Accounting in the International Business Chapter 19 Accounting in the International Business

Introduction Accounting is the language of business – it is the way firms communicate their financial positions Accounting standards differ from country to country These differences make it difficult for investors, creditors, and governments to evaluate firms The International Accounting Standards Board (IASB) has made some attempts to establish common accounting and auditing standards across countries

Introduction Figure 19.1

Country Differences In Accounting Standards A country’s accounting system evolves in response to local demands for accounting information While there have been efforts to harmonize accounting practices across countries, significant differences remain One study found that among 22 countries, there were 76 ways to assess the cost of goods sold, 65 differences in the calculation of return on assets, and 20 ways to calculate net profits The differences make it challenges to compare financial performance of firms from different countries

Country Differences In Accounting Standards Five main variables influence the development of a country’s accounting system: 1. the relationship between business and the providers of capital 2. political and economic ties with other countries 3. the level of inflation 4. the level of a country’s economic development 5. the prevailing culture in a country

Country Differences In Accounting Standards Figure 19.2

Relationship Between Business And Providers Of Capital The three main external sources of capital for firms are: Individual investors Banks Government A country’s accounting system reflects the relative importance of each constituency as a provider of capital So, accounting systems in the U.S. and Great Britain are oriented toward individual investors; Switzerland, Germany, and Japan focus on providing information to banks; and France and Sweden prepare financial documents with the government in mind Three external sources of capital: Individual investors Buying shares and bonds Banks Loan capital Government Make loans or investment

Political And Economic Ties With Other Nations Similarities in accounting systems across countries can reflect political or economic ties The U.S. accounting system influences the systems in Canada and Mexico In the European Union, countries are moving toward common standards

Inflation Accounting The historic cost principal assumes the currency unit used to report financial results is not losing its value due to inflation This principle affects asset valuation If inflation is high, assets will be undervalued

Level Of Development Developed nations tend to have more sophisticated accounting systems than developing countries Many developing nations have accounting systems that were inherited from former colonial powers

Culture The extent to which a culture is characterized by uncertainty avoidance (the extent to which cultures socialize their members to accept ambiguous situations and tolerate uncertainty) impacts the country’s accounting system Countries with low uncertainty avoidance cultures have strong independent auditing professions

National And International Standards Accounting standards are rules for preparing financial statements—they define useful accounting information Auditing standards specify the rules for performing an audit—the technical process by which an independent person gathers evidence for determining if financial accounts conform to required accounting standards and if they are also reliable Management Focus: The Consequences Of Different Accounting Standards Summary This feature explores the consequences of different accounting standards. When firms from different countries merge, their accounting systems also merge. This can be a complicated process! Discussion of the feature can revolve around the following questions: 1. What do differences in accounting standards mean for companies? Use examples from the feature to illustrate your response. How should companies communicate with investors about the differences? Discussion Points: Most students will quickly realize the complexities involved in merging accounting systems from different countries. Educating investors on the implications of the differences could be crucial to the success of the merger. Many students will probably recommend that firms communicate directly with existing shareholders via direct mail, and with potential shareholders through the media. 2. Consider the challenges involved in merging accounting departments from different countries. What problems might occur? What are some of the decisions that will have to be made? Discussion Points: Merging companies from different countries can be challenging even when they have similar corporate cultures, strategies, and so on. One area that can be especially difficult to bring together is the accounting department. Accountants are trained to prepare financial documents according to the system that prevails in that country. As the feature clearly illustrates, the accounting system used in one country can be very different from the accounting system used in another. Companies will have to decide which system to follow, and where it should be followed. In addition, firms will have decide how to handle accounting personnel.

Lack Of Comparability Because of national differences in accounting and auditing standards, comparability of financial reports from one country to another is difficult The growth of transnational financing and transnational investment is promoting the growth of transnational financial reporting

International Standards There has been a substantial effort recently to harmonize accounting standards across countries Many companies obtain capital from foreign providers who are demanding greater consistency Common accounting standards will facilitate the development of global capital markets The International Accounting Standards Board (IASB) is a major proponent of standardization The IASB currently has 45 standards, but compliance is voluntary About 100 nations have adopted IASB standards or permitted their use in reporting financial results

International Standards Most IASB standards are consistent with standards already in place in the United States The European Union has mandated harmonization of accounting principles in its member countries By 2010, there could be only two major accounting bodies with substantial influence on global reporting – FASB in the United States and IASB elsewhere Management Focus: Novartis Joins the International Accounting Club Summary This feature explores the pressure felt by Swiss firms to adopt international accounting standards. Switzerland’s accounting system has been criticized for obscuring as much as it revealed, and foreign investors have been pushing for better information. Discussion of the feature can revolve around the following questions: 1. Why did Ciba move to adopt IASC guidelines? What did the company hope to achieve with this move? In your opinion, was it successful? Discussion Points: Ciba, Switzerland’s largest pharmaceuticals and chemicals firm, now called Novartis, announced that in 1994, its financial statements would be prepared according to IASC guidelines. The company made the decision in an effort to respond to foreign stockholders, and to open the door to the possibility of listing on the New York and London stick exchanges. 2. Reflect on the implications of Ciba’s decision to adopt IASC standards. What does this decision mean to other Swiss companies? Discussion Points: Many students will probably focus on the additional pressure Ciba’s decision will put on other Swiss firms to also adopt IASC guidelines. Other students might also point out that Ciba’s decision, if it is followed by other companies, will help the push towards a more harmonized international accounting system. Another Perspective: For additional information on Novartis’ accounting system, go to the company web site at {http://www.novartis.com/}, and click on Investors. Ciba’s website is {http://www.ciba.com/}.

Multinational Consolidation And Currency Translation A consolidated financial statement combines the separate financial statements of two or more companies to yield a single set of financial statements as if the individual companies were really one Multinational firms typically issue consolidated financial statements

Consolidated Financial Statements The typical multinational company is made up of a parent company and a number of subsidiary companies Economically, all the companies are interdependent The consolidated financial statement provides accounting information about the group of companies Transactions among members of a corporate family are not included in consolidated financial statements, however, because separate legal entities are required to keep their own accounting records they record transactions with other members of the corporate family in separate statements The IASB requires firms to prepare consolidated financial statements, as do most industrialized nations

Currency Translation Foreign subsidiaries usually keep accounting records and prepare financial statements in the local currency To prepare consolidated financial statements, all local financial statements must be converted to the home currency There are two methods to determine what exchange rate should be used when translating financial statement currencies: 1. the current rate method 2. the temporal method

The Current Rate Method Under the current rate method, the exchange rate at the balance sheet date is used to translate the financial statements of a foreign subsidiary into the home currency of the multinational firm The current rate method is incompatible with the historic cost principle

The Temporal Method The temporal method translates assets valued in a foreign currency into the home currency using the exchange rate that exists when assets are purchased So, while the temporal method avoids the problems associated with the current rate method, it is still problematic because different exchange rates are used to translate foreign assets

Current U.S. Practice U.S. multinationals are required to follow FASB 52 which states: the functional currency is the local currency of each self-sustaining foreign subsidiary balance sheets should be translated into the home currency using the exchange rate in effect at the end of the firm’s financial year income statements are translated using the average exchange rate for the firm’s financial year Statement 52 “Foreign Currency Translation” Self-sustaining autonomous subsidiary: Functional currency is local currency Balance sheet uses exchange rate at end of financial year Income statement is financial year average Integral subsidiary: Functional currency is US currency Financial statements use the temporal method Dangling credit or debit increases or Decreases consolidated earnings for the period

Accounting Aspects Of Control Systems The control process in most firms is usually conducted annually and involves three steps: 1. subunit goals are jointly determined by the head office and subunit management 2. the head office monitors subunit performance throughout the year 3. the head office intervenes if the subsidiary fails to achieve its goal, and takes corrective actions if necessary Two factors that can complicate the control process are exchange rate changes and transfer pricing practices

Exchange Rate Changes And Control Systems Most international firms require budgets and performance data to be expressed in the corporate currency-normally the home currency While this facilitates comparisons between subsidiaries, it can also create distortions in financial statements

The Lessard-Lorange Model Donald Lessard and Peter Lorange suggest that firms can deal with the problems of exchange rates and control in three ways: 1. the initial rate - the spot exchange rate when the budget is adopted 2. the projected rate - the spot exchange rate forecast for the ends of the budget picture 3. the ending rate - the spot exchange rate when the budget and performance are being compared

The Lessard-Lorange Model Figure 19.3

The Lessard-Lorange Model Lorange and Lessard suggest that firms use the projected spot exchange rate (usually the forward exchange rate) to translate budget and performance figures into the corporate currency Firms can also use the internal forward rate (company-generated forecast of future spot rates)

Transfer Pricing And Control Systems The price at which goods and services transferred within the firm is the transfer price The choice of transfer price can significantly influence the performance of subsidiaries Transfer prices should be considered when evaluating a subsidiary’s performance Companies can manipulate transfer prices to minimize tax liability, minimize import duties, and avoid government restrictions on capital flows

Separation Of Subsidiary And Manager Performance The evaluation of a subsidiary should be kept separate from the evaluation of its manager A manager’s evaluation should consider the country’s environment for business, and should take place after making allowances for those items over which managers have no control