MBA 6601, International Business 1
Course Learning Outcomes for Unit VII
Upon completion of this unit, students should be able to:
9. Compare the accounting concepts of Generally Accepted Accounting Principles (GAAP) and
International Financial Reporting Standards (IFRS).
Reading Assignment
In order to access the following resource(s), click the link(s) below:
Fuller, C., & Crump, R. (2016). There may be trouble ahead. Financial Director, 30–33. Retrieved from
https://libraryresources.columbiasouthern.edu/login?url=http://search.ebscohost.com/login.aspx?direc
t=true&db=bth&AN=113496250&site=ehost-live&scope=site
Herz, R. (2015). U.S. financial reporting: How are we doing? Compliance Week, 12(142), 39–41. Retrieved
from http://link.galegroup.com/apps/doc/A434530135/ITBC?u=oran95108&sid=ITBC&xid=c5c69fe6
Mishler, M. D. (2015). Don’t let foreign currency fluctuations impair performance measurements. Journal of
Accountancy, 220(6), 60–66.Retrieved from
https://libraryresources.columbiasouthern.edu/login?url=http://search.ebscohost.com/login.aspx?direc
t=true&db=bth&AN=111314570&site=ehost-live&scope=site
Click here to view the Unit VII Presentation. Click here to access a PDF of the presentation, which includes
slide images and audio transcript.
Unit Lesson
International Accounting Issues
In a corporation’s senior management, the finance and accounting functions fall under the same person. Both
the treasurer and the controller report to the chief financial officer (CFO). The treasurer is responsible for
finance, while the controller handles the accounting side.
So, what does the controller control? While they are responsible for accounting standards and procedures,
their job duties go much further. They provide data to evaluate potential acquisitions abroad, disposition of
assets, managing cash flow, hedging currency, internal auditing, tax planning, preparation of financial
statements, and assistance in implementing corporate strategy. A large combination of these duties may only
be found in large multinational enterprises (MNEs), but even small companies that import or export will have
to occasionally handle foreign currency transactions or conduct currency hedging strategies.
One of the big headaches that controllers have to deal with is the differences in the presentation of the
financial information. Under normal conditions, each branch or subsidiary is required to have a financial
statement completed on their operations so that local taxes are computed and paid. Each country has its own
type of accounting procedures that an MNE must follow. Financial statements written in the local language
show financial transactions stated in the local currency. Other considerations include the statement layout and
the Generally Accepted Accounting Principles (GAAP) provided by the local government’s comptroller’s office.
UNIT VII STUDY GUIDE
Managing International Operations, Part 2:
Accounting and Financial Issues
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It is important to note that both the United States and global authorities have organizations that have issued
standardized accounting rules.
U.S. Accounting: The Financial Accounting Standards Board (FASB) is the organization that
establishes the accounting standards for the private sector in the United States. Its rules are the
Generally Accepted Accounting Principles (U.S. GAAP).
Global Accounting: The International Accounting Standards Board (IASB) is the organization that
establishes accounting standards for the global community. Its rules are the International Ffinancial
Reporting Standards (IFRS).
U.S. GAAP is to FASB as IFRS is to IASB. In a few international countries, neither IFRS nor U.S. GAAP are
required; in a few other international countries, either IFRS or U.S. GAAP is required. However, as many as
120 countries currently require or permit IFRS use (Solomonzori, 2013).
Global Convergence to International Standards
Prior to the rise of global capital markets, many foreign countries accepted U.S. accounting standards as a
qualified substitute. Both the U.S. and other global nations mutually recognized accounting standards from
the other. Since the 1970s, efforts have been made to harmonize accounting standards that anyone in the
world could use. Several trends have come together to push this convergence:
Capital markets have spread throughout the world as evidenced by over 60 stock markets.
MNEs have the ability to sell equity and debt at lower transaction costs in foreign countries.
Foreign countries need standard accounting data for tax purposes.
There is pressure from investors, MNEs, and foreign governments for more uniform standards in
financial reporting that are easier to understand.
In the early 2000s, FASB and IASB began working together to eliminate differences in accounting standards.
While there is some similarity between the two accounting standards, it is still felt by the U.S. Securities
Exchange Commission that FASB needs to be stringent and transparent as it relates to U.S. corporations;
characteristics that IASB has yet to embrace for international MNEs.
Transactions in Foreign Currencies
Subsidiaries and branches that operate in foreign countries must convert all of their transactions in foreign
currencies to the currency of the home office at the end of the accounting year. For example, an importer
purchases the service of a freight forwarder to assist with freight going through customs in the foreign country.
The importer will sell its domestic currency to purchase the foreign currency of the freight forwarder.
Depending on the fluctuations of the currency, the importer might gain or lose on the transaction. Those gains
or losses translate into the net income of the importer (Financial Accounting Standards Board, 1981).
The process of restating those gains or losses into the currency of the importer is translation. In the United
States, translation is a two-step process. First, for each country in which the importer was conducting
business, the importer would need to convert the foreign financial statement to a GAAP financial statement in
U.S. dollars. Second, now that all of the financial statements are in U.S. dollars, the importer would combine
them into one financial statement. This combination process is consolidation of all individual operations
(Financial Accounting Standards Board, 1981).
Even in this process, there are similarities between FASB and IASB. For U.S. companies, this process is
outlined in Financial Accounting Statement Number 52 (Financial Accounting Standards Board, 1981). This
same process is outlined for other global companies in the International Accounting Standard Number 21
(Deloitte, 2015).
International Financial Issues
Earlier, we discussed the functions that fall under the accounting side; the treasury side is no less important.
Treasury functions include capital budgeting, cash management, and foreign exchange risk management.
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Capital Budgeting in a Global Context
Every company, big or small, has projects that it would want to complete if it had the resources to do so.
Some projects increase revenues, some decrease costs, and some, like capital maintenance expenditures,
allow the company to keep operating. Companies may not have enough money to pay for all of the projects,
thus they must prioritize them and only finance the top ones that they can afford. Each project gets its ranking
in one of three ways.
Payback method: One method is to determine how long the project will take to repay the initial investment.
For example, a project with an investment of $100,000 and an estimated $20,000 return each year would
have a payback of five years. When compared with other similar projects, the one with the shortest payback is
preferred. The disadvantages of this method are that it ignores the benefits after year five and that it ignores
the time value of money.
Net present value method (NPR): This method estimates the free cash flow for each accounting period of
the project’s economic life and discounts that cash flow by a specified hurdle rate. The discounted cash flows
must exceed the initial cost of investment, or the project is not economically viable. The hurdle rate or
discount rate is the expected rate of return for similar projects with the same amount of risk. An example
would be a small machine costing $75,000 to get it up and running with an expected free cash flow of $20,000
at the end of each year for five years. If the hurdle rate is 10%, then NPV is $75,815 or $815 to the positive.
The disadvantages to this method lie in the forecasts. Forecasting sales and costs is difficult—especially for
factories and plants and especially forecasting 10-20 years into the future. There is more to forecast and more
to go wrong.
Internal rate of return method: The IRR method is similar to the NPR method. The difference is the variable
being calculated is the discount rate. The initial investment is known, and the free cash flow per accounting
period is known. What is not known is the discount rate that will make the free cash flow equal to the initial
investment. For example, using the previous example, if a small machine costing $75,000 will generate free
cash flows of $20,000 per year for five years, what is the discount rate that makes the free cash flow equal to
the initial investment? The answer is 10.42%. Using this method to compare capital projects will allow the
user to compare discount rates on capital. Higher discount rates mean more return on your investment.
Again, the main problem with the method is forecasting revenues and expenses far into the future.
As the methods pertain to global expenditures, it is difficult to know whether foreign currencies will strengthen
or weaken. Capital projects usually span long periods, and while domestic capital projects have economic
risk, foreign projects have economic and political risk.
Cash Management
One responsibility of the treasurer is to determine whether capital project financing should come from internal
sources of funds or external sources of funds such as debt or equity. Large companies can move resources
and assets between branches and subsidiaries. Internal funds grow when deferring payment on expenses.
Taxes decline when payments to the parent company are loans and not dividends. In other words, funds
become available by knowing how to legally declare and transfer assets.
Foreign Exchange Risk Management
If foreign currencies did not constantly strengthen or weaken, companies would not need risk management.
However, the movement of currencies in relation to a company’s domestic currency constantly occurs. A
change in the exchange rate causes a currency risk. That is, a company may lose money due to foreign
exchange losses. This risk exposure is broken down into three categories:
Translation exposure: It is normal practice to create financial statements in the subsidiary’s foreign location.
That means the financial statements post its value in foreign currency. At the end of the accounting period,
the parent company has to consolidate all of the financial statements, which means that the foreign currencies
convert into domestic currency. Generally, there is a gain or a loss from currency translation. That gain or loss
is the translation exposure.
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An example would be if a Japanese subsidiary sold some products to another Japanese company and had a
profit of 1,133,530 yen. At the time of the transaction, the exchange rate was 113.5300 yen to the dollar. The
parent company, in the United States, would need to consolidate all financial statements at the end of the
accounting period. When the time came to consolidate, the yen’s exchange rate was 118.0260 to the dollar.
The parent company would show $9,584.06 profit on its operating statement and a currency loss of $414.94
under its expenses. In actual practice, the company still has the original yen in the bank, so the loss is not an
actual loss; it does not become an actual loss until the yen convert to dollars.
Transaction exposure: Actual transactions that occur between businesses in the international market can
show losses when payment is made in a devaluing currency. Transaction exposure is the risk incurred when
exchange rates change for the worse after the financial obligation has occurred.
For example, a U.S. company sells product to a Japanese company with payment to be in U.S. dollars upon
delivery. The sales contract calls for a $10,000 price, so the Japanese company can immediately buy $10,000
in U.S. currency at an exchange rate of 113.530 yen per dollar or it can wait until closer to delivery. As it turns
out, upon delivery, the exchange rate is 118.0260 yen per dollar. If the Japanese company waited to buy the
U.S. currency, it would lose 44,960 yen or about $381. Transaction exposure measures cash (realized) gains
and losses from a change in exchange rate.
Economic exposure: International companies have cash flows from their different subsidiaries and
branches. These cash flows are subject over time to exchange-rate fluctuations. For example, a company
with factories in countries with weak currencies will make more money when it sells its product in countries
with strong currencies. However, if the countries with weak currencies become strong, and its currency
becomes strong, the product costs will increase. Increasing product cost will change the value of the cash
flow and even the value of the company itself.
An example of this comes from Volkswagen AG. To take advantage of the strong euro versus the U.S. dollar,
in 2011, Volkswagen opened an automobile factory in Chattanooga, TN. Volkswagen found that exporting
cars from Germany to the U.S. was costly. Manufacturing costs were in euros while revenues were in dollars.
Manufacturing cars in the U.S. cut Volkswagen’s economic exposure and boosted its earnings (Ramsey,
2011).
Exposure Management
International companies with exposure to foreign currency exchange have developed sophisticated methods
to protect themselves. The steps are outlined below:
1. Forecast the degree of transaction exposure by currency.
2. Forecast the trend of exchange rates. Short-term trends (weekly and monthly) are difficult to forecast,
but long-term forecasts (yearly) are easy.
3. Report all currency-exchange purchases when they occur. This is an advantage of a centralized
organization structure. Have all subsidiaries report their currency-exchange transactions to a
centralized point.
4. Have the strategic planning department share its plans to expand subsidiaries in the international
market with the treasury department.
5. Formulate hedging strategies.
Transaction hedging strategies: Have sales contracts denominate the price and payment in the subsidiary’s
home currency. A secondary plan would be to denominate any purchases in a weak currency and
denominate any sales in a strong currency. If just the opposite occurs, the corporate office can take out
forward contracts or spot agreements to balance the inflows and outflows.
A lead strategy is another transaction hedging strategy that includes providing incentives to pay early when
collecting receivables. A lag strategy is just the opposite. When collecting receivables in a foreign currency
that is expected to strengthen, provide incentives to delay payment. The lead and lag concepts work for
paying off payables as well.
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Operational hedging strategies: As described previously in the Volkswagen example, the strategy is to build
products in countries with weak currencies and sell the product in countries with strong currencies. In that
manner, costs are lower but revenues are higher.
Another operational hedging strategy is the use of forward contracts and options, as discussed in the Unit IV
lesson.
Exposure management is a form of risk management that international companies use to protect themselves
from currency exchange losses.
References
Bank for International Settlements. (2013). Triennial central bank survey. Retrieved from
http://www.bis.org/publ/rpfx13fx.pdf
Deloitte. (2015). IAS 21–The effects of changes in foreign exchange rates. Retrieved from
http://www.iasplus.com/en/standards/ias/ias21
Financial Accounting Standards Board. (1981). Statement of financial accounting standards No. 52. Retrieved
from
http://www.fasb.org/jsp/FASB/Document_C/DocumentPage?cid=1218220126851&acceptedDisclaime
r=trueRamsey, M. (2011, May 23). VW chops labor costs in U.S. The Wall Street Journal. Retrieved
from http://www.wsj.com/articles/SB10001424052748704083904576335501132396440
Solomonzori. (2013). Who pays and who free rides? International free rider reporting standards or
International Financial Reporting Standards. Retrieved from http://governancexborders.com/tag/ifrs/
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