A Decision-Making Approach, 2nd Edition King, Lembke, and Smith

Financial Accounting

Prepared by Dr. Denise English, Boise State University

John Wiley & Sons, Inc.

CHAPTER SIXTEEN

FINANCIAL REPORTING IN A GLOBAL ECONOMY

After reading Chapter 16, you should be able to:

1. Identify companies that are involved in global business and use this information to refine your decisions about those companies. 2. Explain how transactions involving two different currencies are reported, and identify the exchange risks that are present. 3. Describe how companies minimize their exposure to foreign currency exchange rate risks, why this is important, and what information is available in financial statements to help decision makers assess the rewards and risks of a companys international operations.

CHAPTER SIXTEEN

FINANCIAL REPORTING IN A GLOBAL ECONOMY

After reading Chapter 16, you should be able to:

4. Explain how financial statements are translated into different currencies, and describe how a decision maker can determine what effect the translation has had on those statements. 5. Discuss the formulation of international accounting standards, explain the difficulties in achieving uniformity, and describe the effects of different standards on financial decisions. 6. Describe how financial ratios can provide useful information about a companys international operations.

Decision Making in a Global Economy

When a company operates globally, financial decisions are affected by international regulations, customs, activities, and events. Different counties also use different currencies, and financial reporting is often based on different accounting principles. Understanding how financial reporting reflects these complexities helps financial statement users to better assess a companys operations and position.

The Impact of Global Factors

Economic decisions and the information available to make those decisions depend on the economic, political, and legal characteristics that tend to be most pervasive. Economic factors such as economy type (free or planned), rate of inflation, and the availability and cost of producing information will influence decision making. Legal factors such as the degree of regulation, tax policy, and level of enforcement will influence decision making. Cultural ties and geographical proximity may also influence accounting information.

Financial Reporting for Global Businesses

Operating in a global environment presents several important financial reporting challenges: how should a foreign operation be reported? what currency should be used to account for transactions with foreign business associates? how should foreign financial statements be translated? The answer to the first question is that when included in U.S. consolidated financial statements, a foreign operation must be changed to conform with accounting standards in this country.

Currencies of Countries Around the World

Country
Brazil Canada China Euro currency countries France Germany Greece Hong Kong India Iran Iraq Israel

Exhibit 16-2 Currency

Lira Yen Peso Riyal Rand Won Baht Pound Sterling Dollar (U.S.)

Currency
Real Dollar (Canadian) Renminbi Euro Franc Mark Drachma Dollar (H.K.) Rupee Rial Dinar Shekel

Country
Italy Japan Mexico Saudi Arabia South Africa South Korea Thailand United Kingdom United States

Reporting Transactions Denominated in Foreign Currencies

When a U.S. company does business with foreign customers or suppliers, the transactions are reported in the companys financial statements in U.S. dollars. The currency must be translated into U.S. dollars using the current exchange rate, or the rate at which one currency can be exchanged for another. The current exchange rate is quoted daily in major newspapers and is known as the spot rate. The future exchange rate is referred to as the forward rate.

Reporting Transactions Denominated in Foreign Currencies

Exchange rates for currencies are determined much like any prices in a market economy, through supply and demand. For example, the yen has risen against major currencies because many countries have imported more goods from Japan than they have exported to Japan, cause them to acquire yen to pay for their purchases. The exchange rates of most major countries float so that the rate can change from day to day (or hour to hour).

Reporting Transactions Denominated in Foreign Currencies

If the exchange rate between the dollar and yen changes by 5 yen over a 30-day period, and you were holding a $950,000 account receivable over that same period, you would lose more than $40,000 due to currency exchange. U.S. companies engaged in transactions in foreign currencies must deal with an exchange broker, such as a bank or other type of currency dealer. Without currency dealers and the organized currency exchange markets, international commerce would be severely hindered.

Reporting Transactions Denominated in Foreign Currencies

Foreign transactions must be converted into U.S. dollars, even if the receipt or payment was in a foreign currency, to include the transaction in the financial statements. Whenever a transaction involving borrowing or lending occurs between companies using two different currencies, the possibility exists of a gain or loss from currency fluctuation. Companies that either hold foreign currency or receivables denominated in a foreign currency, or that owe amounts denominated in a foreign currency, are said to have exposed foreign currency positions. Companies that have exposed foreign currency positions must adjust their foreign-currency receivables or payables to the current dollar equivalent based on the exchange rate at the balance sheet date and recognize related exchange rate gains or losses.

Summary of Foreign Currency Exchange Effects

Action Exchange Trend Result

Holding a receivable Currency weakens Loss from holding in a foreign currency against U.S. dollar receivable (the opposite exchange trend would result in a gain) Owing amounts Currency weakens Gain from owing payable in a against U.S. dollar payable foreign currency (the opposite exchange trend would result in a loss)

Reducing Foreign Exchange Risk

Most companies are not in the business of trying to make money on changes in foreign currency exchange rates, but they do want to minimize their risk exposure. One way to avoid these risks is to denominate all international transactions in U.S. dollars, thus pushing the risk of currency fluctuations onto the other party. Another way of minimizing the risk is for the company with an exposed foreign currency position to offset, or hedge, that position by entering into a contract with a broker to buy or sell a fixed amount of foreign currency in the future at a price set currently, known as a forward exchange contract.

Financial Statement Translation

When the financial statements of foreign subsidiaries or divisions are consolidated with those of the U.S. parent company, the accounting practices must be made consistent with those of the U.S. and foreign currencies must be translated to U.S. dollars. Generally, the accounting standards must first be brought into agreement and then the translation into U.S. dollars takes place. The currency of the primary operating environment in which a foreign unit spends and receives cash is referred to as its functional currency.The financial statements of a foreign unit stated in its functional currency must be translated into U.S. dollars using the current rate method of translation.

Current Rate Method of Translation

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Using the current rate method of translation, the following process takes place:
1) income statement amounts are translated at the exchange rates current at the date those elements were recognized. 2) assets and liabilities are translated at the exchange rates current at the balance sheet date. (3) Owners equity, except retained earnings, is translated at the rate that existed when the subsidiary or operating unit was created or when ownership was acquired. (4) Retained earnings at the end of the period is computed by adding the translated net income to the retained earnings balance translated as of the end of last period, and by deducting dividends for the period, translated at the date of declaration.

Current Rate Method of Translation

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One problem arises when the current rate method of translation is used: --because a variety of exchange rates are used from different points in time, a net difference results that is due to changes in exchange rates. This difference is reported in owners equity as a cumulative translation adjustment and is reported as an element of a companys other comprehensive income.

International Accounting Standards

As global commerce has increased, the demand for international accounting standards has become obvious. The lack of consistent accounting standards across different countries makes comparisons difficult for decision makers in a global economy.

International Accounting Standards

Examples of differences in accounting standards include: Japanese firms maximize depreciation and loss deductions because they are forced to equate financial reporting income with taxable income in Japan; Cultural differences cause Germany managers to focus on continued long-term growth through market share, development of new technology, and enterprise continuity, while in the U.S. the focus is on current operating results and earnings.

International Accounting Standards Committee

Representatives from professional accounting bodies from more than a hundred countries were brought together to form the International Accounting Standards Committee in 1973. Progress in establish international standards has been slow, but the SEC has agreed to accept standards developed by the IASC if certain conditions are met to ensure reliability and limiting of alternatives. When analyzing global enterprises, an examination of international operations separate from domestic operations and in relation to overall operations is often important.

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