Because learning changes everything.

Chapter 20
Accounting and Finance in
International Business

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© 2022 McGraw Hill. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution permitted without the prior written consent of McGraw Hill.
 Learning Objectives
LO20-1 Discuss the national differences in accounting standards.
LO20-2 Explain the implications of the rise of international accounting standards.
LO20-3 Explain how accounting systems affect control systems within the
multinational enterprise.
LO20-4 Discuss how operating in different nations affects investment decisions
within the multinational enterprise.
LO20-5 Discuss the different financing options available to the foreign subsidiary
of a multinational enterprise.
LO20-6 Understand how money management in the international business can
be used to minimize cash balances, transaction costs, and taxation.
LO20-7 Understand the basic techniques for global money management.

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 Case: Adoption of International
Accounting Standards in Germany

• In Germany, market for debt is expensive; limited possibility for raising

additional equity

• German firms begin to raise equity on international capital markets only

in 1990

• Major German firms apply for listing on the US Securities and

Exchange commission (SEC)

• SEC was not responsive because German accounting standards were

not comparable to those in the US. Not enough information to investors

• Adhering to generally accepted accounting principles (GAAP) has its

positives and negatives

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 Contents
Accounting in International Business
• Accounting and International Accounting Standard
• Consolidated Financial Statement

Financial Management in International Business

• What activities to finance
• How to finance those activities
• Money management decisions:
• Manage the firm’s financial resources effectively
• Manage exchange rate risks

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 Because learning changes everything. ®

ACCOUNTING IN INTERNATIONAL
BUSINESS
 Accounting Information and
Capital Flows

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 Determinants of National
Accounting Standards

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 Relationship Between
Business and Providers of Capital

Three external sources of capital:

• Individual investors
• Buying shares and bonds
• Banks
Importance of each
• Loan capital varies from country
• Government to country
• Make loans or investment

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 Political and Economic
Ties With Other Countries

Accounting convergence:
• Influence of NAFTA
• Influence of the former British Empire
• Influence of the European Union

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 Inflation Accounting

Historic cost principle:

• Assumes currency is not losing value to inflation
• Most significant impact in the area of asset valuation
• Appropriateness varies with inflation
Current cost accounting:
• Factors out inflation
• Used in Great Britain until inflation rate declined

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 Level of Development

Developed countries have more sophisticated

accounting procedures
• Accounting problems are more complex
• Sophisticated capital markets
• Lenders require comprehensive reports
• Educated workforce can perform complex accounting functions

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 Culture

Hofstede’s uncertainty avoidance has an impact

on accounting systems
• Low uncertainty avoidance - these countries tend to have strong
independent auditing professions that ensure a firm’s compliance
with rules

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 National and
International Standards

• Diverse accounting practices are enshrined in national

accounting and auditing standards
• Accounting standards: Rules for preparing financial
statements
• Auditing standards: Specify rules for performing an audit

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 Lack of Comparability

• One result of national differences in auditing and

accounting standards is lack of comparability of
financial reports
• With growth of global capital markets both transnational
financing and transnational investment have grown
• Firm has to explain to investors why its financial position
looks different in two accountings

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 International Standards

• Efforts to harmonize accounting standards across

countries
• Formation of International Accounting Standards Board
• Members represent 100 countries
• Responsible for formulating international accounting
standards (IAS)
• Has issued over 30 IAS
• Difficult to get requisite votes
• Voluntary compliance
• Recognition is growing

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 Multinational Consolidation and
Currency Translation

• Subsidiaries of multinationals are separate legal entities but not

separate economic entities
• Transactions among members of a corporate family not included in
consolidated financial statements. Only assets, liabilities,
revenues, and expenses statements with external trade parties are
shown
• Purpose is to provide accounting info about a group of companies
that recognizes economic interdependence (subsidiaries)
• Financial statements of subsidiaries are prepared in the local
currency
• For the consolidated accounts of a multinational, these accounts
then have to be converted into currency of multinational’s home
country

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 Currency Translation

The current rate method:

• Exchange rate at the date on the balance sheet is used to translate
foreign subsidiary financial statements into home country currency
• Incompatible with ‘historic cost principle’
The temporal method:
• Translates foreign subsidiary assets into home-country currency at
the time of purchase of the asset
• Changing exchange rates may mean the balance sheet may not
balance!

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 Example

American company invested 100 million US dollars in Vietnam, the

exchange rate is 1$ = 20,000 VND, the factory investment totaled
2,000 billion US dollars. At the end of the year, the exchange rate is
1$ = 16,000 VND.
What is the factory value when converted in the Consolidated
Report?
Factory value:
Current rate method: 125 million US dollars
Temporal rate method: 100 million US dollars

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 Current US Practice

Statement 52 “Foreign Currency Translation”

Self-sustaining autonomous subsidiary:
• Functional currency is local currency Firms using
multidomestic or
• Balance sheet uses exchange rate at
international
end of financial year
strategies.
• Income statement is financial year average
Integral subsidiary:
• Functional currency is US currency
• Financial statements use the
temporal method Firms using
• Dangling credit or debit increases or global or
• Decreases consolidated earnings transnational
for the period strategies.

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 Accounting Aspects of
Control Systems

Annual control process involves three steps:

• Head office and sub-unit management jointly determine sub-unit
goals for the coming year
• Throughout year, head office monitors sub-unit performance against
agreed goals
• If sub-unit fails to achieve goals, head office intervenes to determine
why the shortfall occurred, taking corrective action when appropriate

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 Exchange Rate Combinations in the
Control Process

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 Accounting Aspects of
Control Systems

Lessard- Lorange Model:

• Three exchange rates used to translate foreign currency
into corporate currency for budget and performance
purposes
• The initial rate, the spot exchange rate when the budget is
adopted
• The projected rate, the spot exchange forecast for the end of
budget period (i.e., the forward rate)
• The ending rate, the spot exchange rate when the budget
and performance are being compared

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 Transfer Pricing and
Control Systems

• Transfer prices introduce significant distortions into the

control process
• Transfer price must be taken into account when setting
budgets and evaluating a subsidiary’s performance
• Motives for transfer pricing:
• Reduce corporate income tax
• Reduce import tariffs
• Overcoming barriers to capital movement imposed by
governments

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 Separation of Subsidiary and
Manager Performance

• Valuation of a subsidiary should be separate from the

evaluation of the subsidiary manager
• Manager’s evaluation should take into consideration
how hostile or benign the country’s environment is for
business and make allowances over items for which the
manager has no control, e.g. inflation rates, interest
rates, exchange rates

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 FINANCE IN
INTERNATIONAL
BUSINESS

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Case: Global treasury management at

Proctor & Gamble
60% of P &G’s revenues from international sales
Products sold in 130 countries
Has centralized global treasury management
function
• Management of all foreign exchange transactions
• P& G trades currency between subsidiaries, cutting
out banks and saving on transaction costs
• P & G is pooling foreign exchange risks and buying
an purchasing an umbrella option to cover risks
associated with various currency options
• Subsidiaries can invest in and borrow money from
other P &G entities instead of dealing with banks

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Scope of financial management

Scope of financial management includes three sets of related

decisions:
Investment decisions
• Decisions about what activities to finance
Financing decisions
• Decisions about how to finance those activities.
Money management decisions
• Decisions about how to manage the firm’s financial resources most
efficiently

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Investment decisions
Capital budgeting:
• Quantifies the benefits, costs and risks of an
investment
• Managers can reasonably compare different
investment alternatives within and across countries
Complicated process:
• Must distinguish between cash flows to project and those
to parent
• Political and economic risk can change the value of a
foreign investment
• Connection between cash flows to parent and the source
of financing must be recognized

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Project and parent cash flows

Project cash flows may not reach the parent:

• Host-country may block cash-flow repatriation

• Cash flows may be taxed at an unfavorable rate

• Host government may require a percentage of cash flows to be

reinvested in the host country

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Adjusting for political and economic

risk
Political risk:
• Expropriation - Iranian revolution, 1979
• Social unrest - after the breakup of Yugoslavia, company assets
were rendered worthless
• Political change - may lead to tax and ownership changes
• Examples. Collapse of communism in Eastern Europe
• Attack on the world trade center
Economic risk
• Inflation

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Financing decisions

When considering options for financing a foreign investment, Int.

businesses have to consider two factors
Source of financing
Financial structure

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Source of financing

• Global capital markets for lower cost financing.

• Impact of host country-host-country may require projects to be
locally financed through debt or equity
• Limited liquidity raises the cost of capital.
• Host-government may offer low interest or subsidized loans to attract
investment.
• Impact of local currency (appreciation/depreciation) influences
capital and financing decisions

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Financial structure

Financial structure:
• Debt/equity ratios vary with countries.
• Tax regimes
• Follow local capital structure norms?
• More easily evaluate return on equity relative to local competition
• Good for company’s image
Best recommendation: adopt a financial structure that minimizes the
cost of capital

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Global money management

-The efficiency objective

Minimizing cash balances:

• Money market accounts - low interest - high liquidity
• Certificates of deposit - higher interest - lower
liquidity
Reducing transaction costs (cost of exchange):
• Transaction costs: changing from one currency to
another
• Transfer fee: fee for moving cash from one location
to another

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Global money management

The tax objective
Countries tax income earned outside their
boundaries by entities based in their country.
• Can lead to double taxation
• Tax credit allows entity to reduce home taxes by
amount paid to foreign government
• Tax treaty is an agreement between countries
specifying what items will be taxed by authorities in
country where income is earned
• Deferral principle specifies that parent companies
will not be taxed on foreign income until the dividend
is received
• Tax haven is used to minimize tax liability

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Corporate income tax rates

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Moving money across borders:

Attaining efficiencies and reducing taxes
Unbundling: A mix of techniques to transfer liquid funds from a
foreign subsidiary to the parent company without piquing the host-
country
• Dividend remittances
• Royalty payments and fees
• Transfer Prices
• Fronting loans
Selecting a particular policy is limited when a
foreign subsidiary is part owned by a local joint-
venture partner or local stockholders

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Dividend remittances
Most common method of transfer.
Dividend varies with:
• tax regulations.
• Foreign exchange risk.
• Age of subsidiary.
• Extent of local equity participation.

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Royalty payments and fees

Royalties represent the remuneration paid to
owners of technology, patents or trade names for
their use by the firm.
• Common for parent to charge a subsidiary for
technology, patents or trade names transferred to it.
• May be levied as a fixed amount per unit sold or
percentage of revenue earned.
Fees are compensation for professional services
or expertise supplied to subsidiary.
• Management fees or ‘technical assistance’ fees.
• Fixed charges for services provided

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Transfer prices

Price at which goods or services are transferred within a firm’s entities.

• Position funds within a company.
• Move founds out of country by setting high transfer fees or into a country
by setting low transfer fees.
• Movement can be within subsidiaries or between the parent and its
subsidiaries.

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Benefits of manipulating transfer

prices
Reduce tax liabilities by using transfer fees to
shift from a high-tax country to a low-tax
country.
Reduce foreign exchange risk exposure to
expected currency devaluation by transferring
funds.
Can be used where dividends are restricted or
blocked by host-government policy.
Reduce import duties (ad valorem) by reducing
transfer prices and the value of the goods.

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Problems with transfer pricing

Few governments like it.

• Believe (rightly) that they are losing revenue.
Has an impact on management incentives and performance
evaluations.
• Inconsistent with a ‘profit center’.
• Managers can hide inefficiencies.

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Fronting loans

Loan between a parent and subsidiary is channeled through a financial

intermediary (bank).
• Allows circumvention of host-country restrictions on remittance of
funds from subsidiary to parent.
• Provides certain tax advantages.

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An example of the tax aspects of a

fronting loan

Fig 20.1

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Techniques for global money

management
Need cash reserves to service accounts and insuring against negative
cash flows.
Should each subsidiary hold its own cash balance?
• By pooling, firm can deposit larger cash amounts
and earn higher interest rates.
• If located in a major financial center can get
information on good investment opportunities.
• Can reduce the total size of cash pool and invest
larger reserves in higher paying, long term,
instruments.

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Centralized depositories

Day-to-Day One Standard Required Cash

Cash Needs Deviation (B) Balance
(A) (A+3xB)

Spain $10 $1 $13

Italy $6 $2 $12

Germany $ 12 $3 $21

Total $28 $6 $46

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Techniques for global money

management
Ability to reduce transaction costs.

• Bilateral netting.

• Multilateral netting - simply extending the bilateral

concept to multiple subsidiaries within
an international business

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Cash flows before multilateral

netting

Fig 20.2A

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Cash flows after multilateral netting

Fig 20.2C

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Net receipts

Fig 20.2B

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Managing foreign exchange risk

Risk that future changes in a country’s exchange rate will hurt the firm.
• Transaction exposure: extent income from transactions is affected
by currency fluctuations.
• Translation exposure: impact of currency exchange rates on
consolidated results and balance sheet.
• Economic exposure: effect of changing exchange rates over future
prices, sales and costs.

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Strategies for reducing foreign

exchange risk (a)
Primarily protect short-term cash flows.

Reducing transaction and translation exposure:

• Buying forward and currency swaps.
• Lead strategy: collecting receivables early when
currency devaluation is anticipated and paying early
when currency may appreciate.
• Lag strategy: delaying receivable collection when
anticipating currency appreciation and delaying
payables when currency depreciation is expected.

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Strategies for reducing foreign

exchange risk (b)

Reducing Transaction and translation exposure

• Lead strategy
• Lag strategy
Reducing economic exposure:
• Key is to distribute productive assets to various locations so firm is
not severely affected by exchange rate changes

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Managing Foreign Exchange

Exposure
No agreement as to how, but commonality of
approach does exist:
• Central control of exposure.
• Distinguish between transaction/translation
exposure and economic exposure.
• Forecast future exchange rate movements.
• Good reporting systems to monitor firm’s exposure
to exchange rate changes.
• Produce monthly foreign exchange exposure
reports.

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Case: Motorola’s global cash management

system
Pre netting and post netting info flows
Fig C1 Fig C2

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Case: Motorola’s global cash

management system

Fig C1

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Case: Motorola’s global cash

management system: Currency netting
model
Fig C3

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Case: Motorola’s global cash

management system

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© 2022 McGraw Hill. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution permitted without the prior written consent of McGraw Hill.