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Chapter 1 Introduction Discussion Questions 1. In the domestic case, accounting is an information service that provides financial information about a domestic entity to domestic users of that information. International accounting is distinctive in that the entity being reported on is either a multinational company with operations and transactions that transcend national boundaries or involves an entiiy with reporting obligations to readers who are located outside the reporting entity’s country of domicile. 2. Advantage: Some might argue that measurement, disclosure, and external auditing are three distinct (although related) processes, involving different members of the company. For example, corporate attorneys often are involved in disclosure issues, but seldom intervene in measurement issues. The Board of Directors works with the external auditors but not necessarily with the comptroller s office. Thus, discussion of accounting requirements and voluntary accounting choices in different jurisdictions is simplified by focusing on the three components of accounting. Disadvantage: measurement, disclosure and auditing are interdependent, and should not be viewed in isolation of one another. A company choosing to disclose as little as possible, for example, may use accounting measurement approaches that reduce the information content of financial statements, and select an external auditor who will be relatively lenient in enforcing accounting requirements. One alternative classification might include accounting (measurement and disclosure), and auditing. A second classification might include financial reporting (annual and interim reporting, regulatory filings) and ad hoc disclosure (press releases, analyst meetings, etc). Any classification is arbitrary, and potentially useful depending on its purpose. 3. Factors contributing to the internationalization of the subject of accounting include: the growth and spread of multinational operations around the world, the phenomenon of global competition, the increasing number of cross-border mergers and acquisitions that occur almost daily, continued advances in information technology, and the internationalization of the world’s capital markets. 4. International trade involves importing and exporting activities. The major accounting issue associated with foreign trade involves accounting for foreign currency transactions. Foreign direct investment, on the other hand, involves conducting operations abroad. This activity exposes accountants to a new set of issues that run the gamut from having to consolidate foreign currency accounts based on diverse measurement rules to issues of evaluating the performance of foreign subsidiary managers. 5. Students will overwhelmingly argue in favor of harmonization. This is probably a good starting point for the course. After they are introduced to the chapters leading up to Chapter 8, some may no longer feel that harmonization is necessarily the answer to all of their international accounting problems. 6. Recent developments such as the growth and spread of multinational operations, Internationalization of the world’s capital markets, increased cross border mergers and acquisitions, the phenomenon of global competition and financial innovation have increased reader dependence on foreign financial statements. An understanding of accounting differences and their effect on reported measures of profitability, efficiency, solvency and liquidity are critical if proper decisions are to be made. International accounting issues have become more complex in recent years for several reasons. Financial transactions are becoming more complex, affecting both national and international accounting. For example, the use of complex financial instruments and developing accounting standards for these exotic instruments has been problematic. Global financial markets also are becoming more volatile, leading to large changes in asset and balance sheet amounts (such as related to investments) and major sources of income and expense. The related accounting issues are difficult. The growing internationalization of business also promotes complexity. Foreign currency transactions and translation have been troublesome accounting issues for years, and are becoming more important as cross-border business and finance increase. Also, differences in national accounting principles potentially are more troublesome as business becomes more international. However, as convergence efforts worldwide accelerate, and more and more companies and countries adopt International Financial Reporting Standards (IFRS), complexity arising from differences in national accounting principles will decrease. 7. Examples of external reporting issues include: a. Does translation from one set of measurement rules to another change the information content of the original message? b. Should accounts of foreign operations be translated to parent currency when consolidated statements are prepared? c. Which exchange rates should be employed when translating from one currency to another? Examples of internal reporting issues include: a. Which exchange rates should be used for budgeting purposes? b. Should foreign managers be evaluated in terms of parent currency or the local currency of the country in which the manager operates? c. Which prices should one use when transferring goods or services between members of the multinational enterprise- cost, market, cost-plus or some other metric? 8. Global capital market activities and transactions reach beyond single political or legal jurisdictions. For example, global capital market transactions include the following: (1) an American tourist buying Australian dollars for travel purposes in the South Pacific; (2) a Japanese insurance company buying German government bonds as an investment; and (3) a Nigerian agricultural development project receiving cash subsidies from the European Union (EU). The international equities market is one global capital market. A second such market covers foreign exchange transactions, that is, when one national currency is exchanged into, traded forward, hedged, swapped, or otherwise converted to another national currency. This market is estimated at hundreds of billions of U.S. dollars per day. The total world foreign exchange market is the largest market on earth. The international bond market is still another global capital market. The bonds constituting this market are underwritten by international syndicates of banks and are marketed and traded all over the world. Global capital markets are a vital part of the world economy. 9. English should be designated as the formal international accounting language. Technical accounting terms ( terms of art) do not travel well internationally. Since technical accounting terms often have attributed meanings (for example, generally accepted accounting principles are neither generally accepted nor principles ), it is difficult or impossible to translate these terms into other languages and retain their original meanings. In other disciplines, such considerations have caused the establishment of Latin as the universal language for botanical classifications, Italian as the language for specifying the tempo (and other matters of interpretation) of musical compositions, and English as the language of electronic computing. Since accounting is used worldwide, a single worldwide language for accounting makes sense. Why should English be the worldwide language for accounting? English already has become the language of world commerce and multinational business. Thus, the universal use of English in accounting would parallel a well-established business practice. Also, the accounting discipline was in many respects developed as an offshoot of Anglo-American economics, which means that the language roots of many accounting terms and concepts are English. Among non-English speaking people, English is the most common second language. The vast majority of the world’s accounting literature is written in English, and nearly all international accounting conventions and conferences use English as the official language. Multinational corporations generally use English in their accounting and financial operating manuals, as well as for corporate communications, without regard to national domiciles. Therefore, the worldwide benefits of adopting English as the universal language of accounting are likely to be greater than for any other language, and the worldwide costs are likely to be less. 10. Emerging markets are those whose financial systems are emerging from state domination through a process of liberalization. Developed countries are those with liberalized financial systems. Many people believe that liberalization is highly beneficial to sustained economic growth. Many different classifications of developed versus emerging market countries are used, and often the terms are not defined, although no one correct set of definitions for developed and emerging markets exists. Students should be encouraged to suggest their own criteria as to what constitutes a developed as opposed to an emerging market. The emerging market countries are in geographic regions that are generally not highly industrialized. But one cannot generalize here as extensive economic liberalization is taking place in these countries (in some more than in others). For example, entry barriers to foreign businesses, government regulation of banking operations, and credit controls have been eased in many of the countries once classified as “emerging.” 11. Privatizations of state-owned corporations have had dramatic effects on global capital markets. Often, the privatized entities are large, well-known companies in which the national government retains a large ownership interest, and retail (individual, non-institutional) investors often are encouraged to buy shares in newly privatized entities. As a result, the shareholder base in the market grows dramatically, investors become more active market participants, and market capitalization increases. Privatizations also mean that management must now compete in the market place for market share, external capital and corporate control. In such a world, accounting systems must properly motivate managers to work toward the accomplishment of the organization’s overall goals in an efficient manner while putting together credible external financial statements that will enable it to secure the necessary capital to finance corporate growth. Many of these external and internal reporting issues are covered in the balance of the chapters in this book. 12. Those opposed to outsourcing see it as a threat to domestic jobs and a form of exploitation by companies engaged in the practice. Some even see it as a moral issue. However, they miss the point of international trade. While outsourcing may reduce jobs in one sector, they reflect differences in comparative advantage, which ultimately makes possible greater employment in other sectors and or lower consumer prices which increases real wealth. One need only look at higher education in America. Whereas stenographers in the U.S. may be losing jobs to stenographers in India, more and more Indian families are sending their children to the U.S. for their higher education, increasing the demand for support services in the higher education sector. A look at Exhibit 1.2 shows that over time, countries with greater exports than imports eventually become net importers and vice versa. The importance of international accounting will not diminish. Countries have been trading with each other since antiquity and will continue to do. Even if the volume of trade were to diminish, an unlikely event, the network of trading partners continues to expand globally and with it accounting issues associated with international trade. Exercises 1. For steps one and two in which the idea for the Proliant ML150 is spawned in Singapore and approved in Texas, differences in legal practices regarding rights and compensation schemes for intellectual property development may vary between the U.S. and Singapore as the latter’s legal system has been influenced by the U.K. system. International tax issues also surface in terms of royalty payment arrangements and their tax consequences in both Singapore and the U.S. For step 34, language communications between Singapore and Taiwan could pose some issues of interpretation. Production in Taiwan raises internal reporting issues such as should exchange rate fluctuations between the Taiwanese dollar and the U.S. dollar be incorporated into the cost of production or accounted for separately as a non-operating foreign exchange gain or loss. (I guess this is step 4) In evaluating the creditworthiness of the Taiwanese manufacturer, should the financial statements of the Taiwanese manufacturer be translated to U.S. GAAP or not. If a ratio analysis is performed, should Taiwanese liquidity and solvency ratios be interpreted based on U.S. financial norms or Taiwanese norms? For step 5, should clients in Southeast Asian countries be charged identical prices or should prices be flexed for differences in exchange rates, transportation arrangements and “facilitating” payments. What legal issues are raised in the case of bribes expected on the part of commercial buyers and how would these payments be treated under the U.S. Foreign Corrupt Practices Act? 2. A suggested index might look like the following. The instructor should focus on the student’s rationale for his or her rating as some students may have more knowledge of specific country developments than others and students will naturally exhibit different degrees of risk-aversion. Industrialized Countries United States 1 Canada 1 Japan 1 United Kingdom 1 France 1 Germany 1 Italy 1 Australia 2 New Zealand 2 East Asia Hong Kong 1 Indonesia 3 South Korea 2 Malaysia 2 Phillipines 1 Singapore 1 Taiwan 3 Thailand 2 Latin America Argentina 2 Brazil 2 Chile 2 Colombia 2 Mexico 1 Peru 1 Venezuela 2 Middle East and Africa Egypt 3 Israel 2 Morocco 2 South Africa 1 Turkey 2 South Asia Bangladesh 2 India 2 Nepal 3 Pakistan 3 Sri Lanka 3 3. The compounded annual growth rate for merchandise exports from 1985 to 2005 was approximately 8.7%. The growth rate for merchandise imports was also 8.7% . The comparable growth rates for exports of services was 9.6% over the same 20 year period. It was 9.2% for imports. The outlook for accounting services to travel internationally are very good. Students interested in accounting careers should take note. 4. The purpose of this exercise to get students to check out the wealth of stock related information available on the web. They will probably choose the five whose countries are most familiar to them. Their exchanges will probably be located in highly industrialized economies and which afford access to relatively deep pools of capital. As one example, Luxembourg has long been popular because of its accommodating listing requirements. However, students should note that the numbers of foreign companies listed in markets other than the NYSE have been declining. This suggests that many issuers question the benefits of such listings, and that the benefits of a foreign listing generally are greater in the United States. In particular, the U.S. represents a well-established market with strong investor protection. This is especially important in a down economy, as stringent disclosure requirements help to minimize perceived information risk which, in turn, reduces price volatility. 5. This exercise will require that students combine certain geographic categories of merchandise exports to achieve some comparability with Henekin’s disclosures. It would be interesting to poll students’ ex ante predictions of the correlations and have them ponder reasons for any differences they find. Geographic Region Merchandise Exports Geographic Sales for Heineken Africa and Middle East 7.9% 12.6% Asia 29.2% 9.1% Europe 41% 65.5% Americas 17.6% 12.7% While correlations between percentage geographic distributions of merchandise exports and beer sales are closer for Africa and the Middle East and for the Americas, there are big differences in beer sales and merchandise export patterns for Asia and Europe. Obviously one cannot generalize microeconomic behavior from macroeconomic data. However, some students will be inclined to hypothesize similar patterns given the popularity of beer consumption around the world. It will be fun brainstorming reasons for the observed differences. Might observed differences be due to national differences in consumer tastes, import restrictions and perhaps the success of national advertising campaigns? More important, this exercise should reinforce the notion of environmental differences as explanatory variables. 6. The geographic spread of Heineken’s revenue streams suggest that the company is exposed to foreign exchange rate risk. This complicates the process of forecasting the company’s future earnings and resultant cash flows. Moreover, the numbers being reported are the results of a consolidation process. The cardinal rule to remember here is that when exchange rates change, data in parent currency may change even though local currency amounts may not. For managerial accountants, the conduct of foreign operations raises numerous issues of financial control. For example, which currency should be used to evaluate foreign subsidiary performance, the parent currency or the local currency? In preparing operating budgets, which exchange rate combination should be used to translate original budgets and subsequently track performance? When planning capital expenditures, how do you factor inflation, foreign exchange rate risk and sovereign risk into measures of future project cash flows, cost of capital estimates and planned investment outlays? Should capital budgeting decisions be made from the project’s perspective or a company perspective? Again, this exercise is designed to raise questions that will be addressed in subsequent chapters. 7. Issues triggered by Exhibit 1-5 include : a. What criteria are used to determine when a foreign affiliate is to be consolidated with that of the parent company? While majority ownership is one criterion for consolidation, do other criteria exist internationally and why? b. When consolidating the accounts of a foreign affiliate with that of the parent should accountants first restate the accounting measurement rules of the foreign affiliate to the reporting requirements of the parent company or should the reporting requirements of the affiliate’s country of domicile prevail? Which method produces the more meaningful information for statement readers? c. When consolidating the accounts of a foreign affiliate should the accountant translate the currency of the affiliate to the reporting currency of the parent company? If so, which exchange rates should be employed for each balance sheet account? For each income statement account? d. If fluctuating exchange rates produce foreign currency gains and losses during the consolidation process, how should these gains and losses be accounted for? 8. The ROE ratios for Electrolux based on IFRS and U.S. GAAP was derived as follows: IFRS U.S. GAAP ROE 1,763/25,888 + 23,636 1,518/25,057 + 23,567 2 2 = 1,763/24,762 =1,518/24,312 9. For this exercise, we consider information provided by three stock exchanges: The London Stock Exchange, the Deutsche Boerse and the Tokyo Stock Exc