Separation of Subsidiary and Manager Performance

Table 19.1 suggests that in many international businesses, the same quantitative criteria are used to assess the performance of both a foreign subsidiary and its managers. Many accountants, however, argue that although it is legitimate to compare subsidiaries against each other on the basis of return on investment (ROI) or other indicators of profitability, it may not be appropriate to use these for comparing and evaluating the managers of different subsidiaries. Foreign subsidiaries do not operate in uniform environments; their environments have widely different economic, political, and social conditions, all of which influence the costs of doing business in a country and hence the subsidiaries' profitability. Thus, the manager of a subsidiary in an adverse environment that has an ROI of 5 percent may be doing a better job than the manager of a subsidiary in a benign environment that has an ROI of 20 percent. Although the firm might want to pull out of a country where its ROI is only 5 percent, it may also want to recognize the manager's achievement.

Accordingly, it has been suggested that the evaluation of a subsidiary should be kept separate from the evaluation of its manager.¹⁶ The manager's evaluation should consider how hostile or benign the country's environment is for that business. Further, managers should be evaluated in local currency terms after making allowances for those items over which they have no control (e.g., interest rates, tax rates, inflation rates, transfer prices, exchange rates).

Chapter Summary

This chapter focused on financial accounting within the multinational firm. We explained why accounting practices and standards differ from country to country and surveyed the efforts under way to harmonize countries' accounting practices. We discussed the rationale behind consolidated accounts and looked at currency translation. We reviewed several issues related to the use of accounting-based control systems within international businesses. This chapter made the following points:

1. Accounting is the language of business: the means by which firms communicate their financial position to the providers of capital and to governments (for tax purposes). It is also the means by which firms evaluate their own performance, control their expenditures, and plan for the future.

2. Accounting is shaped by the environment in which it operates. Each country's accounting system has evolved in response to the local demands for accounting information.

3. Five main factors seem to influence the type of accounting system a country has: (i) the relationship between business and the providers of capital, (ii) political and economic ties with other countries, (iii) the level of inflation, (iv) the level of a country's development, and (v) the prevailing culture in a country.

4. National differences in accounting and auditing standards have resulted in a general lack of comparability in countries' financial reports.

5. This lack of comparability has become a problem as transnational financing and transnational investment have grown rapidly in recent decades (a consequence of the globalization of capital markets). Due to the lack of comparability, a firm may have to explain to investors why its financial position looks very different on financial reports that are based on different accounting practices.

6. The most significant push for harmonization of accounting standards across countries has come from the International Accounting Standards Committee (IASC). So far, the IASC's success, while noteworthy, has been limited.

7. Consolidated financial statements provide financial accounting information about a group of companies that recognizes the companies' economic interdependence.

8. Transactions among the members of a corporate family are not included on consolidated financial statements; only assets, liabilities, revenues, and expenses generated with external third parties are shown.

9. Foreign subsidiaries of a multinational firm normally keep their accounting records and prepare their financial statements in the currency of the country in which they are located. When the multinational prepares its consolidated accounts, these financial statements must be translated into the currency of its home country.

10. Under the current rate translation method, the exchange rate at the balance sheet date is used to translate the financial statements of a foreign subsidiary into the home currency. This has the drawback of being incompatible with the historic cost principle.

11. Under the temporal method, assets valued in a foreign currency are translated into the home currency using the exchange rate that existed when the assets were purchased. A problem with this approach is that the multinational's balance sheet may not balance.

12. In most international businesses, the annual budget is the main instrument by which headquarters controls foreign subsidiaries. Throughout the year, headquarters compares a subsidiary's performance against the financial goals incorporated in its budget, intervening selectively in its operations when shortfalls occur.

13. Most international businesses require all budgets and performance data within the firm to be expressed in the corporate currency. This enhances comparability, but it distorts the control process if the relevant exchange rates change between the time a foreign subsidiary's budget is set and the time its performance is evaluated.

14. According to the Lessard - Lorange model, the best way to deal with this problem is to use a projected spot exchange rate to translate both budget figures and performance figures into the corporate currency.

15. Transfer prices also can introduce significant distortions into the control process and thus must be considered when setting budgets and evaluating a subsidiary's performance.

16. Foreign subsidiaries do not operate in uniform environments, and some environments are much tougher than others. Accordingly, it has been suggested that the evaluation of a subsidiary should be kept separate from the evaluation of the subsidiary manager.

Critical Discussion Questions

1. Why do the accounting systems of different countries differ? Why do these differences matter? 

2. Why are transactions among members of a corporate family not included in consolidated financial statements? 

3. The following are selected amounts from the separate financial statements of a parent company (unconsolidated) and one of its subsidiaries 

   		Parent		Subsidiary
   Cash		$180		$80
   Receivables		380		200
   Accounts payable		245		110
   Retained earnings		790		680
   Revenues		4,980		3520
   Rent Income		0		200
   Dividend income		250		0
   Expenses		4160		2960
   Notes: Parent owes subsidiary $70. Parent owns 100 percent of subsidiary. During the year subsidiary paid parent a dividend of $250. Subsidiary owns the building that parent rents for $200. During the year parent sold some inventory to subsidiary for $2,200. It had cost parent $1,500. Subsidiary, sold the inventory to an unrelated party for $3,200.

4. Given this,

1. What is the parent's (unconsolidated) net income?

2. What is the subsidiary's net income?

3. What is the consolidated profit on the inventory that the parent originally sold to the subsidiary?

4. What are the amounts of consolidated cash and receivables?

1. Why might an accounting-based control system provide headquarters management with biased information about the performance of a foreign subsidiary? How can these biases best be corrected?

Closing Case China's Evolving Accounting System

Attracted by its rapid transformation from a socialist planned economy into a market economy, economic annual growth rates of around 12 percent, and a population in excess of 1.2 billion, Western firms over the past 10 years have favored China as a site for foreign direct investment. Most see China as an emerging economic superpower with an economy that will be as large as that of Japan by 2000 and of the US before 2010 if current growth projections hold true.

The Chinese government sees foreign direct investment as a primary engine of China's economic growth. To encourage such investment, the government has offered generous tax incentives to foreign firms that invest in China, either on their own or in a joint venture with a local enterprise. These tax incentives include a two-year exemption from corporate income tax following an investment, plus a further three years during which taxes are paid at only 50 percent of the standard tax rate. Such incentives when coupled with the promise of China's vast internal market have made the country a prime site for investment by Western firms. However, once established in China, many Western firms find themselves struggling to comply with the complex and often obtuse nature of China's rapidly evolving accounting system.

Accounting in China has traditionally been rooted in information gathering and compliance reporting designed to measure the government's production and tax goals. The Chinese system was based on the old Soviet system, which had little to do with profit or accounting systems created to report financial positions or the results of foreign operations. Although the system is changing rapidly, many problems associated with the old system still remain.

One problem for investors is a severe shortage of accountants, financial managers, and auditors in China, especially those experienced with market economy transactions and international accounting practices. As of 1995, there were only 25,000 accountants in China, far short of the hundreds of thousands that will be needed if China continues on its path toward becoming a market economy. Chinese enterprises, including equity and cooperative joint ventures with foreign firms, must be audited by Chinese accounting firms, which are regulated by the state. Traditionally, many experienced auditors have audited only state-owned enterprises, working through the local province or city authorities and the state audit bureau to report to the government entity overseeing the audited firm. In response to the shortage of accountants schooled in the principles of private sector accounting, several large international auditing firms have established joint ventures with emerging Chinese accounting and auditing firms to bridge the growing need for international accounting, tax, and securities expertise.

A further problem concerns the somewhat halting evolution of China's emerging accounting standards. Current thinking is that China won't simply adopt the international accounting standards specified by the IASC, nor will it use the generally accepted accounting principles of any particular country as its model. Rather, accounting standards in China are expected to evolve in a rather piecemeal fashion, with the Chinese adopting a few standards as they are studied and deemed appropriate for Chinese circumstances.