Upjohn Company is a U.S.-based pharmaceutical firm with extensive global operations. It must comply with U.S.

tax laws and tax laws of each country in which it does business. International taxation has dramatic impacts on management decisions, such as were a company should invest; what form of business organization is used; what products are produced where; how prices and transfer prices are set; which currency should be used to denominate transactions; and what financing should be used. A firm must have professional expertise on its staff or available to review its tax status and the impacts that changes in tax treaties, agreements, laws, and regulations will have. Government and taxpayers are equally aware of tax minimization strategies. Tax laws in each country reduce the management accountants flexibility. Even if we assume that they have a desire to be inherently fair, governments want to generate revenue, plug tax and cash-flow loopholes, get at least their share of tax revenues, promote specific types of economic growth, and perhaps build in subtle bases in favor of domestic firms. The European Community (EC), General Agreement on Tariffs and Trade (GATT), North America Free Trade Agreement (NAFTA), and other bilateral and multilateral agreements have as their main themes encouraging free trade. While free means loosening many barriers, reducing or eliminating import duties and other cross-border taxes and fees is of major importance. Avoidance of Financial Restrictions Foreign governments often place financial restrictions on international subsidiaries operating within their boundaries. Government restrictions are placed on the amount of cash that may leave the country and for management fees charged by the parent company. Thus, moving profits and, therefore, stuck cash by high transfer prices can reduce those restricted profits and increase firm-wide liquidity and financial mobility. Gaining Host Country Approval Governments are not nave. They are becoming sophisticated and aware of the results of using high or low transfer prices. Prices are compared to arms-length sales price elsewhere. Products are analyzed for content. Price controls may be based on the transferred-in cost. For example, price increases may be limited by government regulators to cost increases. In the long run, companies find that transfer pricing policies which satisfy foreign authorities may be in the best interest of the company when compared to the greater profits that might be sacrificed. A foreign governments requirements about domestic ownership, percentage of locally produced content, and approval for government sales can be significant factors in determining how an international market is entered and how a company will operate there. ACCOUNTING FOR TRANSACTIONS IN FOREIGN CURRENCY The management accountant must facilitate business activity wherever it occurs. Therefore, a basic understanding of currency trading and exchange is expected. Global business basically means buying and selling goods and services across national borders. For example, a manufacturer of computer-aided design

equipment may expand its market by selling to foreign customers. Or it might try to lower its costs by buying memory chips from ales expensive source in another country. These transactions are commonly denominated in the currency of the country in which the transaction takes place. Thus, an international transaction typically involves two currencies. The values of currencies rise and fall daily in each relation to each other. An international transaction itself may earn a profit. But, because the foreign currency exchange rates change, a risk of loss exists. Foreign currency exchange rates are quoted in both currencies, such as 100 Japanese yen per one U.S. dollar (100 = $1) or one hundredth U.S. dollar to one yen ($0.01 = 1). On U.S. exchanges, the latter expression is more common. A sample of currency rates as of a specific date for several years is shown in Figure 16.1. Notice the significant changes for Britain, China, and particularly Mexico between 1994 and 1995. Of note is the fact that the March 1993 date comes three days after the bombing of the World Trade Center in New York City, a disruptive event for foreign exchange markets. A foreign currency transaction is one in which settlement is in the currency of another country. A transaction with a foreign company that is settled in a domestic currency is an international transaction but not a foreign currency transaction. The more common foreign currency transactions are: 1. Importing (buying) or exporting (selling) goods or services on credit with the amount to be paid or received denominated in a foreign currency. 2. Borrowing from or lending to a foreign company with the amount to be paid or received denominated in a foreign currency. A third transaction type commonly undertaken to reduce foreign exchange risk is: 3. Hedging operations. These types of transactions create a payable or receivable with time elapsing before cash changes hands to complete the deal. This time interval creates the opportunity for exchange gain or loss from foreign currency transactions. FIGURE 16.1 Sample of Foreign Exchange Rates as of the First Monday of March

U.S. Dollar Equivalent Country Currency March 1992 March 1993 March 1994 Australia . . . . . . . . . . . . . . . . . Dollar $ 0.7533 $ 0.7045 $ 0.7130 Britain . . . . . . . . . . . . . . . . . . . . Pound 1.7530 1.4380 1.4896 Canada . . . . . . . . . . . . . . . . . . . Dollar 0.8430 0.8009 0.7403 Chile . . . . . . . . . . . . . . . . . . . . . . Peso 0.0030 0.0026 0.0024 China (PRC) . . . . . . . . . . . . . . Yuan 0.1830 0.1712 0.1149 Germany . . . . . . . . . . . . . . . . . Mark 0.6086 0.6040 0.5855 Hungary . . . . . . . . . . . . . . . . . . Forint 0.0130 0.0117 0.0097 India . . . . . . . . . . . . . . . . . . . . . Rupee 0.0390 0.0305 0.0322 Israel . . . . . . . . . . . . . . . . . . . . . Shekel 0.4225 0.3662 0.3339 Japan . . . . . . . . . . . . . . . . . . . . . Yen 0.0077 0.0084 0.0096 Mexico . . . . . . . . . . . . . . . . . . . . Peso 0.3270 0.3237 0.3145 Saudi Arabia . . . . . . . . . . . . . Riyal 0.2674 0.2670 0.2670 Singapore . . . . . . . . . . . . . . . . Dollar 0.6088 0.6078 0.6317 Sweden . . . . . . . . . . . . . . . . . . Krona 0.1679 0.1281 0.1248 Thailand . . . . . . . . . . . . . . . . . . Baht 0.0392 0.0393 0.0395 Source: Wall Street Journal, March 2, 1992; March 3, 1993; March 2, 1994; March 2, 1995.

March 1995 $ 0.7367 1.6275 0.7113 0.0024 0.1186 0.7005 0.0090 0.0316 0.3376 0.0106 0.1586 0.2666 0.6920 0.1376 0.0403

Importing or Exporting Goods or Services The most common form of foreign currency transaction is importing or exporting goods or services. Lets look at the financial impacts of these transactions. Foreign Exchange Purchases. When a domestic company purchases goods or services abroad, it pays either in its own currency or in the foreign currency. If both billings and payments are in the domestic currency, no foreign exchange accounting problem exists. A normal payable and a cash payment are recorded. Assume that our U.S. company buys memory chips from a Japanese company in yen at a cost of 20,000,000 when the exchange rate is $0.0100 per yen, or $200,000. Our accounting records would reflect the purchase as follows: Accounts Payable, Japanese Company $200,000 If the exchange exchange $210,000 Purchases $200,000

Japanese company bills our U.S. company in yen and requests payment in yen, the U.S. company incurs an gain or loss if the exchange rate changes between the dates of purchase and payment. Assume that the yen rate moves from $0.0100 to $0.0105 at the settlement, or payment, date. At the payment date, we spend to buy 20,000,000 (20,000,000 $0.0105). The payment is recorded as follows: Cash (20,000,000 $0.0105) $210,000 Accounts Payable, Japanese Company $200,000 $200,000

Exchange Loss $ 10,000 Here, the U.S. company incurred an exchange loss of $10,000 because it agreed to pay 20,000,000; and, between the dates of purchase and payment, the exchange value of the yen relative to the dollar increased. More dollars were required to buy the same number of yen. Foreign Exchange Sales. Sales are the opposite of purchases. Although the same rationale applies to sales, exchange gains or losses are reserved. If the billing and subsequent payment are made in U.S. dollars, no exchange accounting problems arise. Assume that our U.S. company sells computer products to a German company in marks for DM1,000,000. If the exchange rate is $0.60 per mark, we record a sale of $600,000 as follows: Sales $600,000 Accounts Receivable, German Company $600,000

Using German marks (DM) for the transaction, the U.S. company will incur an exchange gain or loss if the exchange rates change between the dates of billing and settlement. Assume that the exchange rate on the settlement date is $0.61, changed from the $0.60 per mark rate. The sale is still recorded as

$600,000 and represents DM1,000,000 of revenue. On the settlement, or collection, date, we receive DM1,000,000. But, the marks are now worth $610,000 (DM1,000,000 $0.61). The transaction is recorded as follows: Accounts Receivable, German Company $600,000 $600,000 Cash $610,000 (DM1,000,000 $0.61) Exchange Loss $ 10,000 The U.S. company incurred an exchange gain of $10,000 because it agreed to receive DM1,000,000 and the exchange rates changed between the billing and collection dates. In this case, the German marks convert into more dollars at the collection date. Dates of Concern to Accountants. Because exchange gains and losses occur and must be reported properly, three dates concern accountants. The dates and the proper exchange rates used in translating foreign currencies are as follows: 1. Transaction date: Each asset, liability, revenue, expense, gain, or loss arising from the transaction is measured and recorded in the domestic currency at the current foreign exchange rate. 2. Balance sheet date: Balances that are denominated in a foreign currency are adjusted to reflect the exchange rate at any interim balance sheet date. This date is important to apportion the gains and losses to the proper reporting period. This is a requirement of current financial accounting reporting under SFAS 52. 3. Settlement date: In the case of a foreign currency payable, a domestic company must convert the domestic currency into foreign currency units to settle the accounts payable. For an accounts receivable in which foreign currency is received, the foreign currency must be converted to domestic currency. To illustrate the impacts of these dates, assume that in 1998 our U.S. company sold computer products to a French company for Fr500,000 when the franc exchange rate was $0.18. The billing to the French company was for Fr500,000. The spot rate, the rate of exchange between two currencies that are being bought and sold for immediate delivery, for francs at three dates is as follows: Transaction date (December 1) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Balance sheet date (December 31) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Settlement date (March 1) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 0.180 0.165 0.170

1. On December 1, the U.S. company records a sale and accounts receivable at the domestic equivalent of $90,000 (Fr500,000 $0.180). 2. On the balance sheet, December 31, the receivable denominated in foreign currency is adjusted using the exchange rate in effect at the balance sheet date. The receivable is $82,500 (Fr500,000 $0.165). The foreign exchange loss is as follows:

Initial receivable recorded (December 1) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Value of receivable at yearend (December 31) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Foreign exchange loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 90,000 82,500 $ 7,500

We record the receivable decrease and an exchange loss of $7,500 in 1998. 3. On the settlement date, March 1, 1999, the U.S. company receives Fr500,000 and must convert them into U.S. currency. With a conversion rate of $0.170, the U.S. company receives $85,000 (Fr500,000 $0.170). The foreign exchange gain is as follows: Value of francs received at settlement date (March 1). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Value of receivable at yearend (December 31) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Foreign exchange gain . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 85,200 82,500 $ 2,500

The receivable is collected, and a 1999 exchange gain of $2,500 is recognized. For the total transaction, the company realizes a net exchange loss of $5,000 ($90,000 - $85,000). When a balance sheet date comes between the transaction and settlement dates, U.S. accounting rules require companies to identify exchange gains and losses with the proper time interval. Borrowing or Lending Accounting for borrowing or lending in foreign currencies follows the same approach as for trade payables and receivables. Any cash flow, asset acquired, or revenue earned is accounted for independent of the loan receivable or note payable. For example, if machining equipment is purchased from a foreign company using long-term credit, the cost of the asset is recorded at the acquisition date using the spot rate at the transaction date. The machines cost is not adjusted for subsequent changes in the exchange rate, but the liability is adjusted at each balance sheet date using the spot exchange rate on that date. Any currency adjustment creates a foreign exchange gain or loss on the income statement. The interest expense recorded is the translation of the foreign currency needed to pay interest expense for the time interval. If a loan receivable is involved instead of a liability, a periodic adjustment is made to the receivable account. This accounting treatment suggests that companies need to develop policies covering borrowings and lendings (investments) internationally. Judgments about how currencies will move relative to each other are speculative at best. Over time, a strong currency may weaken; or a weak currency may strengthen. International economics, global politics, and the economic health of any particular country relative to the others influence the value of currencies. Hedging As we have seen, a domestic firm doing business with companies in other countries and engaging in foreign currency transactions faces an exchange risk.

To minimize this exchange risk, companies use hedging. Hedging, in its broadest sense, is any transaction with the specific purpose of offsetting loses or locking gains from transactions already under contract. In this case, the gains and losses are due to foreign currency exchange rate changes. The hedging transaction dates usually match the dates of the transaction to be hedged. Hedges can occur in a number of ways. Perhaps the most common hedge is a forward exchange contract (forward contract). It is an agreement to exchange currencies of two different countries at a specified rate (the forward rate) on a stipulated future date. A forward rate is the rate of exchange between two currencies being bought or sold for delivery at a future date. A forward contract can be written for a specific amount. Other hedges commonly used internationally are buy or sell options or currency swap contact in futures markets. Brokers deal in contracts with standard terms and notional amounts to facilitate buying and selling. In most developed countries, futures markets exist for commodities, interest rates, and currencies. The variety of financial instruments and contracts is growing dramatically. Two simple examples using forward contracts follow. Hedge for a Foreign Currency Exposed Liability. In a foreign purchase transaction where settlement occurs on a future date, a liability is created on the transaction date. If the transaction is denominated in a foreign currency, we crate an exposed liability. To illustrate the accounting necessary for a forward exchange contract to hedge an exposed liability position, the same data from the foreign purchases section presented earlier are used. The assumptions are: 1. Memory chips were purchased for 20,000,000 payable in yen. 2. Exchange rates: Transaction date: Spot rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Forward rate (60 days) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Settlement date spot rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3. The transaction is denominated in yen.

$ 0.0100 $ 0.0101 $ 0.0105

The U.S. company made a purchase on credit. The exchange rate for this transaction is the spot rate on the purchase date. The liability will be settled in 60 days in yen. The company could do nothing and assumes the risk of a foreign exchange loss. The company could immediately purchase yen at a cost of $200,000, but this ties up cash for 60 days. The treasurer could also go into the foreign currency market and purchase a 60-day forward contract to buy 20,000,000 at $0.0101. The forward rate differs from the spot rate because of differences in the relative market rates between the two countries, not because the foreign currency is expected to strengthen or weaken over the next 60 days. A completed hedging transaction consists of two parts: (1) a premium or discount paid which is the difference between the spot rate and the forward rate on the transaction date; and (2) an exchange gain or loss which is the difference between the spot rates on the transaction and settlement dates. For our illustration, assume that U.S. company entered into a forward contract to buy 20,000,000 on the settlement date for $0.0101. The hedging transaction is treated separately from the actual memory chip purchase. (See the purchase entry made earlier.) Recording all elements of a hedging transaction is straightforward but includes several accounts with which managers are not usually familiar. Therefore, we will deal only with the calculations