law? What does the audit report for these
companies contain?
11. Use the information in Exhibit 15.4 to compare the audit function, ethical standards
and enforcement, and audit reports of three countries from different continents.
Develop a matrix that includes countries down one side and the three dimensions just
described across the top so you can compare and contrast the different countries.
Answer the following questions:
a. Which of the three countries has the most stringent requirements? Which one has
the least stringent requirements? This depends on which three countries the students
select. In general, they are likely to pick the U.S., U.K., and Australia.
b. Do you see a correlation between economic development of a country and the
sophistication of its auditing profession? If so, explain your findings.
c. Why is a strong, trustworthy auditing profession in a country necessary to foster
investment?
If individuals or institutions are going to invest their funds in companies, they need to be sure
that their money will be safe. Otherwise, they will invest funds in family-owned businesses or
other firms over which they exert control, thus concentrating wealth in the hands of a few.
12. The establishment of the PCAOB in the U.S. as the standard setting body for the audit
profession marked the end of a long tradition of self-regulation by auditors in that
country. Visit www.pcaobus.org and download the most recent annual report.
a. What is the mission of the PCAOB?

The Public Company Accounting Oversight Board is a private-sector, non-profit corporation,
created by the Sarbanes-Oxley Act of 2002, to oversee the auditors of public companies in
order to protect the interests of investors and further the public interest in the preparation of
informative, fair, and independent audit reports.
b. Read the registration requirements for auditors in the U.S. As of the writing of this
book, the PCAOB required any foreign auditors to register with the PCAOB and be
subject to a review every three years. Do you agree with the PCAOB’s policy on
foreign auditors?
c. What type of firms does the PCAOB inspect annually?

The Sarbanes-Oxley act requires the board to conduct a continuing program of inspections of
registered accounting firms to assess compliance with the act, the rules of the board, the rules
of the securities and exchange commission, and professional standards in connection with the
firm’s performance of audits, issuance of audit reports, and related matters involving issuers.
The act requires the board to conduct annual inspections of the registered firms that audit
more than 100 public companies. Other firms that audit, or play a substantial role in auditing,
any public companies are required to be inspected at least once every three years. The board
also has the Authority to conduct special inspections as is necessary or appropriate to address
issues that come to the board’s attention.
d. When was the first auditing standard set by the PCAOB? What main requirement
in Standard No. 1?
The Board’s first permanent auditing standard appropriately set out the language to be used
by registered public accounting firms in their reports on the financial statements of public
companies. The standard requires that the reports include a statement that the engagement
was conducted in accordance with “the standards of the Public Company Accounting
Oversight Board (United States).”
13. The International Federation of Accountants’ (IFAC) strategic plan for 2005-2008,
found on www.ifac.org, provides an excellent discussion of the environmental factors
influencing the accounting and audit professions worldwide. Understanding these
factors will help you have a better understanding of the opportunities and challenges
faced by the auditing industry. Read Section 4 of IFAC’s strategic plan and answer the
a. What are the three global environmental factors affecting the audit profession?
Globalization, regionalization, and technological advances
b. What factors are affecting the accounting profession in general?

Credibility of Financial Reporting and the Worldwide Accountancy Profession; Corporate
Credibility; Regulation of the Worldwide Accountancy Profession; Need for Convergence;
New Needs of Information Users; Technological Advances; Diminishing Value of a
Professional Designation; Competition.
c. What factors are specifically affecting the audit profession?

Scope of Services; Concentration of Large Firms; The Expectations Gap; Audit Performance
Gap.
d. How do all these factors affect IFAC’s mission to harmonize audit standards and
unify the audit profession worldwide?
It will be imperative that IFAC successfully implements the agreed oversight reforms and
other initiatives and continues to identify other opportunities aimed at restoring public
confidence. Maintaining relationships with the international regulatory community and
developing new ones will be critically important for IFAC throughout the implementation of
the oversight and standard-setting reforms.
IFAC and the IAASB must work to ensure that its due process continues to be strengthened.
IFAC needs to understand what barriers exist towards implementation of international
standards and thereby identify what role it can play to assist the profession in managing to
break down those barriers.
To ensure that IFAC continues to maintain its relevance to member bodies, it needs to engage
in regular dialogue with its member bodies and respond to their concerns in a positive and
realistic manner. It must continually prioritize its strategies and activities and assess the
efficiency with which it is carrying out these activities. Additionally, IFAC must continue to
assess existing and potential revenue sources, while ensuring that its ability to act in the
public interest is not compromised.
14. In Exercise 10 you read Section 4 of IFAC’s strategic plan for 2005-2008. Sections 5
and 6 of the plan outline the organization’s objectives and priorities for the upcoming
years. Read these two sections and answer the following questions:
a. What are IFAC’s main objectives?

The IFAC’s main objectives include
 Provide leadership to the worldwide accountancy profession in serving the public interest
 Contribute to the efficient functioning of the international economy
 Speak out on public interest issues where the profession’s expertise is most relevant
b. Do you agree with IFAC’s mission? What are the benefits of having a set of
worldwide auditing standards?
c. Do you think it’s possible to harmonize auditing standards worldwide? Justify

your answer.
15. The International Auditing and Assurance Standards Board (IAASB) is the arm of
the IFAC specifically charged with setting ISA’s. Find one of the IAASB’s current
projects by going to www.ifac.org/IAASB.
a. What is the standard about?

b. How long has the IAASB been working on this project?
c. When is the new standard expected to be approved?
d. Find an explanation of the process followed by the IAASB in writing an
ISA. Describe the process in one paragraph.
The answers to these questions depend on the standard found by the student.
Chapter 16
Exercises 1-4 refer to the following information. Assume a VAT situation where the tax
rate is 15 percent, with export sales exempt. The manufacturer does not purchase
inputs on which VAT has been paid, and its net selling price to the wholesaler before
VAT is £250. The wholesaler adds value of £300, and the retailer adds value of £500 to
the consumer.
1. What are the gross and net selling prices at the manufacturer, wholesaler, and
retailer levels?
See chart in exercise #2.
2. How much in VAT is paid to the tax authorities at each level?
Manufacturer Wholesaler Retailer

Gross Price 287.5 632.5 1207.5
Net Price 250 550 1050
Net VAT paid 37.5 45 75
3. What is the final amount that the domestic consumer pays, and how much of that is
VAT?
Cost to final consumer = £1207.50; VAT = £157.50
4. Would your answer to 3 be the same if the retailer were to export the goods instead
of selling them to a domestic consumer?
No. The Retailer would not have to pay VAT on the value it added. The final cost to the
consumer would be £1,132.50.
5. ABC Company has income from the following countries:
Country Type of Operation Gross Earnings Income Tax Rate

United States Parent 500,000 40%
X Branch (10,000) 25%
Y Distribution 120,000 5%
Z 100%-owned 400,000 45%
ABC’s subsidiary in Z declares a 40 percent dividend; Z’s withholding tax on

dividends is 5 percent. Both the branch and the distribution facility, which is wholly
owned, retain all earnings. The distribution earnings are considered to be foreign-
based company sales income. What is ABC’s final U.S. tax liability?
Initial U.S. Tax Liability .40*1,010,000=404,000
Tax Credit from Y .05*120,000 =6,000
Tax credit from Z = 76,400, usable is only 60,000
Final U.S. Tax Liability 404,000-6,000-60,000=338,000
6. Puerto International has a branch in Mexico that manufactures a garage door

alarm for people with mountain bike racks that fit on the top of their cars. The
subsidiary earned $800,000 in 2000 before tax, with Mexican corporate tax rates at
40 percent. Taxes were paid evenly throughout the year. How much income did
Puerto have to include in its U.S. taxable income in 2000, and what was the tax
credit?
$800,000, $32,000
Exercises 7 and 8 refer to the following: In 2000 San Fernando Drilling shipped 300
diamond drill bits to its subsidiary in Ecuador. The drill bits were shipped at San
Fernando’s cost of $1 million each to avoid Ecuador’s duty of 20 percent. In 2000
Ecuador’s income tax on foreign subsidiaries was 35 percent and the U.S. corporate tax
rate was 35 percent. In 2001 Ecuador proposes to raise the corporate tax rate to 45
percent, eliminate duties, and impose a 10 percent VAT. The U.S. rate will remain the
same.
7. What action (if any) should San Fernando take on its export pricing?
San Fernando should shift the profits to be taxed in the U.S. by raising the transfer price to what
the drill bits will be sold for in Ecuador.
8. What possible U.S. government action may result from your decision in 1?
The government may review past tax filings to see if the transfers to Ecuador were priced as
arms-length transactions. The government will probably find in their favor, and will bill San
Fernando for back-taxes and fees.
9. As a U.S. congressman from South Carolina you are considering proposing a bill to
eliminate a state income tax of 7 percent and a sales tax of 5 percent and replace it
with a value added tax of 10 percent. Discuss the pros and cons of such an action.
You should note that a typical South Carolina family spends about 80 percent of its
taxable income on goods and services that would be covered by this tax.
If families spend 80 percent of their taxable income on items that currently are subject to the
sales tax, and if imports and exports are ignored, the effective tax rate will drop from 11% to
8%. However, the VAT will probably eliminate existing tax loopholes.
Exercises 10 – 12 refer to the following: Belgian Coordination Center

When the United States Tax Reform Act (TRA) of 1986 was enacted, the basic corporate
tax rate in the United States dropped from 46 to 34 percent. At that time, corporate tax
rates in Europe ranged from 35 to 56 percent. Since then, corporate tax rates in some
European countries had fallen, but they were generally higher than in the United States.
To attract significant high-level foreign investment, Belgium enacted several
favorable tax provisions in the late 1980s. Belgium is an interesting country. With 10
million people, it is only the eighth largest country in the European Union. However, it is
the sixth largest in per capita GNP, second in population density (and eleventh in the
world), and first in the European Union in urbanization. In 1988, 66 percent of Belgium’s
GNP was in services, 32 percent in manufacturing, and only 2 percent in agriculture.
One important tax attraction is the possibility of establishing a coordination center.
A coordination center can be established for one or more of the following activities:
development and centralization of advertising; supply and gathering of information;
insurance and reinsurance; R&D; relations with national and international authorities;
financial; accounting and administrative services; currency hedging; and other related
activities. Most coordination centers are financial and accounting in nature.
The activities of the center are free from Belgian exchange controls and are virtually
tax free. Taxes are based on a small percentage (usually 8 percent) of expenses, except for
salary costs and finance charges. Any dividends paid by the center to its parent company
are exempt from paying withholding tax. A coordination center can hold title to assets that
it can lease to other members of the corporate group both inside and outside Belgium. The
center can also be used to finance operations in other countries. For example, a member of
the corporate group in Germany could borrow money from the coordination center and
pay all interest to the center.
10. How does the establishment of the coordination center impact the tax liability of
companies that lease assets from the center and companies that finance asset
acquisitions through the center?
If Multicorp, for example, decided to establish a coordination center in Belgium to service its
subsidiaries in France and Germany, it could own the assets in Belgium and lease them to the
subsidiaries. The lease payments would be tax-deductible in France and Germany, lowering
their taxable income and tax liability. The lease payments to the coordination center would be
taxed at only 8%, a much lower rate than anywhere else in the EU. One of the advantages of the
coordination center is that it is taxable on only 8% of its expenses, other than salary costs and
financing charges. Dividends are also exempt from Belgian withholding tax. Treaty provisions
may fully exempt the lease payments from withholding tax and the coordination center will
receive the lease payments virtually tax free.
11. What would be the impact on the tax liability of the parent company of the activities
listed in question 10?
The overall tax liability of the parent company would be lowered, depending on how the
income is treated in Belgium. If the income is construed as subpart F income, it would be
immediately taxed to the parent company, and there would be no benefit to collecting the income
in Belgium. However, if the coordination center were generating enough active income, the
subpart F income might be too small to be recognized by the parent company. If the lease
payments are made by a Belgian subsidiary, the payments would not be considered subpart F
income.
12. Other than the issues identified in question 11, what are some other reasons why a U.S.
company might want to establish a coordination center in Belgium? What must it do to
gain the maximum tax benefits from operating in Belgium?
The coordination center can also serve as financing and treasury management companies for the
group. The only stipulation is that the services must be performed for the sole benefit of the
members of the multinational group. To gain the maximum tax benefits, the center must make
sure that its subpart F income does not exceed the lesser of 5% of aggregate gross income or
$1,000,000.
13. What tax issues might an U.S. ex-patriot have when working in Belgium?
Ex-patriots, like companies, have to pay taxes both where the money is earned and where the ex-
patriot is “incorporated” (has citizenship). Ex-patriots need to be aware of both countries’ tax
systems and understand the credits available to people in their situations to avoid being double-
taxed
Exercises 14 and 15 refer to the following information. Multinatl Inc. has a manufacturing
facility in Zolondia which incurs costs of $1,000,000 for goods it sells to its retail outlet in
Aborla. The retailer resells these goods to consumers for $2,000,000. Operating expenses
in Zolondia and Aborla are $100,000 and $150,000, respectively. Zolondia and Aborla levy
a corporate income tax of 30 percent on taxable income in their jurisdictions.
14. If Multinatl Inc. raises its transfer price from $1,300,000 to $1,600,000 for these goods
going from Zolondia to Aborla, what effect would this have on total consolidated taxes?
It would not make a difference. As long as neither division sells the product at a loss, the total
tax will be 30% of $750,000.
Zolondia Aborla Total
Change in Net Income 300,000 -300,000 0
Change in Tax Liab. 90,000 -90,000 0
15. If the tax rate were different in each country: Zolondia tax rate = 20 percent and
Aborla tax rate = 40 percent, what would be the tax effects of the transfer pricing
action?
Zolondia Aborla Total
Change in Net Income 300,000 -300,000 0
Change in Tax Liab. 60,000 -120,000 -60,000
The total tax liability would drop by $60,000.

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EXERCISE SOLUTIONS

Answer: Some of the key historical events are:

Answer: This depends on the country selected.

Answer: This depends on the company selected.

8. The following statement is taken directly from the text:

12. Consider the following statement:

“Globalization refers to the deepening relationships and broadening interdependence among

a. What are some of the opportunities created by globalization?

b. What are some of the threat posed by globalization?

b. Would this kind of information be valuable in determining the future financial

c. Why would Schering be interested in reporting about its environmental

Answer: Schering is a European company, and environmental compliance is a major issue in

Answer: Information on the Environment and Corporate Social Responsibility, incljding

Answer: It is a European company where an interest in sustainability is very high. In addition, it

c. Do you think disclosing that kind of information helps StoraEnso be more

Answer: By acting responsibly, StoraEnso is demonstrating to shareholders that it can be both

b. How does the concept of sustainability create a demand for nontraditional

Dow Jones Sustainability World Index

2. Locate each country in Gray’s ‘Authority and Enforcement” and “Measurement

8. Consider Parmalat’s accounting problems in 2003. What societal values and

2. Locate each country in Gray’s “Authority and Enforcement” and “Measurement

3. Comment on the relevance and reliability of your findings.

8. What countries seem to fit those values identified as ideal?

Exercises 10 and 11: IFAC (the International Federation of Accounants) is a worldwide

1. Consider the differences between developing countries and developed countries:

b. Why might these differences be justified?

2. As a potential investor in one of the developing countries, list some requirements in

7. IFAC (the International Federation of Accounants) is a worldwide organization of

8. If an accounting system is primarily concerned with collecting taxes how will it

Volkswagen and GM (questions 1-7)

GENERAL MOTORS CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

Years Ended December 31,

Basic earnings (loss) per share attributable to

Earnings (loss) per share attributable to

Reference should be made to the notes to consolidated financial statements.

GENERAL MOTORS CORPORATION AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

Cash and cash equivalents (Note 1) $32,554 $20,320

LIABILITIES AND STOCKHOLDERS' EQUITY

Accounts payable (principally trade) $25,422 $21,138

Reference should be made to the notes to consolidated financial statements.

13. Why is the consolidation issue so tricky here?

Use Electrolux’s 2003 Annual Report (April 5, 2004) to do exercises 9-11.

13. How might an analyst or investor use this information?

15. Overall, how useful is the forecast statement? Why?

Figure 6.7 Excerpt from 2004 Annual Report of Schering AG.

2. Should international accounting standards be set on the basis of a philosophy of

3. If the goal is “uniformity,” how can the “right” answers be found?

5. How can international financial reporting standards be enforced?

b. What might they do to ease the transition?

Exercises 8 and 9: Visit the International Accounting Standards Board website

9. What news has recently been announced about the IASB?

11. What is on the current agenda?

b. Which presentation option do you think provides the most accurate

1. Simple Purchasing Problem: Mautz Company is considering buying S&H

Mautz Co, Cost Fair Market Value

LIABILITIES 1320 120 1435 (1440 – 5)

EQUITY 868 110 868 Same as parent equity

EXPENSES 750 320 1070

LIABILITIES 1190 230 1305 (1190 + (230x50%))

EQUITY 326 176 326 Same as parent equity

EXPENSES 630 190 725 (630 + (190 x 50%))