Week Ten

Strategic Accounting
Issues in Multinational
Corporations

McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Strategic Accounting Issues in Multinational
Corporations
Learning Objectives
Explain the role played by accounting in formulating
multinational business strategy.
2. Demonstrate and understanding of multinational capital
budgeting.
3. Describe the factors that influence strategy implementation
within a multinational corporation.
4. Discuss the role of accounting in implementing multinational
business strategy.
5. Identify the issues involved in the design and implementation
of an effective performance evaluation system within a
multinational corporation.
12-2
Strategy

 Strategies are large scale plans that reflect the desired

direction of the company.
 Strategy formulation involves determining organizational
goals and strategies to achieve those goals.
 Strategy implementation involves managerial efforts to
influence employees to attain organizational goals.
 Managerial influence is also referred to as management
control.
 Accounting has a significant role to play in strategy
formulation and implementation.

12-3
 Accounting and Strategy Formulation

 Information is a key ingredient in the strategy formulation

process providing information about both internal and
external factors.
 This involves analysis of customer, market, and competitor
information, risk assessment.
 It also includes financial expressions of firm strategy and
preparation of budgets.
 Capital budgeting is an important part of strategy
formulation.

Learning Objective 1 12-4

 Accounting and Strategy Formulation

Budgeting
 Budgeting is the primary use of accounting information in
strategy formulation.
 Budgeting assists in strategy formulation by providing
managers with information about short-term and long-term
planning responsibilities.
 Budgeting also provides expectations against which future
results can be judged.

Learning Objective 1 12-5

 Capital Budgeting

Overview
 The fundamental concepts of capital budgeting are the same
in either a domestic or international context.
 Large, long-term investments are referred to as capital
investments.
 Capital budgeting is a key activity in selecting capital
investments.
 Capital budgeting involves three steps: project identification
and definition, evaluation and selection, and monitoring and
review.

Learning Objective 2 12-6

 Capital Budgeting

Steps in capital budgeting

 Project identification and definition provides a clear basis for
understanding the project and predicting the associated cash
flows.
 Evaluation and selection involves identifying cash flows and
then using one or more of the capital budgeting methods to
evaluate the project.
 Monitoring and review involves updating the analysis and
project plan during the implementation stage.

Learning Objective 2 12-7

 Capital Budgeting

Capital budgeting techniques

 Payback period.
 Return on investment.
 Net present value.
 Internal rate of return.

Learning Objective 2 12-8

 Capital Budgeting

Payback period
 Represents the length of time it takes to recoup the initial
investment.
 Equal to the initial investment amount divided by the annual
after-tax cash flows.
 The project will be accepted if the payback period does not
exceed a predetermined length.
 The primary weaknesses of this method are that it ignores the
time value of money, and it ignores the total profitability of
the project.

Learning Objective 2 12-9

 Capital Budgeting

Return on investment
 Represents an average annual return on the initial
investment.
 Equal to the average annual net income divided by the initial
investment.
 The project will be accepted if the return on investment
exceeds a predetermined rate.
 The primary weaknesses of this method are that it ignores the
time value of money, and it ignores possible cash outlays
subsequent to initial investment.

Learning Objective 2 12-10

 Capital Budgeting

Net present value

 Equal to the present value of net future cash flows less the
initial investment.
 Requires the estimate of minimum rate of return to be used
as the discount rate.
 The project will be accepted if the net present value is equal
to or greater than zero.
 The primary weaknesses of this method are that it cannot be
used for comparing projects of different sizes and that it
tends to be biased toward large investments.

Learning Objective 2 12-11

 Capital Budgeting

Internal rate of return

 Represents the discount rate that results in a net present
value of zero.
 It is equal to the discount rate that causes the net present
value of future cash flows to equal the initial investment.
 The project will be accepted if the IRR is greater than the
companies desired rate of return (hurdle rate).
 The primary weaknesses of this method are that it sometimes
requires unrealistic assumptions about reinvestment of funds,
and manual calculation is difficult.

Learning Objective 2 12-12

 Multinational Capital Budgeting

 Capital budgeting in an international context is complicated

by several factors.
 These factors relate primarily to the risk associated with
future cash flows.
 These risks are generally categorized as political risk,
economic risk, and financial risk.
 Taxes, import duties, dividend restrictions, and cash flow
limitations imposed by governments also must be considered.

Learning Objective 2 12-13

 Multinational Capital Budgeting

Political Risk
 This refers to the likelihood that political events will impact
cash flows.
 Nationalization and expropriation of assets is an extreme type
form of political event.
 Political risk is also associated with changes in foreign
exchange controls, repatriation restrictions, tax rules, and
labor laws.
 This risk can vary significantly from one country to another.

Learning Objective 2 12-14

 Multinational Capital Budgeting

Economic Risk
 This refers to the likelihood that changes in the host country
economy will impact cash flows.
 Inflation is the most significant of economic risks.
 Inflation affects the ability of the local population to purchase
goods and also impacts the overall cost structure of a
business.
 There are also costs associated with manager time and effort
to respond to inflation.

Learning Objective 2 12-15

 Multinational Capital Budgeting

Financial Risk
 This refers to the likelihood that changes currency values,
interest rates and other financial factors will impact cash
flows.
 Foreign exchange risk is also a component of financial risk.
 Whether to evaluate the project based on host country or
parent country cash flows is affected by foreign exchange risk.

Learning Objective 2 12-16

 Strategy Implementation

Management control
 The management control system is the primary mechanism
for implementing and evaluating the effectiveness of
strategy.
 Accounting is involved in management control primarily
through its role in operating budgets and performance
evaluation.
 Operating budgets provide a link between strategy and
performance.
 A number of organizational and cultural factors influence
management control.

Learning Objectives 3 and 4 12-17

 Strategy Implementation

Factors affecting strategy implementation

 Organizational structure affects strategy implementation.
 Different forms of organizational structures include:
ethnocentric, polycentric, and geocentric.
 Ethnocentric firms use an approach that assumes that the
cultural background of the firm is universal.
 Polycentric firms consider the culture of the host country to
be most important and adopt it.

Learning Objectives 3 and 4 12-18

 Strategy Implementation

Factors affecting strategy implementation

 Geocentric firms often consist of units that play very distinct
roles. These roles include: global innovator, integrated player,
implementer, and local innovator.
 Levels of control and delegation are factors that influence
management control system type.
 One major type of management control system is
bureaucratic control which employs a significant amount of
structure.
 The other major type is cultural control which is more
informal and less structured.

Learning Objectives 3 and 4 12-19

 Performance Evaluation

Major aspects of performance evaluation

 The measure or measures of performance.
 Classification of the foreign operation as cost, profit or
investment center.
 Joint or separate evaluation of the foreign operation and the
manager of the operation.
 The profit measurement method.

Learning Objective 5 12-20

 Performance Evaluation

Performance evaluation measures

 Financial measures are based directly on financial statement
data.
 Examples include net profit, return on investment and
comparison of budgeted to actual profit.
 Nonfinancial measures are based on data not obtained
directly from financial statements.
 Examples include market share, relationship with host
country government, and labor turnover.

Learning Objective 5 12-21

 Performance Evaluation

Performance evaluation – Balanced scorecard

 This approach gives “balanced” consideration to both
financial and nonfinancial measures.
 It considers the perspectives of four stakeholder groups.
 Shareholder’s perspectives are considered by financial
performance measures.
 The internal business perspective is reflected in business
process measures.
 Innovation and learning perspectives and customer’s
perspectives are also considered.

Learning Objective 5 12-22

 Performance Evaluation

Responsibility centers
 The idea of responsibility centers is to identify the activities
that individual units perform and for which they should be
held accountable.
 Cost centers are responsible for producing output using a
certain amount of resources.
 Profit centers are responsible for costs and revenues.
 Investment centers have the responsibilities of a profit center
plus responsibility for investment decisions.
 Return on investment (ROI) is the most common performance
measure for an investment center.

Learning Objective 5 12-23

 Performance Evaluation

Separating managerial and unit performance

 In an international context a number of factors exist that
cause a disconnect between manager performance and unit
performance.
 These factors that the manager cannot control are known as
uncontrollable items.
 Responsibility accounting implies that managers should not
be held accountable for uncontrollable items.
 Uncontrollable items include those controlled by the parent,
the host government, or controlled by others.

Learning Objective 5 12-24

 Performance Evaluation

Choice of currency in measuring profit

 Profit can be measured in either the local currency or parent
currency.
 Local currency is appropriate if the subsidiary is not expected
to pay parent currency dividends.
 Otherwise, parent currency is appropriate.
 When parent currency is used, the company also must choose
a translation method.
 Further, a decision must be made about whether to include
the translation adjustment in the profit measure.

Learning Objective 5 12-25

 Performance Evaluation

Translation to parent currency

 Since the translation is for internal purposes, financial
accounting standards need not be followed.
 Likewise, the inclusion of the translation adjustment in the
profit measure is based on internal needs rather than
accounting standards.
 One factor in this decision is whether the adjustment reflects
the impact of exchange rates on parent currency cash flows.
 A second factor whether the local manager has the authority
to hedge against exchange rate changes.

Learning Objective 5 12-26

 Performance Evaluation

Choice of currency in operational budgeting

 Operational budgets often include budget-to-actual
comparisons.
 The international context adds an element of complexity due
to exchange rate fluctuations.
 Exchange rates may change during the period between
making the budget and recording profits.
 The three available exchange rates are: actual at time of
budget, projected at time of budget, actual at end of budget
period.

Learning Objective 5 12-27

 Performance Evaluation

Budget and actual rate combinations

 Lessard and Lorange (1977) illustrated five budget and actual
exchange rate combinations.
 Three combinations involve using the same exchange rate for
both budget and actual translations.
 A fourth combination translates the budget at the actual rate
at the time of budget and translates actual results using the
actual rate at the end of period.
 A fifth combination translates the budget using a projected
end of period rate and translates actual results using the
actual rate at the end of period.

Learning Objective 5 12-28

 Performance Evaluation

Implementing performance evaluation

 The success of a performance evaluation system depends on
a number of factors. These include:
 Integration of the system with the overall business strategy.
 Feedback of actual results and revision of budget.
 Comprehensiveness of the set of performance measures.
 Organizational buy-in.
 Reasonableness of budgeted measures.
 Understandability and simplicity of the system.

Learning Objective 5 12-29

 Performance Evaluation

Cultural considerations in management control

 One of the objectives of a management control system is to
influence human behavior.
 People in different cultures will react differently to aspects of
management control systems.
 Japan is a more collectivist than the United States.
 Management control mechanisms designed in the U.S. to
assign individual responsibility will not work as effectively in
Japan.

Learning Objective 5 12-30

Example of International Capital Budgeting
Lomax Ltd. is an international company based in Australia which
manufactures tractors. It is considering building a plant in
Hong Kong. The project is expected to cost HK20 Million and
is expected to generate HK$9Million per year for 3 years.

Spot Rate HKD5 =1AUD

OR AUD0.2 = 1HKD
Risk free rate is as follows:
Australia : 5%
Hong Kong : 7%
The company’s required return is 10%. Should this project be
undertaken?

12-31
Method One – The Home Currency Approach
 Convert all HK$ cash flows to AUS$ and then discount at 10%
to find the NPV in AUS$.
 We have to come up with the future exchange rates to
convert HK$ to AUS$.

12-32
Method One – The Home Currency Approach
 Uncovered interest rate parity
E (st) = So x 1 + [( RHK –RA )] t
E (st) = Expected future exchange rate
RHK = Risk-free rate in H.K. = 7%
RA = Risk-free rate in Aus = 5%
So = Spot rate = HKD5 =1 AUD

12-33
Method One – The Home Currency Approach
E (st) = 5x 1 + ( 0.07-0.05) t

= 5 x 1.02 t

YR EXP. EXCHANGE RATE

1 HKD5 x 1.021 = HKD5.1
2 HKD5 x 1.022 = HKD5.202
3 HKD5 x 1.023 = HKD5.306

12-34
Convert All HKD to AUD
YR CASH FLOW EXPECTED CASH FLOW PV PV
IN HKD EXCHANGE IN AUD FACTOR
RATE

0 (HKD20M) / HKD5.0 = (-$4.00m) x 1 (-4)

1 HKD 9M / HKD5.1 = $1.76m x 0.909 1.60
2 HKD 9M / HKD5.202 = $1.73m x 0.826 1.43
3 HKD 9M / HKD5.306 = $1.70m x 0.761 1.29

NPV @ 10% = AUD0.32Million NPV + 0.32

======
Accept since NPV is +

12-35
Method Two – The Foreign Currency
Approach
 Determine the required return on HK Investments and then
discount the HKD Cash flow to find the NPV in HKD. Then
convert this HKD NPV to AUD NPV.

 We need to convert the 10% AUD return to the equivalent HK

required return.

12-36
Method Two – The Foreign Currency
Approach
SOLUTION

The different in the nominal rates as follows:-

RFC - RHC

= 7% - 5% = 2%

The discount rate to be used to evaluate the project will be

10% + 2% (Inflation risk in HK) = 12%

12-37
Method Two – The Foreign Currency
Approach
HK$ (12%)
YR CASH FLOW PV FACTOR PV

0 (-HK$20) x 1 (-HK$20)
1 HK$ 9 x 0.893 HK$ 8.037
2 HK$ 9 x 0.797 HK$ 7.173
3 HK$ 9 x 0.712 HK$ 6.408
NPV : HK$ 1.618M

Convert to AUS$ at the spot rate of HKD5/AUD

NPV IN AUD = HKD1.618 ÷ 5
= AUD0.32
Since the NPV is positive, the project can be accepted.

12-38
Exercise
A company in Singapore intends to built a plant in Indonesia. The
initial cost of investment is IDR800million and the investment
is expected to generate IDR320million per year for 3 years.

Spot Rate at the date of investment: IDR10,000 = SGD1

The risk free rate in Indonesia is 8% and 6% in Singapore. The

firm’s required rate of return is 12%.

Required: Should the company make this investment? Prepare

you answer using Method One and Method Two.

12-39
Exercise from Textbook
• Page 560, Question 1 – 14
• Quiz for Final Exam Revision (10%)
• Translation of Foreign Financial Statement
• Analysis of Foreign Financial Statement
• Strategic Accounting Issues in Multinational Corporation

Format:
1. Two calculations questions
2. 6 Essay questions – 3 from Analysis of Foreign Financial
Statement and 3 from Strategic Accounting Issues in
Multinational Corporation

12-40