INTRODUCTION TO INTERNATIONAL ACCOUNTING

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CHAPTER 1

INTRODUCTION TO INTERNATIONAL ACCOUNTING

Chapter Outline

• International accounting is an extremely broad topic.
• At a minimum, it focuses on the accounting issues unique to multinational corporations,

especially with respect to international transactions and foreign investments.

• At the other extreme, it encompasses the study of the various functional areas of

accounting in all countries of the world, as well as the activities of a number of supranational organizations.

• This book provides an overview of the broadly defined area of international accounting,

including certain supranational guidelines, but focusing on the accounting issues related to international business activities and foreign investments. In other words, this book focuses on international accounting issues at the company level that are specifically relevant to multinational corporations.II. There are several accounting issues encountered by companies involved in international trade.

• One issue is the accounting for foreign currency-denominated export sales and import

purchases. An important issue is how to account for changes in the value of the foreign currency-denominated account receivable (payable) that occur as exchange rates fluctuate.

• A related issue is the accounting for derivative financial instruments, such as forward

contracts and foreign currency options, used to hedge the foreign exchange risk associated with foreign currency transactions.III. There is an even greater number of accounting issues encountered by companies that have made a direct investment in a foreign operation. These issues primarily result from the fact that accounting rules, tax laws, and other regulations differ across countries, and include:

• Figuring out how to make sense of the financial statements of a foreign acquisition target

prepared in accordance with an unfamiliar GAAP when making a foreign direct investment decision.

• Determining the correct amounts to include in consolidated financial statements for the

assets, liabilities, revenues, and expenses of foreign operations. The consolidation of a foreign subsidiary involves a two-step process: (1) restate foreign GAAP financial statements into parent company GAAP and (2) translate foreign currency amounts into parent company currency. Determining the appropriate translation method and deciding how to report the resulting translation adjustment are important questions.

• Complying with host country income tax laws, as well as home country tax laws related

to income earned in a foreign country (foreign source income). Double taxation of income is a potential problem, and foreign tax credits are the most important relief from this problem.

• Establishing prices for intercompany transactions that cross national borders

(international transfer prices) to achieve corporate objectives and at the same time comply with governmental regulations.

• Evaluating the performance of both a foreign operating unit and its management.

Decisions must be made with respect to issues such as the currency in which a foreign operation should be evaluated and whether foreign management should be held responsible for items over which they have little control.(International Accounting, 6e Timothy Doupnik, Mark Finn, Giorgio Gotti, Hector Perera) (Solution Manual all Chapters) 1 / 4

Chapter 01 - Introduction to International Accounting

1-2 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

• Establishing an effective internal audit function to help maintain control over foreign

operations. Differences in culture, customs, and language must be taken into consideration.

• Deciding whether to cross-list securities on foreign stock exchanges and complying with

local stock exchange regulations to do so. This could involve the preparation of financial information in accordance with a GAAP different from that used by the company.IV. As companies have become more multinational, so have their external auditors. The Big 4 public accounting firms are among the most multinational business organizations in the world.

• Problems encountered by MNCs when confronted with different local GAAP in different

countries lead to the desire for a single set of global accounting standards. There would be significant advantages to MNCs if all countries used the same GAAP.VI. The world economy is becoming increasingly more integrated. International trade (imports and exports) has grown substantially in recent years and has become a normal part of business for relatively small companies. The number of U.S. exporting companies has increased four-fold over the last three decades.VII. The tremendous growth in foreign direct investment (FDI) over the last several decades is partially attributable to the liberalization of investment laws in many countries specifically aimed at attracting FDI. The aggregate revenues generated by foreign operations are more than twice as large as the revenues generated through exporting.VIII. There were more than 82,000 multinational companies in the world in 2009 with 810,000 foreign subsidiaries. The 100 largest multinationals generated approximately 4% of global GDP. A disproportionate number of multinational corporations are headquartered in the United States, China, Japan, and the European Union.IX. According to one definition of multinationality used by the United Nations, six of the ten most multinational companies in the world in 2020 were headquartered in Europe.

• In addition to establishing operations overseas, many companies also cross-list their shares

on stock exchanges outside of their home countries. There are a number of reasons for doing this, including having access to a larger pool of capital.Answers to Questions

• In 2020, companies worldwide exported over $17.5 trillion worth of merchandise. Although

international trade has existed for thousands of years, recent growth in trade has been phenomenal. Over the period 2009–2019, U.S. exports increased from $1,056 billion to $1,645 billion per year, a 56% increase. During the same period, Chinese exports more than doubled to $2,499 billion in 2019.

• Companies engaged in international trade with imports and exports denominated in foreign

currencies are faced with the accounting issue of translating foreign currency amounts into the company’s reporting currency and reporting the effects of changes in exchange rates in the financial statements. Many of these companies also engage in hedging activities to reduce the risk of changes in exchange rates. The accounting for derivative financial instruments used to hedge foreign exchange risk can be quite complicated. 2 / 4

Chapter 01 - Introduction to International Accounting

1-3 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

• Financial reporting issues that result from foreign direct investment are (a) conversion of

foreign GAAP to parent company GAAP and (b) translation of foreign currency to parent company reporting currency to prepare consolidated financial statements.

• Two major taxation issues related to a foreign direct investment are (a) taxation of the

investee’s income by the host country in which the investment is located and (b) taxation of the investee’s income by the investor’s home country. Companies with foreign direct investments need to develop an expertise in the host country’s income tax rules, as well as in the home country’s tax rules with respect to foreign source income.

• Companies must make several decisions in designing the system for evaluating the

performance of foreign operations. Two of these are (a) deciding whether to evaluate performance on the basis of foreign currency or parent company reporting currency and (b) deciding whether to factor out of the performance measure those items over which the foreign operation’s managers have no control.

• Two reasons to have stock listed on the stock exchange of a foreign country are (a) to

obtain capital in that country, perhaps at a more reasonable cost than is available at home, and (b) to have an “acquisition currency” for acquiring firms in that country through stock swaps.

• The United Nations, as an example, measures the multinationality of companies based on

the average of three factors: the ratio of foreign sales to total sales, the ratio of foreign assets to total assets, and the ratio of foreign employees to total employees. Information about foreign sales and foreign assets generally is provided in a company’s annual report.Information about the number of foreign employees also might be provided in the annual report or other publications through which a company provides information to the public.

• A single set of accounting standards used worldwide would have the following benefits for

multinational corporations:

• Reduce the cost of preparing consolidated financial statements • Reduce the cost of gaining access to capital in foreign countries • Facilitate the analysis and comparison of financial statements of competitors and potential acquisitions Solutions to Exercises and Problems

• Sony uses the following procedures to translate the foreign currency financial statements of

its foreign subsidiaries into Japanese yen:

• All assets and liabilities are translated at the year-end exchange rate • All income and expense accounts are translated at the exchange rate prevailing on the transaction date • The resulting translation adjustment is included in accumulated other comprehensive income (stockholders’ equity) Sony uses the following procedures to translate foreign currency payables and receivables

into Japanese yen:

• All foreign currency receivables and payables are translated into Japanese yen at the year-end exchange rate • Changes in the Japanese yen value of foreign currency receivables and payables are reported as gains and losses in income 3 / 4

Chapter 01 - Introduction to International Accounting

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• Note: Since this book went to press, the Tax Foundation discontinued providing a

separate PDF file with corporate tax rate data on its “Corporate Tax Rates Around the World” webpage. Instead, the webpage has a “Print this Page” button that pops out on the right-hand side of the page. Students should be directed to “Print this Page” and “Save to PDF.” Answers to complete this exercise can then be found in the printed/saved PDF.The answers below are based on the Tax Foundation’s “Corporate Tax Rates around the World, 2022” publication (https://taxfoundation.org/publications/corporate-tax-rates-around- the-world/) dated December 13, 2022.

• Table 2 indicates the following countries have a tax rate larger than 35 percent:

Comoros, Puerto Rico, and Suriname.

• Table 3 indicates the following countries have a tax rate smaller than 10 percent:

Barbados, Turkmenistan, and Hungary.

• Table 4 provides a list of countries without a general corporate income tax including:

Bahamas, Bahrain, Cayman Islands, and United Arab Emirates.

• Table 5 shows that South America has the largest average corporate income tax rate

(28.38%).

• Table 5 shows that Asia has the smallest average corporate income tax rate (19.52%).
• Table 5 indicates that the World average corporate income tax rate is 23.37%.
• Table 6 shows that the corporate income tax rates in Italy and Switzerland are 27.81%

and 19.7%, respectively. Thus, all else equal, a multinational corporation would pay a smaller amount of corporate income tax to the local government by establishing a subsidiary in Switzerland rather than in Italy.

3.

• The BRL pre-tax income becomes a USD pre-tax loss because Sales and Expenses are

translated at different exchange rates. Specifically, we can deduce that Sales are translated at an exchange rate of USD 0.25 per 1 BRL [USD 2,500 / BRL 10,000] and Expenses are translated at an exchange rate of USD 0.30 per 1 BRL [USD 2,850 / BRL

9,500].

Note: In Chapter 7, “Translation of Foreign Currency Financial Statements,” students will learn that, under the temporal method of translation, sales revenue is translated at the average for the current year exchange rate and depreciation expense is translated at the exchange rate that existed when property, plant, and equipment was acquired. Thus, when a foreign currency is falling in value against the U.S. dollar, and depreciation represents a significant amount of a foreign operation’s expenses, it is possible for a positive net income in foreign currency to be translated into a U.S. dollar net loss.

• The question is whether Modular Office Corporation should use BRL income or USD

income to evaluate the performance of MOB’s president. There is no unequivocally

correct answer to this question. Issues that might be discussed include:

• What is the Brazilian subsidiary’s objective? For example, to generate profits that can be distributed to U.S. stockholders? If so, then USD would be the logical currency for evaluating performance.• Does MOB’s president have the ability to “control” USD income, for example, by hedging against changes in the USD per BRL exchange rate? If not, then it might not make sense to evaluate MOB’s president’s performance on the basis of USD income.• Do the translation procedures that result in a USD pre-tax loss make economic

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