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INTERNATIONAL ACCOUNTING

S e v e n t h E d i t i o n

Frederick D. S. Choi New York University

Gary K. Meek Oklahoma State University

Prentice Hall Boston Columbus Indianapolis New York San Francisco Upper Saddle River

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Library of Congress Cataloging-in-Publication Data

Choi, Frederick D. S., International accounting / Frederick D.S. Choi, Gary K. Meek.—7th ed.

p. cm. Includes index. ISBN-13: 978-0-13-611147-4 (alk. paper) ISBN-10: 0-13-611147-5 (alk. paper) 1. International business enterprises––Accounting. I. Meek, Gary K., II. Title. HF5686.I56C53 2011 657'.96—dc22

2010014971

ISBN 10: 0-13-611147-5 ISBN 13: 978-0-13-611147-4

10 9 8 7 6 5 4 3 2 1

To our families

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CONTENTS

Preface xv

Chapter 1 INTRODUCTION 1 Historical Perspective 2

Contemporary Perspective 3

Growth and Spread of Multinational Operations 4

Financial Innovation 10

Global Competition 11

Cross-Border Mergers and Acquisitions 12

Internationalization of Capital Markets 13

Americas 15

Western Europe 16

Asia 17

Cross-Border Equity Listing and Issuance 18

Where Are We? 19

Learning Objectives 20 Appendix 1-1: Stock Exchange Web Sites 24 Appendix 1-2: Financial Statements and Selected Notes from

the Annual Report of INFOSYS 25 Discussion Questions 26 • Exercises 26

� CASE 1-1: E-centives, Inc.—Raising Capital in Switzerland 28 � CASE 1-2: Global Benchmarks: Infosys Technologies Limited 29

Chapter 2 DEVELOPMENT AND CLASSIFICATION 30 Development 31

Classification 37

Four Approaches to Accounting Development 37

Legal Systems: Common Law vs. Code Law Accounting 38

Practice Systems: Fair Presentation vs. Legal Compliance Accounting 39 Discussion Questions 41 • Exercises 42

� CASE 2-1: Are Classifications of Accounting Outmoded? 44 � CASE 2-2: Volkswagen Group 45

Chapter 3 COMPARATIVE ACCOUNTING: EUROPE 49 Some Observations about Accounting Standards and Practice 51

IFRS in the European Union 52

v

Five National Financial Accounting Systems 54

France 54

Germany 60

Czech Republic 65

The Netherlands 68

United Kingdom 73 Discussion Questions 79 • Exercises 79

� CASE 3-1: Old Habits Die Hard 81 � CASE 3-2a: What Difference Does It Really Make? 82 � CASE 3-2b: Do the Differences Really Matter? 83

Chapter 4 COMPARATIVE ACCOUNTING: THE AMERICAS AND ASIA 84 Five National Financial Accounting Systems 86

United States 86

Mexico 91

Japan 96

China 101

India 106 Discussion Questions 112 • Exercises 112

� CASE 4-1: Standing on Principles 115 � CASE 4-2: Casino Capital 116

Chapter 5 REPORTING AND DISCLOSURE 119 Development of Disclosure 119

Voluntary Disclosure 120

Regulatory Disclosure Requirements 121

The U.S. SEC Financial Reporting Debate 122

Reporting and Disclosure Practices 124

Disclosures of Forward-Looking Information 124

Segment Disclosures 125

Social Responsibility Reporting 130

Corporate Governance Disclosures 132

Internet Business Reporting and XBRL 157

Annual Report Disclosures in Emerging-Market Countries 158

Implications for Financial Statement Users and Managers 159

Discussion Questions 160 • Exercises 160 � CASE 5-1: In the Green 162 � CASE 5-2: Seeing Is Believing 162

vi Contents

Chapter 6 FOREIGN CURRENCY TRANSLATION 164 Reasons for Translation 168

Background and Terminology 169

The Problem 172

Financial Statement Effects of Alternative Translation Rates 172

Foreign Currency Transactions 174

Single-Transaction Perspective 176

Two-Transaction Perspective 177

Foreign Currency Translation 178

Single Rate Method 178

Multiple Rate Methods 179

Financial Statement Effects 181

Which Is Best? 183

Appropriate Current Rate 185

Translation Gains and Losses 185

Deferral 186

Deferral and Amortization 186

Partial Deferral 187

No Deferral 187

Where Are We? 187

Translation Accounting Development 188

Pre-1965 188

1965–1975 188

1975–1981 188

1981–Present 189

Features of Standard No. 52/International Accounting Standard 21 189

Translation When Local Currency Is the Functional Currency 190

Translation When the Parent Currency Is the Functional Currency 190

Translation When Foreign Currency Is the Functional Currency 190

Measurement Issues 192

Reporting Perspective 192

What Happened to Historical Cost? 193

Concept of Income 193

Managed Earnings 193

Contents vii

Foreign Currency Translation and Inflation 194

Foreign Currency Translation Elsewhere 195 Appendix 6-1: Translation and Remeasurement Under

FAS No. 52 196 Discussion Questions 200 • Exercises 201

� CASE 6-1: Regents Corporation 204 � CASE 6-2: Managing Offshore Investments: Whose Currency? 206

Chapter 7 FINANCIAL REPORTING AND CHANGING PRICES 210 Changing Prices Defined 214

Why are Financial Statements Potentially Misleading During Periods of Changing Prices? 216

Types of Inflation Adjustments 217

General Price-Level Adjustments 218

Price Indexes 218

Use of Price Indexes 218

Object of General Price-Level Adjustments 219

Current-Cost Adjustments 222

General Price-Level Adjusted Current Costs 225

National Perspectives on Inflation Accounting 227

United States 227

United Kingdom 229

Brazil 230

International Accounting Standards Board 233

Inflation Issues 234

Inflation Gains and Losses 234

Holding Gains and Losses 235

Foreign Inflation 235

Avoiding the Double-Dip 236 Appendix 7-1: Accounting for Foreign Inflation: A Case Analysis 238 Discussion Questions 241 • Exercises 242

� CASE 7-1: Kashmir Enterprises 245 � CASE 7-2: Icelandic Enterprises, Inc. 246

Chapter 8 GLOBAL ACCOUNTING AND AUDITING STANDARDS 249 A Survey of International Convergence 250

Advantages of International Convergence 250

Criticisms of International Standards 252

Reconciliation and Mutual Recognition 252

Evaluation 253

viii Contents

Some Significant Events in the History of International Accounting Standard Setting 253

Overview of Major International Organizations Promoting Accounting Convergence 255

International Accounting Standards Board 256

IASC’s Core Standards and the IOSCO Agreement 261

The IASB Structure 262

Recognition and Support for the IASB 264

U.S. Securities and Exchange Commission Response to IFRS 264

European Union (EU) 265

Fourth, Seventh, and Eighth Directives 266

Transparency Directive 266

Have EU Harmonization Efforts Been Successful? 267

The EU’s New Approach and the Integration of European Financial Markets 268

International Organization of Securities Commissions (IOSCO) 269

International Federation of Accountants (IFAC) 272

United Nations Intergovernmental Working Group of Experts on International Standards of Accounting and Reporting (ISAR) 275

Organization for Economic Cooperation and Development (OECD) 275

Conclusion 275 Discussion Questions 276 • Exercises 276

� CASE 8-1: PetroChina Company Limited 279 � CASE 8-2: Whither The Withering Standard Setters? 280

Chapter 9 INTERNATIONAL FINANCIAL STATEMENT ANALYSIS 281 Introduction 281

Challenges and Opportunities in Cross-Border Analysis 281

Business Analysis Framework 283

International Business Strategy Analysis 283

Information Availability 284

Recommendations for Analysis 285

Accounting Analysis 285

Suggestions for the Analyst 287

Contents ix

International Financial Analysis 288

Ratio Analysis 288

Cash Flow Analysis 291

Coping Mechanisms 291

International Prospective Analysis 292

Further Issues 295

Information Access 295

Foreign Currency Considerations 298

Differences in Statement Format 302

Language and Terminology Barriers 303

Financial Statement Analysis and Auditing 303

The Attest Function 304

The Audit Report 304

Auditing and Credibility 307

Coping Mechanisms 309

Internal Auditing 310

Professional Organization 312

Evolving Role of Internal Auditing 315 Appendix 9-1: Illustration of Restatement of Japanese

GAAP Financial Statements to a U.S. GAAP Basis 316

Appendix 9-2: International Ratio Analysis 320 Discussion Questions 322 • Exercises 322

� CASE 9-1: Sandvik 325 � CASE 9-2: Continental A.G. 331

Chapter 10 MANAGERIAL PLANNING AND CONTROL 340 Business Modeling 341

Planning Tools 341

Capital Budgeting 343

Financial Return Perspectives 344

Measuring Expected Returns 345

Multinational Cost of Capital 348

Management Information Systems 350

Systems Issues 350

Information Issues 352

Management Information and Hyperinflation 353

Sales Revenue 354

x Contents

Issues in Financial Control 357

Domestic Versus Multinational Control System 358

Operational Budgeting 360

Analysis of Exchange Rate Changes 364

Strategic Costing 367

Performance Evaluation of Foreign Operations 369

Consistency 369

Unit Versus Managerial Performance 370

Performance Criteria 372

Measurement Issues and Changing Prices in Evaluation 374

Performance Evaluation Practices: ICI 374

Foreign Currency Effects 376

Performance Standards 377

Value Reporting 379 Discussion Questions 380 • Exercises 380

� CASE 10-1: Foreign Investment Analysis: A Tangled Affair 384 � CASE 10-2: Assessing Foreign Subsidiary Performance in a World of Floating

Exchange Rates 386

Chapter 11 FINANCIAL RISK MANAGEMENT 388 Essentials 391

Why Manange Financial Risks? 391

Role of Accounting 392

Identifying Market Risks 392

Quantify Trade-offs 394

Risk Management in a World of Floating Exchange Rates 394

Forecasting Exchange Rate Changes 394

Translation Exposure 396

Transaction Exposure 400

Accounting Versus Economic Exposure 401

Accounting for Hedge Products 407

Practice Issues 413

Hedge of a Recognized Asset, Liability, or an Unrecognized Firm Commitment 414

Hedge of a Net Investment in a Foreign Operation 416

Speculating in Foreign Currency 417

Disclosure 418

Financial Control 422

Contents xi

Appropriate Benchmarks 422 Discussion Questions 423 • Exercises 424

� CASE 11-1: Exposure Identification 426 � CASE 11-2: Value at Risk: What Are Our Options? 426

Chapter 12 INTERNATIONAL TAXATION AND TRANSFER PRICING 431 Initial Concepts 432

Diversity of National Tax Systems 432

Types of Taxes 432

Tax Burdens 435

Tax Administration Systems 436

Foreign Tax Incentives 437

Tax Havens and Harmful Tax Competition 438

International Harmonization 438

Taxation of Foreign-Source Income and Double Taxation 439

Foreign Tax Credit 439

Limits to Tax Credits 441

Tax Treaties 442

Foreign Exchange Considerations 443

Tax-Planning Dimensions 443

Organizational Considerations 444

Controlled Foreign Corporations and Subpart F Income 444

Offshore Holding Companies 445

Financing Decisions 445

Pooling of Tax Credits 446

Cost Accounting Allocations 446

Location and Transfer Pricing 447

Integrating International Tax Planning 447

International Transfer Pricing: Complicating Variables 448

Tax Considerations 448

Tariff Considerations 450

Competitive Factors 450

Environmental Risks 451

Performance Evaluation Considerations 452

Resolving Trade-offs 452

Transfer Pricing Methodology 453

Market vs. Cost vs. . . . ? 453

Arm’s-Length Principle 453

xii Contents

Comparable Uncontrolled Price Method 454

Comparable Uncontrolled Transaction Method 454

Resale Price Method 454

Cost-Plus Pricing Method 455

Comparable Profits Method 457

Profit-Split Methods 457

Other Pricing Methods 458

Advance Pricing Agreements 459

Transfer Pricing Practices 460

The Future 460 Discussion Questions 462 • Exercises 462

� CASE 12-1: The Shirts Off Their Backs 465 � CASE 12-2: Muscle Max: Your Very Own Personal Trainer 467

Index 469

Contents xiii

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PREFACE

This book is written with the express purpose of introducing students to the interna- tional dimensions of accounting, financial reporting and financial control. The world in which they will pursue their professional careers is a world dominated by global business and cross-border investing. As these activities require decisions premised on financial data, a knowledge of international accounting is crucial for achieving proper understanding in external and internal financial communications. While ideal for upper division undergraduate students and masters students, we are pleased that the contents of this award-winning effort have also benefited practicing accountants, financial executives, investment managers, university educators and professional administrators around the world.

This revision of a work that has spanned four decades features a number of enhancements. These include:

• Updated coverage of corporate governance and related legislation. See Chapters 4, 5, 8 and 9.

• Examination of international auditing, both external and internal. See Chapters 8 and 9.

• Current discussion of comparative accounting emphasizing developments in Europe, the Americas and Asia in Chapters 3 and 4.

• Capital market, managerial, taxation and institutional updates reflective of current trends and issues throughout most chapters.

• Discussion of international accounting convergence and the major players in this important effort. See Chapters 3, 5 and 8.

• Examination of reporting and disclosure practices spanning both developed and emerging market countries. See Chapters 4, 5 and 7.

• Expanded listings of relevant international Web site addresses and data sources. • Updated discussion questions, exercises and cases.

We have benefited from the professional literature and from many of our students and faculty colleagues whose thoughtful comments have triggered new ideas for us to consider. We are in their debt. In addition, many individuals furnished able assistance in producing the manuscript. We especially thank Julie Broich, Karen Kirincich and Christina Rumbaugh at Prentice Hall for their encouragement and editorial support.

However hard one tries to avoid them, errors are bound to occur in a work of this type. As authors, we accept full responsibility for all errors and omissions in the manuscript. As always we welcome constructive comments from all who use this book as students are the ultimate beneficiaries of your thoughtfulness.

F. D. S. Choi New York, N.Y.

G. K. Meek Stillwater, OK

xv

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1

Accounting plays a vital role in society. As a branch of economics, it provides information about a firm and its transactions to facilitate resource allocation decisions by users of that information. If the information reported is reliable and useful, scarce resources are allocated in an optimal fashion, and conversely, resource allocations are less than optimal when information is less reliable and useful.

International accounting, the subject of this text, is no different in its intended role. What makes its study distinctive is that the entity being reported on is either a multinational company (MNC) with operations and transactions that cross national boundaries, or an entity with reporting obligations to users who are located in a country other than that of the reporting entity.

Recall that accounting entails several broad processes: measurement, disclosure, and auditing. Measurement is the process of identifying, categorizing, and quantifying economic activities or transactions. These measurements provide insights into the profitability of a firm’s operations and the strength of its financial position. Disclosure is the process by which accounting measurements are communicated to their intended users. This area focuses on issues such as what is to be reported, when, by what means, and to whom. Auditing is the process by which specialized accounting professionals (auditors) attest to the reliability of the measurement and communication process. Whereas internal auditors are company employees who answer to management, exter- nal auditors are nonemployees who are responsible for attesting that the company’s financial statements are prepared in accordance with generally accepted standards.

An understanding of the international dimensions of the accounting processes that were just described is important to those engaged in importing or exporting activities, as well as those seeking to manage a business, or obtain or supply financing across national borders. Even a company operating solely within the confines of a single country is no longer insulated from the international aspects of accounting as reliance on international vendors to contain production costs and remain globally competitive is a common feature of contemporary business. Accounting amounts may vary significantly according to the principles that govern them. Differences in culture, business practices, political and regulatory structures, legal systems, currency values, local inflation rates, business risks,

C H A P T E R 1

Introduction

2 Chapter 1 • Introduction

and tax codes all affect how the MNC conducts its operations and financial reporting around the world. Financial statements and other disclosures are impossible to understand without an awareness of the underlying accounting principles and business culture.

The importance of studying international accounting has grown over the years. We begin with a brief history of this subject.

HISTORICAL PERSPECTIVE

The history of accounting is an international history. The following chronology demon- strates that accounting has been remarkably successful in its ability to be transplanted from one national setting to another while allowing for continued development in theory and practice worldwide.

To begin, double-entry bookkeeping, generally thought of as the genesis of accounting as we know it today, emanated from the Italian city states of the 14th and 15th centuries. Its development was spurred by the growth of international commerce in northern Italy during the late Middle Ages and the desire of government to find ways to tax commercial transactions. “Bookkeeping in the Italian fashion” then migrated to Germany to assist the merchants of the Fugger era and the Hanseatic league. At about the same time, business philosophers in the Netherlands sharpened ways of calculating periodic income, and government officials in France found it advantageous to apply the whole system to governmental planning and accountability.

In due course, double-entry accounting ideas reached the British Isles. The devel- opment of the British Empire created unprecedented needs for British commercial inter- ests to manage and control enterprises in the colonies, and for the records of their colonial enterprises to be reviewed and verified. These needs led to the emergence of accounting societies in the 1850s and an organized public accounting profession in Scotland and England during the 1870s. British accounting practices spread not only throughout North America but also throughout the British Commonwealth as it then existed.

Parallel developments occurred elsewhere. The Dutch accounting model was exported to Indonesia, among other places. The French accounting system found a home in Polynesia and French-administered territories in Africa while the reporting framework of the Germans proved influential in Japan, Sweden, and czarist Russia.

As the economic might of the United States grew during the first half of the 20th century, its sophistication in matters of accounting grew in tandem. Business schools assisted in this development by conceptualizing the subject matter and eventually having it recognized as an academic discipline in its own right on college and univer- sity campuses. After World War II, U.S. accounting influence made itself felt throughout the Western world, particularly in Germany and Japan. To a lesser extent, similar factors are directly observable in countries like Brazil, Israel, Mexico, the Philippines, Sweden, and Taiwan.

Despite this international heritage, in most countries accounting remained a nationalistic affair, with national standards and practices deeply anchored into national laws and professional regulations. (Examples of comparative accounting practices are provided in Chapters 3 and 4.) There was little understanding of parallel requirements in other countries. Yet, accounting increasingly serveed people and organizations whose decisions were increasingly international in scope.

Chapter 1 • Introduction 3

Resolving the historical paradox of accounting has long been a concern of both users and preparers of accounting information. In recent years, institutional efforts to narrow differences in measurement, disclosure, and auditing processes around the world have intensified. A description of this effort and the major players with an important stake in attaining convergence of global accounting systems is the focus of Chapter 8.

CONTEMPORARY PERSPECTIVE

While the effort to reduce international accounting diversity is important in its own right, there are today a number of additional factors that are contributing to the growing importance of studying international accounting. These factors stem from significant and continuing reductions in national trade barriers and capital controls together with advances in information technology.

National controls on capital flows, foreign exchange, foreign direct investment, and related transactions have been dramatically liberalized in recent years, reducing the barriers to international business. Changes in financial sector policy in both devel- oped and developing countries reflect the growing realization that information and financial technolgy render capital controls ineffective. National governments also real- ize that financial market liberaliztion affords them access to international funds with which to finance national debts. As accounting is the language of business, cross-border economic interactions mean that accounting reports prepared in one country must increasingly be used and understood by users in another.

Advances in information technology are also causing a radical change in the economics of production and distribution. Vertically integrated production is no longer proving an efficient mode of operation. Real-time global information linkages mean that production, including accounting services, is increasingly being outsourced, or offshored, to whomever in the world can do the job, or portions of the job, best.1 Leading locations for offshore services today include Argentina, Brazil, Canada, Chile, Costs Rica, Mexico, and Panama in the Americas; Australia, China, India, Malaysia, New Zealand, Pakistan, the Philippines, Singapore, Thailand, and Vietnam in Asia Pacific; and the Czech Republic, Egypt, Hungary, Ireland, Israel, Morocco, Poland, Romania, Russia, Slovakia, South Africa, Spain and the Ukraine in Europe, the Middle East, and Africa.2 Adversarial, arm’s- length relationships that have characterized companies’ relations with their suppliers, middle persons, and customers are being replaced by cooperative global linkages with suppliers, suppliers’ suppliers, middle persons, customers, and customers’ customers.

Exhibit 1-1 provides an illustration of the outsourcing phenomenon. In producing the ProLiant ML150, a small box that helps companies manage customer databases and run e-mail systems, among other things, Hewlett-Packard (H-P) turned to the usual sources of low-cost labor: China and India. However, it also decided to make some ML150s in higher-cost locations such as Singapore and Australia, which were closer to targeted customers. Initial design for the ML150 was done in Singapore and then handed off to an outside contractor in Taiwan. Although China possesses the lowest wage rates, it is but one part of a highly specialized manufacturing system.

1 For example, see Arie Lewin, Silvia Massini, and Carine Peters, “Why Are Companies Offshoring Innovation? The Emerging Global Race for Talent,” Journal of International Business Studies 40 (2009): 901–925. 2 Robert Kennedy, “The Tough Game You Have to Play,” Financial Executive, May 2009, pp. 23–25.

4 Chapter 1 • Introduction

EXHIBIT 1-1 Outsourcing Process for Hewlett-Packard’s ProLiant 150

India ; 5

China ; Taiwan 5 4

Australia ; T c 5 Singapore : Houston

5 3 1 ; 2 H-P’s Path to Market 1. Idea for ML150 spawned in Singapore 2. Concept approved in Houston 3. Concept design performed in Singapore 4. Engineering design and initial manufacture in Taiwan 5. Final assembly in Australia, China, India, and Singapore. Machines produced in Australia,

China, and India sold in local markets; machines assembled in Singapore marketed to Southeast Asia.

Considerations ranging from logistics to tariff policies reportedly kept H-P from put- ting all of its production lines in China. It would take too long for machines manufac- tured in China to reach customers in other Asian markets. Moreover, shipping goods to India triggered steep tariffs, so it made sense to produce some ML150s in India with imported parts for the local market. All of the links in this outsourcing example are associated with accounting issues discussed in the following pages of this chapter.

Spurred by the twin developments we have just described, there are several factors that are contributing to the growing importance of the subject matter of this text. We describe each in turn.

GROWTH AND SPREAD OF MULTINATIONAL OPERATIONS

International business has traditionally been associated with foreign trade. This activity, rooted in antiquity, continues unabated. While trade in services has tradition- ally paled in comparison to trade in merchandise, the former is gaining in signifi- cance and growing at a faster rate than the latter. Current trends in exports and imports of both goods and services by region and selected economy are depicted in Exhibit 1-2.

What is not shown in Exhibit 1-2 is the composition of each region’s exports and imports. To obtain a better picture of the pattern of global trade at the micro level, one could examine the foreign operations disclosures of any major MNC. Exhibit 1-3 contains the geographic distribution of sales of AKZO Nobel, a multina- tional company headquartered in the Netherlands and concentrating on healthcare products, coatings, and chemicals. As can be seen, the company’s sales literally blan- ket every continent in the world. Unisys, the U.S.-based information technology services company, provides its expertise to clients in over 100 countries, while

Chapter 1 • Introduction 5

EXHIBIT 1-2 World Trade by Region

Total Merchandise Trade Unit: U.S. dollar at current prices (millions)

Region Activity Partner Stet 1990 1995 2000 2005 2007 Africa Exports World 106,000 112,000 147,800 297,700 424,100 Africa Imports World 99,600 126,700 129,400 249,300 358,900 Asia Exports World 792,400 1,446,800 1,836,200 3,050,900 4,131,000 Asia Imports World 761,500 1,403,300 1,677,100 2,871,000 3,804,300 Europe Exports World 1,684,940 2,335,635 2,633,930 4,371,915 5,722,205 Europe Imports World 1,750,925 2,334,760 2,774,755 4,542,675 6,060,845 Mid. East Exports World 138,400 151,000 268,000 538,000 759,900 Mid. East Imports World 101,300 132,500 167,400 322,100 479,300 N. America Exports World 562,035 856,550 1,224,975 1,477,530 1,853,500 N. America Imports World 684,460 1,015,760 1,687,580 2,284,735 2,707,460 S./C. America Exports World 106,000 148,900 195,800 354,900 499,200 S./C. America Imports World 85,900 176,900 206,300 297,600 456,000 World Exports World 3,449,000 5,164,000 6,452,000 10,431,000 13,950,000 World Imports World 3,550,000 5,284,000 6,724,000 10,783,000 14,244,000

Total Trade in Commercial Services Unit: U.S. dollar at current prices (millions)

Region Activity Partner 1985 1990 1995 2000 2005 2007 Africa Exports World 18,600 25,700 31,300 56,900 78,400

Africa Imports World 26,500 34,400 37,400 69,300 102,100 Asia Exports World 131,500 257,800 309,500 525,300 739,600 Asia Imports World 178,800 328,100 367,900 573,500 760,000 Europe Exports World 597,100 721,900 1,244,800 1,703,200 Europe Imports World 560,200 674,100 1,120,100 1,461,300 Mid. East Exports World 33,100 54,900 76,900 Mid. East Imports World 48,800 85,400 132,900 N. America Exports World 135,500 171,200 268,200 366,300 535,600 N. America Imports World 135,500 171,200 268,200 366,300 440,100 S./C. America Exports World 22,400 34,600 47,100 68,200 92,200 S./C. America Imports World 24,900 45,300 54,600 70,500 98,600 World Exports World 780,500 1,185,100 1,491,000 2,414,300 3,291,500 World Imports World 820,500 1,200,700 1,474,600 2,347,400 3,085,900

Source: World Trade Organization, International Trade Statistics, 2008.

Japan’s Cannon Inc. sells cameras and other professional and consumer imaging equipment in virtually every country of the world. An aggregation of such disclo- sures for all MNCs in all countries would confirm that trade today is neither bilateral nor regional, but truly global.

6 Chapter 1 • Introduction

EXHIBIT 1-3 Selected 2008 Foreign Operations Data for AKZO Nobel (Euro millions)

Net Sales By Destination

Capital Expenditures

Invested Capital

Number of Employees

The Netherlands 867 86 2,007 5,000

Germany 1,141 25 1,006 3,600 Sweden 478 50 557 3,800 U.K. 1,093 31 1,324 4,200 Other Europe 3,666 81 2,359 3,666 U.S./Canada 3,330 94 3,250 12,000 Latin America 1,306 49 776 4,800 China 1,054 67 861 6,300 Other Asia 1,866 43 1,030 7,800 Other regions 614 8 174 2,400

A major accounting issue associated with export and import activities relates to accounting for foreign currency transactions. Assume, for example, that Heineken exports a certain quantity of beer to a Brazilian importer and invoices the sale in Brazilian reals. Should the real devalue relative to the euro prior to collection, Heineken will experience a foreign exchange loss as reals will yield less euros upon conversion after the devaluation than before. The measurement of this transaction loss is not straightforward and is a subject that is dealt with in Chapter 6.

Today, international business transcends foreign trade and is increasingly associ- ated with foreign direct investments, which involve operating production or distribu- tion systems abroad by way of a wholly or majority-owned affiliate, a joint venture, or a strategic alliance.

While there is clearly a developed country bias of foreign direct investors, the boom of foreign direct investment flows to developing countries since the early 1990s indicates that MNCs are increasingly finding these host countries to be attractive investment locations.3

At the level of the firm, foreign direct investment activities are captured by a com- pany’s segmental disclosures and its roster of shareholdings in affiliated companies. Exhibit 1-3 also provides operating statistics by region for AKZO Nobel.

Exhibit 1-4 illustrates the extensive holdings in operating group companies of Nestle, one of the world’s largest food and beverage companies headquartered in Vevy, Switzerland. While both AKZO and Nestle’s foreign operations are extensive, the numbers relating to capital expenditures, invested capital, production sold locally, and number of foreign employees understate the extent of their foreign operations. They do not reflect the extent of either company’s joint venture, strategic alliance, or other coop- erative arrangements.

3 World Bank Chief Economist, Francois Bourguignon, predicts that over the next 25 years, developing countries will move to the center stage in the global economy, “Global Economic Prospects 2007: Managing the Next Wave of Globalization,” World Bank Panel Discussion sponsored by the Global Business Institute, NYU Stern School of Business, December 12, 2006.

Chapter 1 • Introduction 7

EXHIBIT 1-4 Countries in Which Nestle Owns One or More Majority-Owned Companies

Europe

Germany Austria Belgium Bulgaria Crotia Denmark Spain Finland France Greece Hungary Italy Lithuania Malta Norway The Netherlands Poland Portugal Ireland Czech R. Romania U.K. Russia Serbia Slovakia Sweden Switzerland Turkey Ukraine

Africa

S. Africa Cameroon Cote d’Ivoire

14

4 8 1 1 3

10 3

18 2 5 8 1 1 3 6 5 7 1 3 1 9

12 1 1 7 8 3 3

4 1 1

Egypt Gabon Ghana Guinea Kenya Mauritius Morocco Mozambique Niger Nigeria Senegal Tunisia Zimbabwe

Americas

Argentina Bolivia Brazil Canada Chile Colombia Costa Rica Cuba Salvador Ecuador U.S. Guatemala Honduras Jamaica Mexico Nicaragua Panama Paraguay Peru Puerto Rico

2 1 1 1 1 2 1 1 1 1 1 1 1

3 1 5 2 2 5 1 2 2 2 9 1 1 1 8 2 2 1 1 2

Dom Rep. Trinidad Uruguay Venezuela

Asia

Saudi Arabia Bangladesh Cambodia UAE India Indonesia Israel Japan Jordan Kuwait Lebanon Malaysia Pakistan Philippines S. Korea China Singapore Sri Lanka Syria Thailand Vietnam

Oceana

Australia Fiji N. Zealand New Guinea F. Polynesia New Caledonia 1

1 2 1 3

3 1 1 1 2 1 1 9 1 1 3 7 1 4 4

21 1 1 2 9 2

3 1 1 1 1 1

Note: This list is conservative as it does not include affiliated companies for which proportionate consolidation is employed, associated companies for which the equity method is used, subholding financial and property companies, and technical assistance, research and development companies.

8 Chapter 1 • Introduction

Operations conducted in foreign countries expose both financial managers and accountants alike to an additional set of problems that they do not encounter when solely engaged in international trade. As one example, how should an MNC like Nestle report the results of its operations, both domestic and international, to its South Korean investors? Each affiliate listed in Exhibit 1-4 must prepare its accounts according to the generally accepted accounting principles of the country in which it is domiciled for statutory and tax purposes. As Chapters 3 and 4 will attest, national financial reporting principles can vary significantly from country to country as they are shaped by different socio-economic environments. Environmental influences that impinge on accounting development are examined in Chapter 2. Nestle’s domestic shareholders are used to seeing reports on the basis of Swiss reporting conventions. Examination of Nestle’s accounting policies on consolidation suggests that the company first restates all of its foreign accounts to the reporting framework of the parent company prior to consolida- tion. The report of Nestle’s auditors state that the consolidated financial statements com- ply with Swiss Law and are in accordance with International Financial Reporting Standards (IFRS) issued by the International Accounting Standards Board (IASB) and with the Interpretations issued by the International Financial Reporting Interpretations Committee (IFRIC). But in restating from one set of principles to another, does something get lost in the translation? To illustrate, Mexican companies adjust their financial state- ments for changing prices (a subject that we cover in Chapter 7), owing to serious bouts of inflation in the past. Their adjustment for changing prices utilizes a methodology that incorporates changes in specific prices or replacement costs. Nestle, on the other hand, restates assets located in hyperinflationary countries for changes in the general purchas- ing power of the local currency prior to consolidation. Since general price changes seldom move in tandom with specific price changes, does Nestle’s methodology reduce the information content of the Mexican subsidiary’s inflation-adjusted accounts? Yamaha, producer of world-renowned musical instruments and other lifestyle products, expresses this concern in the first footnote to its consolidated financial accounts:

Yamaha Corporation (the Company) and its domestic subsidiaries maintain their accounting records and prepare their financial statements in accor- dance with accounting principles and practices generally accepted in Japan, and its foreign subsidiaries maintain their books of account in conformity with those of their countries of domicile. The Company and all consolidated subsidiaries are referred to as the “Group.” The accompanying consolidated financial statements have been prepared from the financial statements filed with the Ministry of Finance as required by the Securities and Exchange Law of Japan. Accordingly, the accompanying consolidated financial statements may differ in certain significant respects from accounting principles and practices generally accepted in countries and jurisdictions other than Japan.

Then there is the choice of exchange rate to use in converting foreign accounts to a single reporting currency. As Chapter 6 explains, there are a variety of rates that an MNC can use. As foreign exchange rates are seldom constant, restating accounts using exchange rates that gyrate almost daily produces gains and losses that can have a significant effect on the reported profitability and perceived riskiness of multinational operations. As you might suspect, account- ing treatments for these gains and losses are far from uniform internationally.

Chapter 1 • Introduction 9

Domestic readers are not the only audience that reporting entities must address. What about statement readers that are domiciled abroad? Their information needs must be considered when a firm seeks access to foreign sources of capital and at reasonable costs. Market access and cost of capital considerations are, in turn, related to the nature and quality of a firm’s external financial communications. Should a company send the same set of accounts that it prepares for its domestic readers to its foreign readers? Or, should the reporting entity restate its reports according to the language, currency and/or accounting principles of the reader’s country? This is not a trivial consideration as foreign readers are generally unaccustomed to providing money capital on the basis of an unfamiliar currency, language, and measurement framework. Evidence suggests that some institutional investors tend to exhibit a home country bias in their portfolio choices and tend to invest in nondomestic firms whose accounting and reporting methods conform to the GAAP framework that they are accustomed to.4 Would you be interested in investing in the shares of a Chinese company if the numbers in the annual report you received were expressed in Renmenbi, the text written in Mandarin, and the accounting measurements based on Chinese GAAP?

Both AKZO and Nestle, mentioned earlier, have chosen to accommodate their for- eign readers by restating their financial statements to International Financial Reporting Standards (IFRS). AKZO’s initiative is in compliance with a European Union (EU) directive that mandates all EU listed companies to follow IASB standards. Nestle’s decision is voluntary as its decision to conform to IFRS predates the EU requirement. Issues associated with management’s use of special disclosures for nondomestic finan- cial statement readers are covered in Chapter 5.

In addition to external reporting, a firm’s internal users of accounting information, that is, financial managers and accountants, must also understand the effects of environ- mental complexities of an MNE’s accounting measurements. Discussion of these topics begins in Chapter 10. For example, understanding the effects of changes in foreign exchange and inflation rates is critical in areas such as the preparation of short- and long-term budgets for parent companies and their subsidiaries (or branches), measuring and evalu- ating the performance of local business units and managers, and making corporate-wide decisions on the allocation of investment capital and retained earnings, among others. To make matters more complex, foreign exchange and inflation rates do not work in tandem. The effect on accounting measurements of changes in foreign exchange rates and foreign inflation is so pervasive that domestic financial control systems cannot serve managers well in the absence of appropriate environmental adaptation. Then there are issues of management control. While companies often expand operations abroad to take advan- tage of low-cost labor or untapped markets, productivity and decision-making styles can be so different that company expectations are often met with disappointment. Imposing culturally inappropriate control systems on foreign managers only magnifies such disap- pointments.5 Managerial accounting from an international perspective includes possibly the most complex and detailed material in this book.