Chapter 1 Introduction To International Accounting

Chapter 1:
Introduction to
International
Accounting
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Learning Objectives
 Discuss the nature and scope of international accounting
 Describe accounting issues confronted by companies
involved in international trade (import and export
transactions)
 Explain the reasons for, and the accounting issues
associated with, foreign direct investment
 Describe the practice of cross-listing on foreign stock
exchanges
 Explain the notion of global accounting standards
 Understand the importance of international trade, foreign
direct investment, and multinational corporations in the
global economy
1-2
What is International Accounting?
 The word Accounting encompasses:
 The functional areas of financial reporting, management

accounting, auditing and taxation
1-3
What is International Accounting?
 The word International can be defined at three different levels:
1) General level
The standards, guidelines and rules of accounting, auditing and
taxation within and across countries
2) Supranational accounting
The standards, guidelines, and rules issued by supranational
organizations such as the International Accounting Standards Board
(IASB), European Union (EU) and the Organization for Economic
Cooperation and Development (OECD)
3) Company level
The standards and practices followed by a company, specifically
related to international business activities and foreign investments
(e.g., transactions dominated in a foreign currency)
1-4
Accounting Issues Related to International Business
—Sale to Foreign Customer
 First encounter with international business occurs as sales
to foreign customers
 Credit sales are made to foreign customers who will pay in

their own currency
 Gives rise to foreign exchange risk
1-5
 Suppose that on February 1, 2020, Magnum, a US company,
makes a sale and ships goods to Tesco, a British customer,
for £100,000 (UK)
 However, it is agreed that Tesco will pay in Pound Sterling

on March 2, 2020. The exchange rate as of February 1, 2020
is UK £1 = $1.35 dollars. How many dollars does Tesco agree
to pay?
1-6
 Even though Tesco agrees to pay £100,000, Magnum
records the sale in US dollars on February 1, 2020, as
follows: [£1 = $1.35]
 Payment Due =
1-7
 Even though Tesco agrees to pay £100,000, Magnum
records the sale in US dollars on February 1, 2020, as
follows: [£1 = $1.35]
 Payment Due = 100,000 * 1.35 = $135,000
Dr. Accounts Receivable 135,000

Cr. Sales Revenue 135,000
1-8
 Suppose that on March 2, 2020, the exchange rate for Pound Sterling
is £1 =$1.30. Magnum will receive 100,000 Pound Sterling which are
now worth:
 Payment received =
1-9
 Suppose that on March 2, 2020, the exchange rate for Pound Sterling
is £1 =$1.30. Magnum will receive 100,000 Pound Sterling which are
now worth:
 Payment received = 100,000 * 130 = 130,000
 Payment due is higher than payment received [135,000 – 130,000] =

$5,000 (loss)
Dr. Cash 130,000

Dr. Loss on Foreign Exchange 5,000
Cr. Accounts Receivable 135,000
1-10
What is a Foreign Exchange Risk?
 By making a credit sale to a foreign (UK) customer (Tesco),
and accepting to receive payment in a foreign currency
(Pound Sterling), Magnum became exposed to a foreign
exchange risk (the risk that the foreign currency will
decrease in US dollars value over the life of the receivable)
1-11
Foreign Exchange Risk MCQ
Choose the best answer:
Foreign exchange risk arises when::
A. Goods or services purchased from suppliers in a foreign

country are denominated in domestic currency
B. Auditing reports are prepared in a foreign currency
C. Business transactions are denominated in foreign currencies
D. Sales are made to customers in a domestic country
1-12
Sale to Foreign Customer Exercise
Suppose that on January 15, 2020, Qatar Steel, a Qatari company,
sold and shipped steel to Swedish Rail, a Swedish railway
manufacturing company, for €3,000,000 (Euros). Swedish Rail
agreed to make the payment in Euros on April 30, 2020.
 On January 15, 2020, the exchange rate was €1 = QR 4

 On April 30, 2020, the exchange rate was €1 = QR 4.25
Required:
1. Record the sale transaction on January 15, 2020
2. Record the transaction when the payment was received on

April 30, 2020
1-13
Solution
 €1 = QR 4
 Payment Due =
Dr Cr
1-14
Solution
 €1 = QR 4
 Payment Due = 3000,000 * 4 = QR 12,000,000
Dr Cr
Account Receivable 12,000,000
Sales Revenue 12,000,000
1-15
Solution
April 30, 2020
 €1 = QR 4.25
 Payment received =
Dr Cr
1-16
Solution
April 30, 2020
 € 1 = QR 4.25
 Payment received = 3000,000 * 4.25 = QR 12,750,000
 Payment received is higher than payment due [12,750,000 –

12,000,000] = QR 750,000 (gain)
Dr Cr
Cash 12,750,000
Account Receivables 12,000,000
Foreign currency gain 750,000
1-17
Transaction Types, Exposure type and Gain or Loss
A. Export Sales: Asset Exposure (A/R)
 If foreign currency appreciates  foreign exchange gain

 If foreign currency depreciates  foreign exchange loss
A. Import Purchase: Liability Exposure (A/P)
 If foreign currency appreciates  foreign exchange loss

 If foreign currency depreciates  foreign exchange gain
7-18
Purchase from Foreign Customer MCQ
Suppose an American company purchases merchandise from a Mexican

company on credit and the payment is due after 3 months with Mexican
Pesos. If the value of the Mexican Pesos increases at the payment date,
then:
A. The American company will be exposed the foreign exchange losses
B. The American company will be realizing gains on foreign exchange
C. The Mexican company will be exposed to foreign exchange losses
D. The Mexican company will be realizing gains on foreign exchange
1-19
Hedges of Foreign Exchange Risk
 For many companies, the uncertainty of not knowing how

much domestic currency will be received on the export sale
is a great concern
 Techniques to manage (or hedge) exposure to foreign

exchange risk
1. Foreign currency option
2. Forward contract
1-20
1. Foreign Currency Option
 It gives the option’s owner the right (but not the

obligation) to sell foreign currency at a predetermined
exchange rate known as the strike price
 Options must be purchased by paying an option premium
1-21
Foreign Currency Option Example
 Previously, Magnum lost $5,000 without hedging as the

Pound Sterling fell from $1.35 to $1.30
 The loss was ($0.35 - $0.30) x £100,000 = $ 5000
 Magnum could have purchased a foreign currency option

on February 1, 2020
 The option premium is $4,000
1-22
Foreign Currency Option Example Continued
 Magnum would now have the option to sell £100,000 at a

strike price of $1.35 on March 2, 2020.
 In this case, Magnum would have collected $135,000 rather

than $130,000
 Instead of a $5,000 foreign exchange loss, Magnum would

have paid $4,000 for the option
 How much did Magnum save by using a foreign currency

option?
1-23
2. Forward Contract
 Obligation to exchange foreign currency at a future date
 There is no up-front cost to enter into a forward contract
 Instead, a foreign currency is sold at either a premium or a discount:
 Premium: forward rate is greater than the spot rate
 Discount: forward rate is less than the spot rate
 Spot rate is the price at which the foreign currency could be purchased or
sold today
 Forward rate is the price offered today to buy or sell foreign currency at a
future date
1-24
Forward Contract Example
 Previously, Magnum lost $5,000 without hedging as the Pound

Sterling fell from $1.35 to $1.30
 Magnum could have purchased a foreign currency forward contract

on February 1, 2020
 Under the forward contract, Magnum would have agreed to sell

£100,000 for $1.33 on March 2, 2011
 Given that the spot rate on February 1 is 1.35, the pound is selling at a
discount in the one-month forward market (the forward rate is less
than the spot rate)
7-25
Forward Contract Example Continued
 Instead of $130,000, how much would Magnum collect under the
Forward Contract?
 Instead of a $5,000 foreign exchange loss, Magnum would be

selling the Pound Sterling at ………………
 Magnum knows exactly amount of the……..expense (..……..)

that results from using a forward contract
 This could be better than leaving the receivables unhedged when

the size of foreign exchange loss could be unknown
 How much did Magnum save by using a forward contract?
7-26
Forward Contract Example Continued
 Instead of $130,000, Magnum would have collected $133,000
 Instead of a $5,000 foreign exchange loss, Magnum would be

selling the Pound Sterling at a discount of $2000 ( [1.35-1.33] x
1000,000)
 Magnum knows exactly amount of the discount expense

($2000) that results from using a forward contract
 This could be better than leaving the receivables unhedged

when the size of foreign exchange loss could be unknown
 Magnum saved $3000 (5,000 – 2,000) by using a forward

contract
7-27
Foreign Direct Investment
 Ownership and control of foreign assets is known as

Foreign Direct Investment (FDI)
 Two ways of FDI

1. Acquisition
 Investment in existing operations in foreign countries
2. Greenfield investment
 Brand-new operation in foreign countries
1-28
Reasons for Foreign Direct Investment
1. Increase sales and profits
2. Enter rapidly growing or emerging markets
3. Reduce costs
4. Gain a foothold in economic blocs
5. Acquire technological and managerial know-how
6. Protect domestic markets
7. Protect foreign markets
1-29
1. Increase sales and profits

 Additional (international) sales lead to additional profits
2. Enter rapidly growing or emerging markets

 FDI provides a foothold (strong position) in a rapidly growing
emerging markets (can you think of examples?)
3. Reduce costs
 FDI reduce production costs (low labour costs) and eliminate
transportation costs (associated with exports)
1-30
4. Gain a foothold (strong position) in economic blocs

 FDI relives companies from worrying about import tax
(tax on imported foreign products) especially in major
economic blocks (North America, Europe and Asia)
5. Acquire technological and managerial know-how

 By operating close to leading competitors, companies
can learn from them and hire their experienced
employees
1-31
6. Protect domestic markets
 FDI can weaken potential international competitor, which will

be less likely to enter a foreign market if it is preoccupied with
protecting its own domestic market
 For example, Marks and Spencer wants

to protect its domestic market (UK) from Macys, an American
competitor. To do so, Marks and Spencer opens a store in the
USA, so that Macys will be preoccupied with protecting its
own American market than thinking of opening a store in the
UK
1-32
7. Protect foreign markets
 Companies generating sales through exports to a particular

country might find it necessary to establish a presence in the
country to protect their foreign markets
 For example, Marks and Spencer is generating sales through

exports to the USA, so it might find it necessary to establish a
presence in the USA (by opening a store there) to protect its
American foreign market (which was first established
through exports)
1-33
Financial Reporting for Foreign Operations:
Consolidation
As a listed company in the US, Magnum is required to prepare
consolidated financial statements:
 What is the meaning of consolidation?

 Combining the financial statements of all subsidiaries, both
foreign and domestic, into the financial statements of the
parent company
 How to consolidate?
 Two Steps must be completed to consolidate the financial
statements by companies with foreign operations:
1-34
Two Steps to Consolidation
1. Conversion from local to US GAAP
 Records prepared using local GAAP needs to be converted to
US GAAP
 For example, for Magnum, a US multinational company, the

first step to consolidating the financial statements of its
German subsidiary is to convert the German subsidiary’s
financial statements from German GAAP to US GAAP
2. Translate from local currency to US dollars

 After the account balances have been converted to US GAAP,
they must be translated from the local currency into US dollars
 The second step for Magnum is to convert the account

balances from Euros into US dollars
1-35
International Income Taxation
 What are the Objectives of understanding international

income taxation?
 An MNE aims to legally minimize taxes in foreign

countries and home country (overall taxes)
 Minimizing overall taxes will maximize after-tax cash

flows
1-36
International Income Taxation
 Income earned by a foreign subsidiary of a US company is subject

to double taxation. How?
1. Foreign income tax: the subsidiary’s profit taxed in a foreign
country (e.g., Qatar) at a foreign tax rate (e.g., 10%)
2. US income tax: tax paid in the US on the company’s foreign-

based income (e.g., 21%) because tax in the US is based on a
worldwide basis
 Tax treaties provide relief from double taxation (Double Tax

Treaties)
 Most countries (including the US and Qatar) provide tax
credit/relief for the amount of taxes already paid to the foreign
government
1-37
International Transfer Pricing
 How does Transfer pricing happen?

 When two companies that are part of the same MNE,
trade with each other (intercompany sale)
 What is transfer pricing?

 The prices established to record an intercompany sale
1-38
International Transfer Pricing
 Why is transfer pricing a problem?
 Instead of the genuine negotiation between the buyer and the
seller (unrelated companies), intercompany sale is based on
distorted (artificial) prices to minimize the payment of overall
taxes
 Companies shift profits from countries with high-tax rates to

countries with low tax-rates
 How to limit transfer pricing?

 Countries regulate international transfer pricing to ensure
companies pay their fair share of taxes by asking companies to
prove that their prices are at arm’s length
1-39
International Transfer Pricing MCQ
SPAR is a food retailer headquartered in the Neverlands, which has a

corporate tax rate of 19%. SPAR has a subsidiary in Qatar, SPAR
Gardens, that owns gardens of date palms. The corporate tax rate in
Qatar is 10%. To minimize Spar’s overall corporate income tax, how
do you expect SPAR Gardens to set the price of dates, which it will sell
to SPAR in the Neverlands?
A. It doesn't matter what transfer price is used because they are part of
the same company
B. Transfer pricing has nothing to do with the total tax paid by Spar
C. SPAR Gardens will sell the dates to SPAR in the Neverlands at a
low price
D. SPAR Gardens will sell the dates to SPAR in the Neverlands at a
high price
1-40
International Transfer Pricing MCQ
Solution:
 To minimize SPAR overall tax, SPAR Gardens will set

the price of dates as high as possible
 High sales revenue in a country with a lower tax rate and

high cost of goods sold (low gross profit) in a country with a
higher tax rate
1-41
International Transfer Pricing Exercise
Eataly is a food retailer headquartered in Italy, which has a
corporate tax rate of 24%. Eataly has a fishing subsidiary in
Japan, Freshwaters. The corporate tax rate in Japan is 30%.
To minimize Eataly’s overall corporate income tax, how do
you expect it to set the price of fish that Freshwaters in
Japan will sell to Eataly in Italy? Explain:
1-42
Solution:
 To minimize Eataly overall tax, Freshwaters will set

the price of fish as low as possible
 Low sales revenue in a country with a higher tax rate and

low cost of goods sold (high gross profit) in a country with
a low tax rate
1-43
Discretionary Transfer Pricing
 When making an intercompany sale from a low-tax country to
a high-tax country (SPAR’s example)
 The company will set the price as high as possible: high sales
revenue in a country with low tax rate and high cost of goods
sold (low gross profit) in a country with a higher tax rate
 When making an intercompany sale from a high-tax country

to a low-tax country (Eataly's example)
 The company will set the price as low as possible: low sales
revenue in a country with high tax rate and low cost of goods
sold (high gross profit) in a country with a low tax rate
1-44
Performance Evaluation of Foreign Operations
 The process of evaluating performance for home country’s operations

may not be directly transferable to evaluating the performance of
foreign operations
 Companies’ CEOs must consider several issues unique to foreign

operations when evaluating performance
1. Deciding whether to evaluate performance on the basis of foreign

currency or parent company reporting currency because currency
translation can affect ratios that are used to measure performance
2. Deciding whether to factor out (not to consider) those items over

which the foreign operation’s managers have no control such as
inflated price paid in transfer pricing
1-45
International Auditing
 Internal auditing is an important component of a management’s

control process. The internal auditor must:
1. Make sure that the company’s policies and procedures are
being followed
2. Uncover errors, inefficiencies and fraud
 Obstacles faced by internal and external auditors

1. Differences in languages and cultures
2. Differences in accounting standards and auditing standards
between countries
1-46
Cross-Listing on Foreign Stock Exchanges
 What is cross-listing?
 Having the stock (shares) listed and traded on several foreign
stock exchanges
 Why cross list on international capital markets?

 Cross listing helps companies find capital at a reasonable cost
 Issues related to cross-listing:

 Listing regulations differ between foreign companies and
domestic companies. For example, in the US, the SEC requires
all US companies to use US GAAP for their financial statements
while foreign companies can use IFRS
1-47
Global Accounting Standards
 Are the differences that exist in GAAP across countries

necessary? Shouldn’t all countries including the US adopt a set of
common accounting standards? What are the advantages of
using global accounting standards (e.g. IFRS)
1. It avoids GAAP conversion when preparing consolidated

financial statements
2. It is easier to evaluate foreign investment opportunities when

financial statements are prepared according to IFRS
1-48
The Global Economy
 International trade (exports and imports) constitutes a
significant portion of the world economy
 Three largest exporters and importers are China, the United
States and Germany
 Companies may feel the need to switch from exports to FDI to

retain advantage over competition (and other advantages
discussed earlier)
 Multinational company: A company that is headquartered in one

country but has operations in other countries
 UN measures multinationality based on three ratios (foreign
sales/total sales; foreign assets/total assets; foreign
employees/total employees)
1-49
End of Chapter 1
1-50

Chapter 1 Introduction To International Accounting

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Chapter 1 Introduction To International Accounting

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Chapter 1:

 The word Accounting encompasses:

 The functional areas of financial reporting, management

 Credit sales are made to foreign customers who will pay in

 However, it is agreed that Tesco will pay in Pound Sterling

 Payment Due = 100,000 * 1.35 = $135,000

Dr. Accounts Receivable 135,000

 Payment received = 100,000 * 130 = 130,000

 Payment due is higher than payment received [135,000 – 130,000] =

Dr. Cash 130,000

Foreign exchange risk arises when::

A. Goods or services purchased from suppliers in a foreign

B. Auditing reports are prepared in a foreign currency

C. Business transactions are denominated in foreign currencies

D. Sales are made to customers in a domestic country

 On January 15, 2020, the exchange rate was €1 = QR 4

2. Record the transaction when the payment was received on

 Payment Due = 3000,000 * 4 = QR 12,000,000

 Payment received = 3000,000 * 4.25 = QR 12,750,000

 Payment received is higher than payment due [12,750,000 –

A. Export Sales: Asset Exposure (A/R)

 If foreign currency appreciates  foreign exchange gain

A. Import Purchase: Liability Exposure (A/P)

 If foreign currency appreciates  foreign exchange loss

Suppose an American company purchases merchandise from a Mexican

A. The American company will be exposed the foreign exchange losses

B. The American company will be realizing gains on foreign exchange

C. The Mexican company will be exposed to foreign exchange losses

D. The Mexican company will be realizing gains on foreign exchange

 For many companies, the uncertainty of not knowing how

 Techniques to manage (or hedge) exposure to foreign

1. Foreign currency option

 It gives the option’s owner the right (but not the

 Options must be purchased by paying an option premium

 Previously, Magnum lost $5,000 without hedging as the

 The loss was ($0.35 - $0.30) x £100,000 = $ 5000

 Magnum could have purchased a foreign currency option

 The option premium is $4,000

 Magnum would now have the option to sell £100,000 at a

 In this case, Magnum would have collected $135,000 rather

 Instead of a $5,000 foreign exchange loss, Magnum would

 How much did Magnum save by using a foreign currency

 There is no up-front cost to enter into a forward contract

 Instead, a foreign currency is sold at either a premium or a discount:

 Premium: forward rate is greater than the spot rate

 Discount: forward rate is less than the spot rate

 Previously, Magnum lost $5,000 without hedging as the Pound

 Magnum could have purchased a foreign currency forward contract

 Under the forward contract, Magnum would have agreed to sell

 Instead of a $5,000 foreign exchange loss, Magnum would be

 Magnum knows exactly amount of the……..expense (..……..)

 This could be better than leaving the receivables unhedged when

 How much did Magnum save by using a forward contract?

 Instead of a $5,000 foreign exchange loss, Magnum would be

 Magnum knows exactly amount of the discount expense

 This could be better than leaving the receivables unhedged

 Magnum saved $3000 (5,000 – 2,000) by using a forward

 Ownership and control of foreign assets is known as

 Two ways of FDI

1. Increase sales and profits

2. Enter rapidly growing or emerging markets

4. Gain a foothold in economic blocs

5. Acquire technological and managerial know-how