Download Chapter 16

Financial Accounting
A Decision-Making Approach, 2nd Edition
King, Lembke, and Smith
*
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 company’s 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 company’s 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 company’s 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
Exhibit 16-2
Country
Currency
Country
Currency
Brazil
Canada
China
Euro currency
countries
France
Germany
Greece
Hong Kong
India
Iran
Iraq
Israel
Real
Dollar (Canadian)
Renminbi
Italy
Japan
Mexico
Saudi Arabia
South Africa
South Korea
Thailand
United
Kingdom
United States
Lira
Yen
Peso
Riyal
Rand
Won
Baht
Euro
Franc
Mark
Drachma
Dollar (H.K.)
Rupee
Rial
Dinar
Shekel
Pound Sterling
Dollar (U.S.)
Reporting Transactions
Denominated in Foreign Currencies



When a U.S. company does business with foreign
customers or suppliers, the transactions are reported in
the company’s 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
<>
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) Owner’s 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
<>
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 owner’s equity as a cumulative translation
adjustment and is reported as an element of a
company’s 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.
Copyright
Copyright © 2001 John Wiley & Sons, Inc. All rights
reserved. Reproduction or translation of this work beyond
that permitted in Section 117 of the 1976 United States
Copyright Act without the express written permission of the
copyright owner is unlawful. Request for further information
should be addressed to the Permissions Department, John
Wiley & Sons, Inc. The purchaser may make back-up copies
for his/her own use only and not for distribution or resale.
The Publisher assumes no responsibility for errors,
omissions, or damages, caused by the use of these
programs or from the use of the information contained herein.