In Chapter 14, we discussed the concept of consolidated financial statements. These state- ments view the operations of the parent company and its subsidiaries as if the affiliated com- panies were a single business entity. Several special accounting problems arise in preparing consolidated financial statements when subsidiaries operate in foreign countries. First, the accounting records of the foreign subsidiaries must be translated into U.S. dollars. Second, the accounting principles in use in the foreign countries may differ significantly from U.S.
generally accepted accounting principles.
These problems pose interesting challenges to professional accountants and will be addressed in later accounting courses. Readers of the financial statements of U.S.-based cor- porations, however, should know that the consolidated financial statements of these com- panies are expressed in U.S. dollars and conform to U.S. generally accepted accounting principles.
Global Sourcing
Differences in exchange rates can create significant complexities for firms practicing global sourcing. An article in the Los Angeles Times illustrated the additional problems associated with determining the cost of producing a doll using inputs from several countries. Exhibit 15–9
Discuss how global sourcing increases product cost complexity.
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Exhibit 15–9
GLOBAL SOURCING FOR MATTEL INC.’S BARBIETM DOLL
U.S.—
Molds
Japan—Hair
Barbie™ final wholesale price in the U.S. = $10.00
Export value from China = $2.00
Hong Kong
Management = $1.00
Saudi Arabia Taiwan China
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traces the multicountry path of a Barbie TM doll from its raw materials source in a Saudi Ara- bian oil field to U.S. toy stores. After the oil is refined to produce ethylene, Taiwan uses the ethylene to produce vinyl pellets that are shipped to Dongguan in China’s Guangdong prov- ince. At the Chinese joint-venture factory, 5,500 workers, paid between $30 and $40 per month, make the plastic doll and her clothes. However, most of the machinery and tools, including the plastic mold injection machines, are imported from the United States, Europe, and Japan. The molds themselves come directly from the United States. Japan contributes Barbie’s nylon hair. Hong Kong manages the entire process, arranging banking and insurance, supervising exporting and importing, and overseeing transportation back to the United States.
Finally, U.S. domestic packaging, trucking, advertising, and other functions that employ thou- sands of U.S. workers result in a $10.00 Barbie TM wholesale price. Mattel Inc. has indicated that its typical profit from the sale of a Barbie TM is about $1.00.
Exhibit 15–10 illustrates the costs and exchange rate issues involved in the produc- tion of a Barbie TM doll. Panel A provides the currency exchange rates for the countries involved in global sourcing for the Barbie TM doll. Panel B includes estimated product export costs for the Mattel Inc. Barbie TM made at the Meitai factory in Dongguan, China.
The estimated costs in the exhibit are based on a single day’s reported exchange rates.
Companies must choose a representative exchange rate to compute the cost buildup in their domestic currency.
Exhibit 15–10
EXCHANGE RATES AND ESTIMATED PRODUCT COST FOR BARBIETM DOLLS Estimated Product Cost for BarbieTM*
Panel A: Exchange Rates†
Country Currency U.S. $ Equivalent
Saudi Arabia Riyal .2667
Taiwan Taiwanese dollar .0326
Hong Kong Hong Kong dollar .1286
Japan Yen .0095
China Yuan .1225
Panel B: Estimated Product Cost Buildup
Input Foreign Currency Value U.S. $ Equivalent Raw materials:
Saudi Arabia 0.6374 riyal $0.17
Taiwan 4.908 Taiwanese dollars 0.16
Japan 22.11 yen 0.21
China 0.898 yuan 0.11
Direct labor:
China 2.857 yuan 0.35
Overhead:
Hong Kong 7.776 Hong Kong dollars 1.00
Total export cost $2.00
*Estimates based on information provided in R. Tempest, “Barbie and the World Economy,” Los Angeles Times, September 22, 1999, p. 1.
†Based on exchange rates from www.xe.com/ucc.
The information in the exhibit does not provide details about customs duties, import and export fees, multicountry tax laws, and tax treaties. These are also costs of doing business in a global environment. Many companies underestimate the cost of globalizing their business operations because they are not familiar with the environmental characteristics discussed at the beginning of this chapter. Making accurate estimates of costs for global sourcing is a chal- lenge for companies wishing to become more global.
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FOREIGN CORRUPT PRACTICES ACT
In many countries, product costs also include expenses incurred to expedite official paper- work. Kenyan business executives refer to kitu kidogo (“something small”), the Chinese pay huilu, Russians shell out vzyatka, and Middle Easterners pay baksheesh. In dozens of countries around the world, bribery is part of doing business. In many countries, this officially sanc- tioned corruption is not viewed as wrong or unethical. However, U.S.-based businesses are prohibited from influence peddling. The Foreign Corrupt Practices Act (FCPA), passed in 1977 and amended in 1986 and 1998 by the U.S. Congress, prescribes fines and jail time for managers violating its rules. For over 20 years, U.S. companies have complained about the advantage experienced by international competitors who are not bound by the FCPA.
Experiences in the past 5 to 10 years have changed international attitudes about the impact of corrupt practices on economic viability. In particular, the 1997–1998 Asian crisis was blamed partly on graft and influence peddling. According to some estimates, corruption asso- ciated with doing business in China can add 5 percent to operating costs. Corruption can be so rampant that companies refuse to operate in some foreign locations, causing countries to lose valuable direct foreign investment.
The International Monetary Fund and the World Bank instituted policies in the late 1990s to cut off funding to countries ignoring corrupt practices. In 1997, $292 million in loans to Kenya were suspended until policies and procedures to prevent corruption were instituted.
Many of the recommended policies and procedures are modeled after the FCPA. The scope of the FCPA is very broad. Under FCPA rules, it is illegal for all U.S. companies and foreign companies operating in the United States, their affiliates, and their agents to bribe a govern- ment official. Criminal and civil prosecution can lead to fines of up to $2 million for the com- pany and $100,000 for executives involved, with prison terms of up to five years.
The FCPA has implications for accounting in two specific areas: record keeping and internal control procedures. The act requires that all payments, including improper payments, be recorded and disclosed. Further, the act requires an adequate system of internal controls that maintains the integrity of the company’s assets, allowing only authorized personnel to have access to them. The 1986 amendment to the FCPA distinguished between influence peddling, to
Explain the importance of the Foreign Corrupt Practices Act.
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Assume you are the head of international acquisitions for a large multinational toy com- pany traded on the New York Stock Exchange. You have been involved for several months in a deal to acquire a large facility in a midsize city in central China. This building will be remodeled by your company to produce a range of toy products for the Chinese market. For a variety of reasons, progress has been extremely slow on completing the acquisition. In particular, city administrators have continually delayed issuing the neces- sary paperwork. You decide to fly to China to meet with the city’s top three officials. Dur- ing your meeting it becomes clear that the three city officials would guarantee processing the associated paperwork much faster if your company would provide a significant pay- ment to each of them to help expedite the necessary work. These administrators point out that a German company that acquired a facility in the city the previous year was willing to pay extra to expedite paperwork.
Your CEO has made it clear to you that the China project is very important and expe- diting it is critical for its long-run success. What should you do?
(See our comments on the Online Learning Center Web site.)
Y O U R T U R N You as a Head of International Acquisitions
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Concluding Remarks 701
motivate the awarding of business that would not otherwise have been awarded, and facilitating payments, to motivate officials to undertake actions more rapidly than they might otherwise.
A facilitating payment might be given to a customs official to expedite imported merchandise through customs. This latter type of payment is not illegal under the act. Companies engaging in globalization must ensure that their cross-border employees comply with the FCPA.
Concluding Remarks
In this chapter we have established a framework to help you understand international financial reporting issues. You have learned how global environmental differences create demand for different types of financial information. However, other global forces, particu- larly global securities markets and large international firms, are pushing for a uniform set of international accounting standards for financial reporting. What does the development of international accounting standards foreshadow? We believe that significant progress toward harmonization is occurring. However, users of international financial statements should expect wide variation in disclosure levels and financial reporting practices for several years to come.
Concluding Remarks
In this chapter we have established a framework to help you understand international
Ethics, Fraud & Corporate Governance
The Foreign Corrupt Practices Act (FCPA) applies to U.S.
companies and foreign companies operating in the U.S., their affiliates, and their agents. Violations of the FCPA expose companies and individuals to both civil and criminal liability.
For example, the Securities and Exchange Commission (SEC) brought an enforcement action against InVision Technologies, Inc. (InVision), alleging that InVision violated the FCPA. The SEC alleged that InVision authorized improper payments to government officials in China, Thailand, and the Philippines in connection with sales activities.
InVision’s sales agent in China provided $95,000 of foreign travel and other benefits to airport officials in Guangzhou.
The sales agent notified InVision’s regional sales manager, who notified the senior sales executive of these payments.
These payments were improperly recorded by InVision as cost of goods sold.
InVision paid its sales agent in the Philippines $108,000 to be used to make gifts and pay cash to government officials in order to generate sales. InVision improperly recorded this payment as a sales commission.
InVision violated the following provisions of the FCPA:
(1) illegal offers and payments, (2) books and records (e.g., improperly recording gifts and other payments as cost of goods sold or sales commissions), and (3) internal controls.
InVision agreed to disgorge $589,000 in profits from sales where the FCPA was violated, pay $28,700 in prejudgment interest, and pay a $500,000 civil penalty. In addition, InVision agreed to retain an independent consultant to develop a corporate compliance program designed to prevent and detect future violations of the FCPA.
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Define four mechanisms companies use to globalize their business activities. Companies globalize their business activities through exporting, licensing, joint ventures, and wholly owned subsidiaries.
Multinational companies use a global sourcing approach.
Identify how global environmental forces—
(a) political and legal systems, (b) economic systems, (c) culture, and (d) technology and infrastructure—affect accounting practices. Countries use their political and legal systems to transfer and control business assets. Market versus centrally planned economic systems create different demands for financial reporting. Culture influences business relationships through beliefs and expectations of customers and business associates. The technology and infrastructure of each global location will affect the type and costs of business activities and related financial accounting reports.
Explain why there is demand for harmonization of global financial reporting standards. Cross-border differences in accounting and reporting create analysis and comparability problems between and among companies.
The need for comparable information has led to the demand for harmonization.
Demonstrate how to convert an amount of money from one currency to another. To convert a foreign currency to an equivalent dollar amount, multiply the foreign currency by the foreign exchange rate. To convert a dollar amount into an equivalent amount of foreign currency, divide the dollar amount by the exchange rate.
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S U M M A R Y O F L E A R N I N G O B J E C T I V E S
Compute gains or losses on receivables or payables that are stated in a foreign currency when exchange rates fluctuate. The receivable or payable is recorded on the date the transaction is agreed to using the prevailing exchange rate. When exchanging cash completes the transaction, the exchange rate at the completion date is used to record the cash flow; the difference between the cash exchanged and the receivable or payable is recorded as a foreign exchange gain or loss.
Describe techniques for “hedging” against losses from fluctuations in exchange rates. Hedging is offsetting the potential for losses from foreign exchange rate fluctuations. It can be accomplished by having offsetting receivables and payables in the foreign currency or by buying or selling foreign currency future contracts.
Discuss how global sourcing increases product cost complexity. When some of the activities of designing, developing, producing, marketing, and servicing a product or service occur in more than one country, then global considerations affect product costs. These considerations include foreign exchange gains and losses, taxes, import and export duties, trade agreements, foreign trade zones, and limitations on currency flows.
Explain the importance of the Foreign Corrupt Practices Act. The FCPA prohibits influence peddling through bribery in international locations. The act requires companies engaged in global business activities to maintain good record keeping and adequate internal controls to safeguard company assets.
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Key Terms Introduced or Emphasized in Chapter 15
adoption of IFRS (p. 689) Means abandoning the country’s financial reporting standards and replacing them with Interna- tional Financial Reporting Standards (IFRS).
convergence with IFRS (p. 690) A process by which a coun- try’s financial reporting standards are changed so that the use of their country GAAP standards will produce IFRS “equivalent”
financial reports.
cross-border financing (p. 689) Occurs when a company sells its securities in the capital markets of another country.
exchange rate (p. 691) The amount it costs to purchase one unit of currency with another currency.
exporting (p. 685) Selling a good or service to a foreign cus- tomer in a foreign country.
Foreign Corrupt Practices Act (p. 700) Passed in 1977 and amended in 1986 and 1998 by the U.S. Congress, pre- scribes fines and jail time for managers violating its rules.
It distinguishes between illegal influence peddling to moti- vate awarding of business that would not otherwise have been awarded and legal facilitating payments made to motivate officials to undertake actions more rapidly than they might otherwise.
foreign trade zones (p. 686) Goods imported into these desig- nated U.S. areas are duty free until they leave the zone.
future contracts (p. 697) A contract giving the right to receive a specified quantity of foreign currency at a future date.
global sourcing (p. 685) The close coordination of R&D, manufacturing, and marketing across national boundaries.
globalization (p. 684) Occurs as managers become aware of and engage in cross-border trade and operations.
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Demonstration Problem 703
harmonization of accounting standards (p. 689) The glo- balization of similar accounting methods and principles used throughout the world.
hedging (p. 697) The practice of minimizing or eliminating risk of loss associated with foreign currency fluctuations.
industrial organizations (p. 687) Exist when companies group themselves into conglomerates representing different industries. South Korean conglomerates, called chaebol, and Japanese conglomerates, called keiretsu, consist of companies that are grouped as customers and suppliers and usually contain a bank.
infrastructure (p. 689) Access to communication, transporta- tion, and utilities provided to businesses in each global location.
International Accounting Standards Board (IASB) (p. 689) Charged with the responsibility of creating and promulgating international standards.
international joint venture (p. 685) A company owned by two or more companies from different countries.
international licensing (p. 685) A contractual agreement between a company and a foreign party allowing the use of trademarks, patents, technology, designs, processes, intellectual property, or other proprietary advantage.
market economy (p. 687) Exists when ownership of land and the means of production are private and markets dictate the allocation of resources and the output among segments of the economy.
planned economy (p. 687) Exists when the government uses central planning to allocate resources and determine output among various segments of the economy. Government owner- ship of land and the means of production characterize planned economies.
wholly owned international subsidiary (p. 685) Created through a company’s foreign direct investment; involves using domestically generated funds in another country to purchase 100 percent equity control of a foreign subsidiary.
Demonstration Problem
IronMan, Inc., is a U.S. company that manufactures exercise machines and distributes several lines of imported bicycles. Selected transactions of the company were as follows:
Oct. 4 Purchased manufacturing equipment from Rhine Mfg. Co., a German company. The purchase price was 400,000, due in 60 days. Current exchange rate, $0.7020 per euro. (Debit the Equipment account.)
Oct. 18 Purchased 2,500 racing bicycles from Ninja Cycles, a Japanese company, at a price of
¥60,000,000. Payment is due in 90 days; the current exchange rate is $0.0110 per yen.
(IronMan uses the perpetual inventory system.)
Nov. 15 Purchased 1,000 touring bicycles from Royal Lion Ltd., a British corporation. The purchase price was £192,500, payable in 30 days. Current exchange rate, $1.65 per British pound.
Dec. 3 Issued a check to First Bank for the U.S. dollar-equivalent of 400,000 in payment of the account payable to Rhine Mfg. Co. Current exchange rate, $0.7110 per euro.
Dec. 15 Issued a check to First Bank for dollar-equivalent of £192,500 in payment of the account payable to Royal Lion Ltd. Current exchange rate, $1.60 per British pound.
Instructions
a. Prepare entries in general journal form to record the preceding transactions.
b. Prepare the December 31 adjusting entry relating to the account payable to Ninja Cycles. The year-end exchange rate is $0.0113 per Japanese yen.
c. Identify some methods that IronMan, Inc., could use to decrease its exposure to foreign exchange rate fluctuations.
d. Discuss environmental characteristics of Japan, Germany, and the United Kingdom that influ- ence their exchange rate fluctuations.
Demonstration Problem
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Solution to the Demonstration Problem
a. The general journal entries to record the transactions are as follows:
b. The December 31 adjusting entry for the account payable to Ninja Cycles:
c. IronMan could use offsetting payables and receivables to control potential foreign exchange rate losses. For example, if IronMan could export its exercise equipment to Japan, then it would have a receivable to offset its payable. IronMan could also purchase future contracts maturing at the same time the liabilities were due. Gains and losses on the future contracts would offset gains and losses resulting from foreign currency fluctuations.
d. Germany has a lower volume and smaller capitalized equities market. Germany uses the euro and is part of the European Union. Banks are a major provider of capital to businesses in Germany.
Japan has keiretsu organizations for many of its industrial groups. These organizations include GENERAL JOURNAL
Date Account Titles and Explanation Debit Credit Oct. 4 Equipment . . . 280,800
Accounts Payable (Rhine Mfg. Co.) . . . 280,800 To record purchase of equipment from Rhine Mfg. Co.
for 400,000, exchange rate $0.7020 per euro (400,000 ⫻ $0.7020 ⫽ $280,800).
Oct. 18 Inventory . . . 660,000
Accounts Payable (Ninja Cycles) . . . 660,000 Purchased 2,500 bicycles from Ninja Cycles for
¥60,000,000, exchange rate $0.0110 (¥60,000,000 ⫻ $0.0110 ⫽ $660,000).
Nov. 15 Inventory . . . 317,625
Accounts Payable (Royal Lion Ltd.) . . . 317,625 Purchased 1,000 bicycles from Royal Lion Ltd. for
£192,500, due in 30 days. Exchange rate $1.65 per pound (£192,500 ⫻ $1.65 ⫽ $317,625).
Dec. 3 Accounts Payable (Rhine Mfg. Co.) . . . 280,800 Loss on Fluctuations of Foreign Exchange Rates . . . 3,600
Cash . . . 284,400 Paid 400,000 liability to Rhine Mfg. Co.
(Original balance less amount paid equals loss:
$280,800 ⫺ (400,000 ⫻ $0.7110) ⫽⫺$3,600).
Dec. 15 Accounts Payable (Royal Lion Ltd.) . . . 317,625
Gain on Fluctuations of Foreign Exchange Rates . . . 9,625 Cash . . . 308,000 Paid £192,500 liability to Royal Lion Ltd.
(Original balance less amount paid equals gain:
$317,625 ⫺ (£192,500 ⫻ $1.60) ⫽ $9,625).
GENERAL JOURNAL
Date Account Titles and Explanation Debit Credit Dec. 31 Loss on Fluctuations in Foreign Exchange Rates . . . 18,000
Accounts Payable (Ninja Cycles) . . . 18,000 To adjust balance of ¥60,000,000 liability to amount
indicated by year-end exchange rate:
(Original balance less adjusted balance equals loss:
$660,000 ⫺ (¥60,000,000 ⫻ $0.0113) ⫽⫺$18,000).