International Accounting

Dr. Shorouk Esam El-Din Yassien

Lecturer at Accounting
Department (English Section),
Faculty of Commerce, Benha University
 Chapter 8
Translation of Foreign Currency
Financial Statements
US GAAP:

Prior to 1975, there were no authoritative rules in the United States as to which

translation method to use or where the translation adjustment should be reported

in the consolidated financial statements. Different companies used different

combinations, creating a lack of comparability across companies. In 1975, to

eliminate this non comparability, the FASB issued SFAS 8, Accounting for the

Translation of Foreign Currency Transactions and Foreign Currency Financial

Statements. SFAS 8 mandated use of the temporal method with translation

gains/losses reported in income by all companies for all foreign operations

(Combination A).
.
U.S. multinational companies were strongly opposed to SFAS 8. Specifically,

they considered reporting translation gains and losses in income to be inappropriate

given that the gains and losses are unrealized. Moreover, because currency

fluctuations often reverse themselves in subsequent quarters, artificial volatility in

quarterly earnings resulted.

After releasing two Exposure Drafts proposing new translation rules, the FASB

finally issued SFAS 52, Foreign Currency Translation, in 1981. This resulted in a

complete overhaul of U.S. GAAP with regard to foreign currency translation. SFAS

52 was approved by a narrow four-to-three vote of the FASB, indicating how

contentious the issue of foreign currency translation has been. The guidance

provided in SFAS 52 was incorporated into FASB ASC 830, Foreign Currency

Matters, in 2009
U.S. GAAP

• FASB ASC 830, Foreign Currency Matters( formerly SFAS 52, Foreign Currency

Translation) is the relevant accounting standard

• Requires identification of functional currency

• Functional currency is the primary currency of the foreign subsidiary’s

operating environment while reporting currency is the currency in which

financial statements are presented.

• The standard includes a list of indicators as guidance for the foreign currency

decision

• When functional currency is U.S. Dollar, temporal method is required

• When functional currency is foreign currency, current rate method is required

U.S. GAAP Requirements

• Highly Inflationary Economies – U.S. GAAP

• U.S. GAAP defines such economies as those with cumulative

100% inflation over a period of three years (with

compounding—average of 26% per year for three years in a

row)

• Temporal method required—translation gains/losses reported

in income
• Hedging Balance Sheet Exposure

• Companies that have foreign subsidiaries with highly integrated operations use the

temporal method

• Temporal method requires translation gains and losses to be recognized in

income

• Losses negatively affect earnings, and both gains and losses increase earnings volatility

• These gains and losses result from the combination of balance sheet exposure and

exchange rate fluctuations

• Foreign exchange gains and losses on foreign currency borrowings or foreign currency

derivatives employed to hedge translation based exposure (under the current rate

method)
Hedging Balance Sheet Exposure

Companies can hedge against gains and losses by using foreign currency forward

contracts, options, and borrowings

current rate method: Exchange
Cz Rate $

Sales A 540,000 0.72 388,800

Cost of goods sold A (310,000) 0.72 (223,200)

Gross profit 230,000 165,600

Operating expenses A (108,000) 0.72 (77,760)
Income before tax 122,000 87,840
Income taxes A (40,000) 0.72 (28,800)
Net income 82,000 59,040

Retained earnings, 1/1/Y2 154,000 0.80 123,200

Net income 82,000 above 59,040
Dividends (20,000) 0.71 (14,200)

Retained earnings, 12/31/Y2 216,000 168,040

 Exchange
Cz Rate $

Cash (C 50,000 0.70 35,000

Receivables 100,000 0.70 70,000

Inventory 72,000 0.70 50,400

Plant and equipment 300,000 0.70 210,000

Less: accumulated depreciation (70,000) 0.70 (49,000)

Total assets 452,000 316,400

Liabilities 186,000 0.70 130,200

Capital stock 50,000 0.84 42,000

Retained earnings, 12/31/Y2 216,000 above 168,040

Cumulative translation adjustment - (23,840)

Total liabilities and stockholders'

equity 452,000 316,400
 Chapter 12
International Transfer Pricing
Transfer pricing: is the determination of price on the exchange of goods or
services between related parties.

Transfers can be from a subsidiary to its parent (upstream), from the parent to
a subsidiary (downstream), or from one subsidiary to another of the same
parent. Transfers between related parties are also known as intercompany
transactions. Intercompany transactions represent a significant portion of
international trade. (In 2009, intercompany transactions comprised 40 percent
of U.S. total goods trade)

Two factors heavily influence the manner in which international transfer prices
are determined. The first factor is the objective that headquarters management
wishes to achieve through its transfer pricing practices. One possible objective
relates to management control and performance evaluation. Another objective
relates to the minimization of one or more types of costs. These two types of
objectives often conflict.
The second factor affecting international transfer pricing is the law that exists in
most countries governing the manner in which intercompany transactions
crossing their borders may be priced. These laws were established to make sure
that multinational corporations (MNCs) are not able to avoid paying their fair
share of taxes, import duties, and so on by virtue of the fact that they operate in
multiple jurisdictions. In establishing international transfer prices, MNCs often
must walk a fine line between achieving corporate objectives and complying with
applicable rules and regulations
DECENTRALIZATION AND GOAL CONGRUENCE

Business enterprises often are organized by division. A division may be a

profit center, responsible for revenues and operating expenses, or an

investment center, responsible also for assets. In a company organized by

division, top managers delegate or decentralize authority and responsibility to

division managers.
 Decentralization has many advantages:
• Allowing local managers to respond quickly to a changing environment.
• Dividing large, complex problems into manageable pieces.
• Motivating local managers who otherwise will be frustrated if asked only
to implement the decisions of others
However, decentralization is not without its potential disadvantages. The most
important pitfall is that local managers who have been granted decision-making
authority may make decisions that are in their self-interest but detrimental to the
company as a whole. An agency problem can occur since division managers make
decisions in their self-interest. Manager’s self-interest can vary with the best interests
of the company . An effective accounting system can alleviate this agency problem by
providing incentives to division managers to act in the interests of the organization The
corporate accounting and control system should be designed in such a way that
it provides incentives for local managers to make decisions that are consistent
with corporate goals. This is known as goal congruence. The system used for
evaluating the performance of decentralized managers is an important
component in achieving goal congruence.
The price at which an intercompany transfer is made determines the level of

revenue generated by the seller, becomes a cost for the buyer, and therefore

affects the operating profit and performance measurement of both related

parties. Appropriate transfer prices can ensure that each division or

subsidiary’s profit accurately reflects its contribution to overall company

profits, thus providing a basis for efficient allocation of resources. To achieve

this, transfer prices should motivate local managers to make decisions that

enhance corporate performance, while at the same time providing a basis for

measuring, evaluating, and rewarding local manager performance in a way that

managers perceive as fair. If this does not happen (i.e., if goal congruence is

not achieved), then the potential benefits of decentralization can be lost.

 TRANSFER PRICING METHODS:

The methods used in setting transfer prices in an international context are essentially
the same as those used in a purely domestic context. The following three methods are
commonly used:
1. Cost-based transfer price. The transfer price is based on the cost to
produce a good or service. Cost can be determined as variable production
cost, variable plus fixed production cost, or full cost, based on either actual
or budgeted amounts (standard costs). The transfer price often includes a
profit margin for the seller (a “cost-plus” price). Cost-based systems are
simple to use, but there are at least two problems associated with them. The
first problem relates to the issue of which measure of cost to use. The other
problem is that inefficiencies in one unit may be transferred to other units, as
there is no incentive for selling divisions to control costs. The use of
standard, rather than actual, costs alleviates this problem.
2. Market-based transfer price. The transfer price charged a related party is
either based on the price that would be charged to an unrelated customer or
determined by reference to sales of similar products or services by other
companies to unrelated parties. Market-based systems avoid the problem
associated with cost-based systems of transferring the inefficiencies of one
division or subsidiary to others. They help ensure divisional autonomy and
provide a good basis for evaluating subsidiary performance. However, market-
based pricing systems also have problems. The efficient working of a market-
based system depends on the existence of competitive markets and dependable
market quotations. For certain items, such as unfinished products, there may
not be any buyers outside the organization and hence no external market price.
3-Negotiated price:. The transfer price is the result of negotiation between
buyer and seller and may be unrelated to either cost or market value. A
negotiated pricing system can be useful, as it allows subsidiary managers
the freedom to bargain with one another, thereby preserving the autonomy
of subsidiary managers. However, for this system to work efficiently, it is
important that there are external markets for the items being transferred so
that the negotiating parties can have objective information as the basis for
negotiation. One disadvantage of negotiated pricing is that negotiation can
take a long time, particularly if the process deteriorates and the parties
involved become more interested in winning arguments than in considering
the issues from the corporate perspective.
Another disadvantage is that the price agreed on and therefore a manager’s
measure of performance may be more a function of a manager’s ability to
negotiate than of his or her ability to control costs and generate profit
Management accounting theory suggests that different pricing methods are

appropriate in different situations. Market-based transfer prices lead to optimal

decisions when (1) the market for the product is perfectly competitive, (2)

interdependencies between the related parties are minimal, and (3) there is no

advantage or disadvantage to buying and selling the product internally rather

than externally. Prices based on full cost can approximate market-based prices

when the determination of market price is not feasible. Prices that have been

negotiated by buyer and seller rather than being mandated by upper

management have the advantage of allowing the related parties to maintain their

decentralized authority.
OBJECTIVES OF INTERNATIONAL TRANSFER PRICING
there are two possible objectives to consider in determining the appropriate
price at which an intercompany transfer that crosses national borders should
be made: (1)performance evaluation and (2) cost minimization.

1- Performance Evaluation:
To fairly evaluate the performance of both parties to an intercompany

transaction, the transfer should be made at a price acceptable to both parties.

An acceptable price could be determined by reference to outside market prices

(e.g., the price that would be paid to an outside supplier for a component part),

or it could be determined by allowing the two parties to the transaction to

negotiate a price.
Policies for establishing prices for domestic transfers generally should be
based on an objective of generating reasonable measures for evaluating
performance;
otherwise, dysfunctional manager behavior can occur and goal congruence
does not exist. For example, forcing the manager of one operating unit to
purchase parts from a related operating unit at a price that exceeds the
external market price will probably result in an unhappy manager. As a result of
the additional cost, the unit’s profit will be less than it otherwise would be,
perhaps less than budgeted, and the manager’s salary increase and annual
bonus may be adversely affected. In addition, as upper management makes
corporate resource allocation decisions, fewer resources may be allocated to
this unit because of its lower reported profitability.
So regarding Performance evaluation systems we can conclude that:
• Transfer prices directly affect the profits of the divisions involved in an
intercompany transaction
• Some of performance evaluation systems are based on divisional profits
• Effectiveness of these performance evaluation systems is influenced by the
fairness of transfer prices
• Effectiveness of performance evaluation systems affects the satisfaction of
managers
2) Cost minimization.
• Profit maximization and, by extension, cost minimization are important
corporate objectives
• Manipulating transfer prices between countries is one way for multinational
enterprises to achieve cost minimization
• This is referred to as discretionary transfer pricing
• The most common approach is to minimize costs by shifting profits to
lower tax rate jurisdictions

Performance Evaluation, Cost Minimization, and Transfer Pricing

Assume that Alpha Company (a manufacturer) and Beta Company (a retailer)
are both subsidiaries of Parent Company, located in the United States. Alpha
Company is located in Taiwan and Beta Company is located in the United
States , Alpha produces DVD players at a cost of $100 each and sells them
both to Beta and to unrelated customers. Beta purchases DVD players from
Alpha and from unrelated suppliers and sells them for $160 each