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Chapter 19
Accounting in International Business
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Accounting
“The language of business”
Accounting information is the means by which firms communicate their financial position to the providers of capital (investors, creditors and government)
Accounting standards differ from country to country which make it difficult for investors, creditors, and governments to evaluate firms
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Accounting Information and Capital Flows
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Country Differences in Accounting Standards
Accounting systems in every country has evolved in response to the demands for accounting information
The International Accounting Standards Board (IASB) has made some attempts to establish common accounting and auditing standards across countries
Despite attempts to harmonize standards by developing internationally acceptable accounting conventions, differences between national accounting systems still remain
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Country Differences in Accounting Standards
Five Main Variables relationship between business and the providers of
capital
political and economic ties with other countries
level of inflation
level of a country’s economic development
prevailing culture in a country
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Country Differences in Accounting Standards
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Relationship Between Business and Providers of Capital
Three main external sources of capital for firms are: Individual investors Banks Government
A country’s accounting system tends to reflect the relative importance of each constituency as a provider of capital
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Relationship Between Business and Providers of Capital
Accounting systems in:
U.S. and Great Britain are oriented toward individual investors
Switzerland, Germany, and Japan focus on providing information to banks
France and Sweden prepare financial documents with the government in mind
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Political and Economic Ties with Other Nations
Similarities in accounting systems of countries may be due to close political and/or economic ties
U.S. accounting system influences the systems in Canada and Mexico
In the European Union, countries are harmonizing their accounting practices
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Inflation Accounting
The historic cost principal assumes the currency unit used to report financial results is not losing its value due to inflation
There are no adjustments to sales, purchases, etc at a later date due to inflation
This principle affects asset valuation
If inflation is high, assets will be undervalued
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Level Of Development
Developed nations tend to have: large, complex organizations more sophisticated capital markets more sophisticated accounting systems
Many developing nations have accounting systems: that were inherited from former colonial powers
that may not apply to small businesses
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Culture
The extent to which a culture is characterized by uncertainty avoidance (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
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National and International Standards
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National and International Standards
Accounting Standards rules for preparing financial statements—they
define useful accounting information
Auditing standards specify the rules for performing an audit technical process by which an independent
person gathers evidence for determining if financial accounts conform to required accounting standards and also reliable
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Lack Of Comparability
National differences in accounting and auditing standards limit the comparability of financial reports from one country to another
Growth of transnational financing and transnational investment has been accompanied by the growth of transnational financial reporting
But the lack of comparability between accounting standards in different nations can lead to confusion
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International Standards
Substantial efforts have been made recently to harmonize accounting standards across countries
Global capital markets are adding urgency to the issue 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
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International Standards
International Accounting Standards Board (IASB)
Major proponent of standardization
Currently has 45 standards
Compliance is voluntary
About 100 nations have adopted IASB standards or permitted their use in reporting financial results
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International Standards
International Accounting Standards Board (IASB)
Most IASB standards are consistent with standards already in place in the United States
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
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Multinational Consolidation and Currency Translation
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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 one
Multinational firms typically issue consolidated financial statements for the parent company which includes the merging of subsidiaries
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Consolidated Financial Statements Most multinational firms consists of a parent company and a
number of subsidiary companies that are: separate legal entities interdependent economic entities
Consolidated financial statements provide accounting information about a group of companies that recognize the economic interdependence
Transactions among members of a corporate family are not included in consolidated financial statements, only assets, liabilities, revenues, and expenses with external third parties
Since separate legal entities are required to keep their own accounting records, they record transactions with other members of the corporate group in separate statements
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Currency Translation Foreign subsidiaries usually keep accounting records
and prepare financial statements in the local currency
Consolidated financial statements require all local financial statements be converted to the home currency
Two methods to determine what exchange rate should be used when translating financial currencies: the current rate method the temporal method
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Current Rate Method
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
Incompatible with the historic cost principle and might provide a misleading financial picture
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Temporal Method
Translates assets valued in a foreign currency into the home currency using the exchange rate that exists when assets are purchased
Avoids the problems associated with the current rate method
But still problematic because different exchange rates are used to translate foreign assets and the multinational firm’s balance sheet may not balance
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Current U.S. Practice
FASB 52 Requirement for US Multinationals
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
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Accounting Aspects of Control Systems
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 management2. the head office monitors subunit performance
throughout the year3. 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 exchange rate changes transfer pricing practices
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Exchange Rate Changes And Control Systems
Most international firms require all budgets and performance data to be expressed in the “corporate currency” (normally the home currency)
This facilitates comparisons between subsidiaries
However, it also allows exchange rate changes during the year to introduce substantial distortions
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Exchange Rate Changes And Control Systems
Lessard-Lorange Model
Firms can use three exchange rates to translate foreign currencies in the corporate currency Initial Rate
spot exchange rate when the budget is adopted Projected Rate
spot exchange rate forecast for the ends of the budget picture
Ending Rate spot exchange rate when the budget and
performance are being compared
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Lessard-Lorange Model
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Lessard-Lorange Model
Suggests 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 which is the company-generated forecast of future spot rates
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Transfer Pricing And Control Systems
Transfer price is the price at which goods and services are transferred within the firm: can significantly influence the performance of
subsidiaries must be considered when evaluating a
subsidiary’s performance
Firms often manipulate transfer prices to: minimize tax liability minimize import duties avoid government restrictions on capital flows
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Separation of Subsidiary and Manager Performance
Since foreign subsidiaries do not operate in uniform environments, the evaluation of a:
subsidiary should be kept separate from the evaluation of its manager
manager should consider the country’s environment for business
manager should be in the local currency and allow for the consideration of those items over which they have no control