Posted: May 1st, 2022

INTERNATIONAL BUSINESS

BUAD 4710
INTERNATIONAL BUSINESS
Chapter 19. International finance & Accounting

INTERNATIONAL FINANCE

I. INTRODUCTION
MNEs need funds to finance their activities. The focus of the finance function is to acquire financial resources (financing) and to allocate those resources (investment) to activities and projects. Financial resources come from a mix of debt and equity (capital structure). Financial resources can be raised through external as well as internal sources of funds. Other international finance issues of interest are foreign-exchange risks, and taxation of income earned abroad.

II. EXTERNAL SOURCES OF FUNDS
Companies can raise funds from global capital markets and/or offshore financial centers:

A. Global capital markets
Global capital markets include Eurocurrency market, international bonds, and Euro equity market:
1. Eurocurrency Market
A Eurocurrency is any currency banked outside its country of origin. There are four major sources of Eurocurrencies: foreign governments or individuals who want to hold dollars outside the U.S., MNEs that have excessive cash, European banks with excessive currency, and countries with large balance-of-trade surpluses.
A Eurocurrency market is where MNEs can raise Eurocurrencies. This market is a wholesale market, with very large transactions, typically consisting of short to medium term loans. As a source of funding, Eurocurrency market is more attractive because of low interest rates. The global financial crisis forced central banks all over the world to drop interest rates to stimulate economic growth.
2. International Bonds
Many companies have active bond markets available to domestic and foreign investors. There are two types of international bonds: foreign bonds, and Eurobonds. A foreign Bond is a title (bond) sold outside the country of the borrower, but denominated in the currency of the country of issue. A Eurobond is a title sold in a currency other than that of the country of origin.
3. Euro equity Market.
In the Euro equity market, MNEs issue stocks on one or more foreign exchanges. They therefore take ownership positions in return for shares of stock.

B. Offshore financial centers
MNEs can raise debt or equity funds offshore. Offshore financing is the provision of financial services by banks and other agents to nonresidents of a country. Offshore financial centers (OFC) are cities or countries that provide large amounts of funds in currencies other than their own and are used as locations in which to raise and accumulate cash. Generally, OFCs provide a more flexible and less expensive source of funding for MNEs. Also, they exhibit several characteristics, including a large foreign-currency (Eurocurrency) market for deposits and loans, a large net supplier of funds to the world financial markets, economic and political stability, an efficient and experienced financial community, good communications and supportive services, and an official regulatory climate that is favorable to the financial industry.
Offshore financial centers (OFC) can be operational centers, with extensive banking activities involving short-term financial transactions (e.g., London). They can also be booking centers, with little actual banking activities and where transactions are recorded to take advantage of secrecy laws and/or low or no tax rates (e.g., Cayman Islands). Booking centers are often seen as “tax haven” centers.

III. INTERNAL SOURCES OF FUNDS
Internal sources of funds include loans, investment through equity capital, interfirm receivables and payables and dividends. Intrafirm financial links become extremely important as MNEs grow in size and complexity. Funds can flow from parent to subsidiary, subsidiary to parent and/or subsidiary to subsidiary. Goods, services, and funds all can move within an MNE, thus creating receivables and payables. Entities may choose to pay quickly (a leading strategy) or to defer payment (a lagging strategy).
Another source of internal funds is transfer pricing (prices of transactions between related entities). Transfer prices can be used to adjust the size of a payment. One entity (e.g. a subsidiary or parent company) can sell parts at below or above market prices to finance or get funds from another entity within an MNE.

IV. FOREIGN-EXCHANGE RISK MANAGEMENT
MNEs’ financial strategy is to protect against the foreign-exchange risk (or exposure) of investing abroad. Strategies to protect against such risks include the internal movement of funds, and the use of foreign-exchange instruments such as options and forward contracts.

A. Types of Exposure
There are three types of foreign-exchange exposure:
1. Translation Exposure: It is the foreign-exchange risk that occurs because a parent firm must
translate foreign-currency financial statements into the reporting currency of the parent, i.e., the
value of the exposed asset/liability changes as the exchange rate varies.
2. Transaction Exposure: It is the foreign-exchange risk that arises because a firm has
outstanding accounts receivable or payable that are denominated in a foreign currency, i.e., the
receivable or payable changes in value as the relevant exchange rate changes.
3. Economic Exposure: It is the foreign-exchange risk that arises from effects of exchange-rate
changes on future cash flows, the sourcing of parts and components, the location of
investments, and the competitive position of the company in different markets.

B. Strategies for managing foreign-exchange risks
MNEs can devise a number of strategies to protect assets from exchange-rate risk. MNEs can hedge their position by adopting operational and/or financial strategies, each with cost/benefit and operational implications.
1. Operational Hedging Strategies. Firms may choose to balance local assets with local debt
by borrowing funds locally, because that helps avoid the foreign-exchange risk associated with
borrowing in a foreign currency. They may also choose to take advantage of leads and lags for
interfirm payments. A lead strategy means collecting foreign-currency receivables before they
are due when the currency is expected to weaken, or paying foreign-currency payables before
they are due when a currency is expected to strengthen. A lag strategy means delaying
collection of foreign-currency receivables if the currency is expected to strengthen, or delaying
payment of foreign-currency payables when the currency is expected to weaken.
2. Using Derivatives to Hedge Foreign-Exchange Risk. An MNE can also hedge exposure
through forward contracts and options, which establish fixed exchange rates for future
transactions and currency options, i.e., derivatives, which assure access to a foreign currency at
a fixed exchange rate for a specific period of time. A foreign-currency option is more flexible
than a forward contract because it gives the purchaser the right, but does not impose the
obligation, to buy or sell a certain amount of foreign currency at a set exchange rate within a
specified amount of time.

V. TAXATION OF FOREIGN-SOURCE INCOME

Taxes can profoundly affect profitability and cash flow, especially in international business. Taxation has a strong impact on several choices, including location of operations, method of financing (internal or external sourcing, debt or equity), and method of setting transfer prices.

A. International Tax Practices
1. Differences in Tax Practices: Countries differ in terms of the types of taxes they have, the tax rates applied to income, the determination of taxable income, and the treatment of foreign income. A major factor that affects international tax practices is differences in generally accepted accounting principles (GAAP). Variations among countries in GAAP can lead to differences in the determination of taxable income.
2. Two Approaches to Corporate Taxation:
– Separate Entity Approach. Each separate entity, company, or individual is taxed when it receives income.
– Integrated System Approach. Avoids double taxation. When shareholders report the dividends in their taxable income, they also get a credit for taxes paid on that income by the company that issued the dividend.

B. Taxing Branches and Subsidiaries
To illustrate the complexities of taxing foreign-source income, it is useful to examine how U.S.-based companies tax earnings from a foreign branch and a foreign subsidiary.
1. The Foreign Branch. Since a foreign branch is an extension of the parent company, any foreign branch income (or loss) is directly included in the parent’s taxable income.
2. The Foreign Subsidiary. A foreign corporation is an independent legal entity set up in a country according to the laws of incorporation of that country. When an MNE purchases or establishes such an entity, it is called a subsidiary. Subsidiary income is either taxable to the parent or tax deferred (not taxed until it is submitted as a dividend to the parent).

C. Transfer Prices
Transfer pricing applies to transactions between related entities and is not usually an arm’s length price (price between two unrelated entities). MNEs establish arbitrary transfer
prices primarily because of differences in taxation between countries. MNEs manipulate transfer prices in order to minimize tax liability.

D. Double Taxation and Tax Credit
In the United States, the IRS allows a tax credit for corporate income tax for tax that U.S. firms pay to another country in order to avoid double taxation. A tax credit is a dollar-for-dollar reduction of tax liability and must coincide with the recognition of income. Some countries have sign tax treaties to eliminate double taxation or to provide remedies when it occurs.

INTERNATIONAL ACCOUNTING

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I. INTRODUCTION
Accounting is defined as a service activity whose function is to provide quantitative information which will be useful in making strategic decisions and reasoned choices among alternative courses of action. The accounting and finance functions are closely related as the data generated by accountants (controllers) is primarily financial in nature.

II. INTERNATIONAL DIFFERENCES IN ACCOUNTING
Accounting origins and traditions have resulted in financial statements that are presented differently both in form (format) and in content (substance). This presents challenges for MNEs as they must produce financial statements using the standards of their host countries. This poses challenges for MNEs as they will have to consolidate all their statements.

A. Users of accounting information
In the United States, financial accounting standards are established by the Financial Accounting Standards Board (FASB). The FASB states that the users of financial information provided by accounting are potential investors, lenders, and other creditors. For worldwide use, financial accounting standards are set by the International Accounting Standards Board (IASB). For the IASB, users of accounting information are investors, employees, lenders, suppliers and other trade creditors, customers, governments and their agencies, and the public.

B. Factors in International Accounting Practices
Equity markets are influential on accounting standards in the U.S. and the U.K. Banks play a key role in Switzerland and Germany. Taxation is a major influence in France and Japan. International accounting firms have a significant impact. Differences in accounting practices around the world have resulted in a move toward convergence—the process of bringing different generally accepted accounting principles into line with IFRS issued by the IASB.

C. Cultural Differences in Accounting
Culture impacts measurement practices (how firms value assets) and disclosure practices (how and what information firms provide and discuss). The secrecy-transparency/optimism-conservatism matrix illustrates the impact of culture on accounting practices. Secrecy and transparency refer to the degree to which corporations disclose information to the public. Optimism and conservatism refer to the degree of caution that companies exhibit in valuing assets and recognizing income. Anglo-Saxon countries such as the U.K. and the U.S. have accounting systems that tend to be transparent and optimistic, while countries such as Germany, Japan and Switzerland, among others, tend to be secretive and conservative.

D. Classifying Accounting Systems
Accounting systems can be classified according to common characteristics:
1. From Macro-Uniform to Micro-Based Systems. Some countries’ accounting standards are based on macro-uniform accounting systems that are shaped more by government influences (strong, codified, tax-based legal systems). Other countries’ standards are shaped by micro-based accounting systems that rely on pragmatic business practices.
2. Differences in Financial Statements: Financial statements differ from one country to
another because of four key factors:
– Language Differences. English tends to be the first choice of companies choosing to raise capital abroad. Many companies provide their financial statements in different languages.
– Currency Differences. MNEs prepare their financial statements in different currencies.
– Differences in Types of Statements. Financial statement format can be confusing for a reader when accustomed to a different format. The use of accounting footnotes also differs greatly.
– GAAP Usage Differences. A major hurdle in raising capital in different countries is dealing with widely varying accounting and disclosure requirements.

E. Mutual Recognition versus Reconciliation
There are two approaches to dealing with accounting and reporting differences. In mutual recognition, a foreign registrant need only provide information prepared according to the GAAPs of the home country. In reconciliation to the local GAAPs, a foreign registrant reconciles its home-country financial statement with the local GAAPs), and recasting financial statements in terms of local GAAPs.
F. Efforts toward global convergence in accounting standards
Forces encouraging the harmonization of national accounting standards include: investors, global integration of capital markets, the need for MNEs to raise foreign capital, regional political and economic harmonization, MNEs’ desire to reduce their accounting and reporting costs, and convergence efforts of standard-setting bodies such as the International Accounting Standards Committee (IASC) which issued a set of International Accounting Standards (IAS).

III. TRANSACTIONS IN FOREIGN CURRENCIES
In addition to minimizing or eliminating foreign-exchange risk, firms must concern themselves with the proper recording and subsequent accounting of transactions resulting from the purchase or sale of products and the borrowing or lending of foreign currency.
1. Recording Transactions: When accounting for assets, liabilities, revenues and expenses, foreign-currency receivables and payables result in gains and losses whenever the relevant exchange rate changes. Such transaction gains and losses must be included on the income statement in the accounting period in which they arise.
2. Correct Procedures for U.S. Companies: The Financial Accounting Standards Board
Statement (FASB) requires U.S. firms to report foreign-currency transactions at the original
spot exchange rate in effect on the initial transaction date and to report receivables and
payables at the subsequent balance sheet date at the spot exchange rate on those dates. Any
foreign-exchange gains and losses associated with carrying receivables or payables are taken
directly to the income statement.

IV. TRANSLATING FOREIGN-CURRENCY FINANCIAL STATEMENTS
An MNE must eventually develop one set of financial statements in its home-country currency. Translation involves the process of restating foreign-currency financial statements. Consolidation is the process of combining the translated financial statements of a parent and its subsidiaries into a single set. In the U.S., translation is a two-step process: first, statements are recast according to U.S. GAAPs; then foreign currency amounts are translated into U.S. dollars.
There are two translation methods, the current-rate method, and the temporal method. The
method the firm chooses depends on the functional currency of the foreign operation, which is
the currency of the primary economic environment in which the entity operates.
1. Current-Rate method: If the functional currency is that of the local operating environment, the firm must use the current-rate method, which provides that all assets and liabilities be translated at the current exchange rate (the spot exchange rate on the balance sheet date). All income statement items are translated at the average exchange rate, and owner’s equity is translated at the rates in effect when the firm issued capital stock and accumulated retained earnings.
2. Temporal method: If the functional currency is the parent’s currency, then the firm must use the temporal method, which provides that only monetary assets such as cash, marketable securities and receivables and liabilities be translated at the current exchange rate. Inventory and property, plant and equipment are all translated at the historical exchange rates in effect when the assets were acquired. In general, income statement accounts are translated at the average exchange rate, but cost of goods sold and depreciation expenses
are reported at the appropriate historical exchange rates (not an average for
the period).

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INTERNATIONAL BUSINESS BUAD 4710

International Finance and Accounting (Chapter 19)

FINANCE INTERNATIONAL

I. INTRODUCTION

MNEs require funding to carry out their operations. The finance function’s primary goal is to obtain financial resources (funding) and distribute those resources to activities and projects (investment). A combination of debt and equity provides financial resources (capital structure). Financial resources can be obtained from both external and internal sources. Foreign exchange risks and taxation of money earned abroad are two further international finance topics of importance.

II. FINANCIAL RESOURCES FROM OUTSIDE THE UNITED STATES

Companies can raise funds from global capital markets and/or offshore financial centers:

A. Global capital markets

Global capital markets include Eurocurrency market, international bonds, and Euro equity market:

1. Eurocurrency Market

A Eurocurrency is any currency

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