Chapter 19

Multinational Accounting and Tax Functions





!          Examine the major factors influencing the development of accounting practices in different countries and the worldwide harmonization of accounting principles.

!          Explain how companies account for foreign-currency transactions and translate foreign-currency financial statements.

!          Illustrate how companies report their impact on the environment.

!          Investigate the U.S. taxation of foreign-source income.

!          Examine some of the major non-U.S. tax practices and show how international tax treaties can alleviate some of the impact of double taxation.



Chapter Overview


The international accounting and taxation functions comprise great challenges for today’s global business managers. Chapter 19 presents the key accounting and taxation issues confronting firms that do business abroad. First, the chapter examines the ways in which national accounting systems differ and how today’s global capital markets force countries to consider the harmonization of their accounting and reporting standards. It then explores a number of unique issues MNEs face, such as the valuation and translation of transactions and assets that are denominated in foreign currencies. The chapter concludes with an examination of taxation and transfer-pricing concerns, including the use of the value-added tax and the elimination of double taxation.



Chapter Outline


OPENING CASE: Enron and International Accounting Harmonization

This case vividly presents the arguments for changes in and the harmonization of accounting standards on a worldwide basis. It describes the shocking demise of Enron, an energy trading company based in Houston, Texas, and its auditor, Arthur Andersen, and the role faulty accounting practices played in those events. The case also cites the major accounting crises at MCI WorldCom, Tyco International, Vivendi Universal and Global Crossing to emphasize the extent and seriousness of this problem. The basic difficulty is that today’s capital markets are global, but the existing auditing and accounting regulations are not. Even before Enron’s collapse, the European Union announced by 2005 all EU firms will have to follow the International Accounting Standards (IAS). In 2002, the FASB agreed to join the IASB in the effort to eliminate the differences between their two sets of standards. However, convincing the FASB and the SEC to move away from their rules-based approach and toward the IASB’s principles-based approach will not be easy. Cultural, economic and institutional factors will have to be overcome for the global harmonization of accounting standards to actually occur.

Teaching Tip: Review the PowerPoint slides for Chapter 19 and select those you find most useful for enhancing your lecture and class discussion. For additional visual summaries of key chapter points, also review the map, figures and tables in the text.


I.                   INTRODUCTION

International business managers cannot make informed decisions without relevant and reliable accounting and taxation information. While the financial manager of any firm is responsible for procuring and managing the company’s financial resources, today’s corporate controller (accountant) is responsible for providing information to the firm’s financial decision makers, and to a wide variety of other stakeholders as well.



Accounting origins and traditions are as individual as the languages of the nations that produce them. As a result, financial statements in different countries appear different from each other both in form (format) and in content (substance). While some people argue differences in format are a minor problem, the fact that companies can value assets and determine income differently in different countries is not.

A.        Accounting Objectives [See Figure 19.3]

Accounting is defined as a service activity whose function is to provide quantitative information, primarily financial in nature, that will be useful in making strategic decisions and reasoned choices among alternative courses of action. It is crucial that the accounting process identify, record, and interpret economic events. The private sector body that establishes financial accounting standards in the U.S. is the Financial Accounting Standards Board (FASB). The FASB states that the external reporting of accounting information should help investors (i) make investment and credit decisions, (ii) assess cash flow prospects and (iii) evaluate enterprise resources. The international private-sector organization that sets financial accounting standards for worldwide use is the International Accounting Standards Board (IASB). The IASB and its predecessor, the International Accounting Standards Committee (IASC), identified the following key users of accounting information: investors, employees, lenders, suppliers and other trade creditors, customers, governments and their agencies, and the public. While equity markets are an important influence on accounting standards in the U.S. and the U.K., banks are influential in Switzerland and Germany, and taxation is a major influence in France and Japan. Generally accepted accounting principles (GAAPs) are those standards established in each country that must be followed by organizations when generating their financial statements.

B.                 Cultural Differences in Accounting [See Figure 19.4]

Culture influences both measurement practices (how firms value assets) and disclosure practices (how and what information firms provide and discuss). From an accounting standpoint, 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 Germanic countries, among others, tend to be secretive and conservative.

C.                Classification of Accounting Systems [See Figure 19.5]

Although accounting standards and practices vary worldwide, systems can nonetheless be classified according to common characteristics. While macro-uniform accounting systems are shaped more by government influences (strong, codified, tax-based legal systems), micro-based accounting systems rely on pragmatic business practices. International accounting standards (IAS), i.e., IASC-sponsored standards designed to harmonize the national treatment of accounting issues across its members’ countries, more closely approximate the standards used in micro-based systems. Because MNEs must adjust to different accounting systems on a worldwide basis, the international accounting function becomes increasingly complex and costly. Financial statements differ from one country to another in six major ways: (i) language, (ii) currency, (iii) the type of statement (income, statement, balance sheet, etc.), (iv) the financial statement format, (v) the extent of footnote disclosures and (vi) the underlying GAAPs on which financial statements are based. Firms must deal with all six issues. Major approaches to dealing with accounting and reporting differences include mutual recognition (a foreign registrant need only provide information prepared according to the GAAPs of the home country), 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. A Form 20-F is the document used to recast financial statements in the U.S.



Forces encouraging the harmonization of national accounting standards include: investor orientation, the global integration of capital markets, the need for MNEs to raise foreign capital, regional economic integration and the pressure from MNEs to reduce their accounting and reporting costs. The most ambitious harmonization efforts are occurring in the EU, which promotes, among other things, the free flow of capital and the adoption of the International Accounting Standards as set forth by the IASB by 2005. In 1981 the International Federation of Accountants (IFAC), which is comprised of more than 150 accounting organizations representing more than 2 million accountants worldwide, agreed that the IASB would have full and complete autonomy in the setting of international accounting standards and in the issue of discussion documents. However, the key turning point in the significance of the IAS standards came in 1995 when the International Organization of Securities Commissions (IOSCO) announced it would endorse IASB core standards if a set were developed that both organizations could agree upon.



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.

A.                Recording of 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.

B.                 Correct Procedures for U.S. Companies

The Financial Accounting Standards Board Statement (FASB) No. 52 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. Practices vary in other countries, although the IASB procedure is somewhat similar to that of the U.S., except that it permits a firm to increase the value of an asset by the amount of foreign-exchange loss and then write it off over the useful life of the asset as part of the depreciation charge.



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, and 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 all foreign currency amounts are translated into U.S. dollars.

A.                Translation Methods

FASB No. 52 allows firms to use either of two methods when translating foreign-currency financial statements into dollars. 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. 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. 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).

B.                 Disclosure of Foreign-Exchange Gains and Losses

Under the current-rate method of translating foreign-currency financial statements, the gain or loss is called an accumulated translation adjustment and is recognized in owners’ equity. Under the temporal method, the gain or loss is taken directly to the income statement, thus affecting earnings per share.



Environmental reports vary from firm to firm and country to country because they provide voluntary information. These reports identify the impact of the firm on the environment, focusing especially on the use of natural resources and efforts to recycle waste. Typically, the environmental report is separate from the annual report and is not part of the financial statements or footnotes.



Tax planning influences both profitability and cash flow and thus impacts several decisions including the location of the initial investment, the choice of operating form, the legal form of a new enterprise, the method of financing and the method of setting transfer prices.

A.                Exports of Goods and Services

To gain tax advantages from exporting, a U.S. firm can set up a foreign sales corporation (FSC) to shelter some of its income and repatriated dividends. To qualify, a firm must be engaged in substantial business activity and maintain a foreign office, operate under foreign management, keep a permanent set of books at the foreign office, conduct foreign economic processes and be an established foreign corporation. The WTO has judged the FSC tax provision to be an illegal export subsidy and ordered the U.S. to comply with WTO guidelines—at the moment that does not seem likely.

B.                 Foreign Branch

Inasmuch as a foreign branch is an extension of the parent company rather than a separate subsidiary, any income it generates is directly included in the parent’s taxable income; similarly, foreign branch losses are deducted from the parent’s taxable income.

C.                Foreign Subsidiary

A foreign subsidiary is a foreign operation legally separate from the parent firm, i.e., it is incorporated in a foreign country, even if wholly-owned. Subsidiary income is either taxable to the parent or tax-deferred, i.e., not taxed until remitted as a dividend. Which tax status applies depends on whether the subsidiary is a controlled foreign corporation (CFC), i.e., a firm in which U.S. shareholders hold more than 50 percent of the voting stock. When a foreign subsidiary qualifies as a CFC, U.S. tax law requires its income to be classified as active, i.e., derived from the direct conduct of trade or business, or passive, i.e., derived from operations in a tax-haven country. A tax-haven country is a nation in which tax rates are low or non-existent on foreign-source income. Subpart F income, i.e., passive income, is generally derived from holding company transactions, foreign sales corporation operations and the performance of services.

D.                Transfer Prices

A transfer price represents an internal company price charged as materials, components and/or finished goods and services move from one entity within a firm to another, i.e., it is the price at which goods and services are transferred to another corporate entity. An arm’s-length price is thought to be a market-based price because it is the price that would be established by two firms with no ownership interest in one another. Arbitrary transfer prices reflect differences in taxation rates and currency controls between countries and are designed to maximize profitability and currency flows. As such, they make an unbiased performance evaluation nearly impossible and may be rejected by governments.

E.                 Tax Credit

A tax credit is a dollar-for-dollar reduction in tax liability paid to the U.S. government by U.S. firms that pay taxes to other countries; it must coincide with the recognition of income. Such credits are usually capped at the amount of tax the firm would have had to pay the U.S. government if the income had all been generated in the U.S.



The lack of familiarity with tax laws and customs, as well as loose enforcement, can create problems for firms operating internationally. Taxation of corporate income is accomplished through one of two approaches in most countries. Under the U.S.-based separate entity approach, governments tax each entity when it earns income—often the result is double taxation, i.e., taxing the same earnings more than once. An integrated systems approach (used by most industrial countries) tries to avoid the double taxation of corporate income through split tax rates or tax credits. Countries also have unique systems for taxing the earnings of the foreign subsidiaries of their domestic firms—some use a territorial approach, others use a global approach.

A.                Value-Added Tax

A value-added tax represents a percentage of the value added to a product at each stage of the business process. For a firm that is fully vertically integrated, the tax rate applies to net sales because the firm owns everything from raw materials to finished product. While VAT rates vary among European countries, the EU is narrowing differences in rates for like categories of goods. In addition, the EU effectively stimulates exports by not applying the VAT to products exported from the bloc.

B.                 Tax Treaties: The Elimination of Double Taxation

The primary purpose of a tax treaty is to prevent international double taxation or to provide remedies when it occurs. The general pattern between two treaty countries is to grant reciprocal reductions on dividend withholding, and to exempt royalties and sometimes interest payments from any withholding tax.



Because taxes affect both profits and cash flow, they are a major consideration in a firm’s foreign investment decision process. Companies should set up branches in the early years to recognize losses and subsidiaries in later years to shield profits. Debt and equity financing also have tax ramifications. To maximize cash flow on a worldwide basis, firms should concentrate profits in low-tax or tax-haven countries.



In Transfer Pricing, “Legal” Doesn’t Always Mean “Ethical”?

Arbitrary transfer pricing can create both legal and ethical problems. Establishing transfer prices on an arm’s-length basis assures firms pay taxes on profits based on market decisions. However, some countries lack rigid transfer pricing policies, and others, which choose to operate as tax-havens, have none. In some instances, an MNE might use transfer pricing as a means to transfer cash out of weak-currency countries. In others, a firm may under-invoice transfer shipments to minimize customs payments and manipulate profits, i.e., to maximize cash flows and minimize global tax payments. When a country has no legal requirements pertaining to transfer pricing, management is likely to assume that (i) the absence of law implies permission to pursue the firm’s self-interest and (ii) legal means ethical. The latter is an especially shaky assumption.



What Will Become the Coca-Cola of Accounting Standards?

It is difficult to predict future developments in international tax policy simply because policy is subject to the whims of governments. In Europe, tax differences within the EU will surely narrow in years to come as harmonization occurs in both the determination of taxable income and the actual setting of tax rates. From an international accounting standpoint, however, the question is whether the principle-based GAAPs of the IASB or the rules-based GAAPs of the U.S. will become the globally accepted accounting standard. As the FASB continues to cooperate with the IASB and other institutions to establish new, effective accounting principles, U.S. accounting standards will become more international. Further, the more the standards of these two organizations begin to converge, the more likely resistance on both sides will begin to lessen.




Teaching Tip: Visit for additional information and links relating to the topics presented in Chapter 19. Be sure to refer your students to the on-line study guide, as well as the Internet exercises for Chapter 19.




CLOSING CASE: Vivendi Universal [See Figures 19.9-10, Table 19.8]

[Note: information pertinent to this case is embedded throughout the chapter.]


1.       Based on this short description, do you agree with Vivendi Universal’s acquisition and diversification strategy?

It would be useful to see the mission statement that drove Vivendi’s acquisition and diversification strategy. Firms the world over choose to expand via diversification in order to offset economic fluctuations and the unpredictable dynamics of the consumer marketplace. Some choose to so by moving into an attractive industry and seeking specific opportunities there; others will choose to acquire an attractive firm (or series of firms) and by default expand into the industry represented. Vivendi’s expansion into the communications and media area seems to have been carefully planned and executed; its holdings cover the breadth of the industry, and each entity is a major player in its respective market. Whether Vivendi’s move away from environmental services and into communications was deliberate or opportunistic is not known. However, while Vivendi Environment contributes substantial strength and stability to the firm, there appears to be little synergy between the two clusters.


2.                  If you were to sell off $10 billion of Vivendi Universal’s assets, which divisions would you keep and which would you eliminate?

A sale of $10 billion in assets represents a sizable divestiture; it would be helpful to be able to review Vivendi’s income statement. For purposes of operating efficiencies, Vivendi would likely choose to sell its non-core operations, but they alone will not yield sufficient revenues. In considering the divestiture of an additional segment, Vivendi should look to its mission. If in fact the firm now defines itself as a major player in the communications and media area, it would seem logical to sell the Vivendi Environment group. As a world leader in water services and waste management, and as a European leader in energy services and transportation, Vivendi Environment should be very attractive to potential investors. The sale of the group would make a major contribution to the desired debt reduction and would permit the firm to consolidate and focus its energies in the communication and media segment.


3.                  Using the 20-F reconciliation, what is the most common type of reconciliation? What impact does this have on current and future financial statements under U.S. and French GAAPs?

The most common type of reconciliation is probably the one in which a foreign registrant reconciles its home-country financial statement with the local generally accepted accounting principles. As Table 19.8 shows, there are three primary differences in Vivendi’s statements between French and U.S. GAAPs. First, accounting for proportionate ownership is different. Second, certain transactions (e.g., gains and losses on foreign exchange) are reclassified. Third, adjustments represent a difference in accounting conventions. All in all, the adjustment of a net loss of 1.135 billion under U.S. GAAPs and 13.597 billion under French GAAPs represents a change of 1,198 percent—a difference of phenomenal proportions.


4.                  What do you see as the key accounting issues facing Vivendi Universal’s board of directors? How might these be resolved through the use of International Accounting Standards?

Key issues facing Vivendi’s board of directors include reducing the $19 billion worth of debt associated with various acquisitions, and the restoration of investor confidence in the firm. The use of International Accounting Standards could aid in this process because not only do the standards tend to be transparent, but companies incorporated in EU countries are required to adopt IAS by 2005. By implementing those standards now, investors and analysts would be reassured of Vivendi’s commitment to meeting the highest professional accounting standards and nurturing the long-term viability of the firm.



Additional Exercises: Multinational Accounting


Exercise 19.1. The value-added tax has been assessed by most West European countries since 1967, and is now used by many other countries as well. Ask the students to debate the pros and cons of the tax from the perspective of (a) businesses and (b) governments. Are the advantages of such a tax primarily limited to regional economic blocs like the EU?


Exercise 19.2. Tax-haven countries and tax-haven operations are appealing to certain governments and businesses on the one hand, but are criticized by many on the other. Ask students to debate both the practical (competitive) problems and moral challenges associated with tax-haven countries. Then ask them to discuss the extent to which they believe an MNE should incorporate tax-haven advantages into its strategic planning process.


Exercise 19.3. Many transition economies such as China, Russia and the former Soviet satellite nations have not only different accounting standards from those found in West Europe, North America and Japan, but their accounting systems are seriously underdeveloped, given the dynamics of today’s global business environment. Ask the students to discuss the logic of those countries’ adopting the International Accounting Standards as the basis of their national business accounting systems.