Case in point: Enron
(Audited by Arthur Andersen)
Stocks
Bonds
Intermediary
Company
Enron
Cash
Dr. Cash
Cr. Stockholders
Equity
- Enron books no loans
- Enron incurs no losses
on too much debt
interest expense
- Enrons debt:equity ratio
improves
Dr. Long-term investment
Cr. Bonds payable
- Intermediary company
books all loans
Creditor(s)
Cash
Dr. Bonds Receivable
Cr. Cash
- Creditors are glad to
loan for interest income
Is this legal? Yes.
Is this ethical? No.
-
Upon discovery of this anomalous arrangement, Arthur Andersen was forced to
close down.
Enron eventually could not shoulder its debt losses
Environmental Influences on Accounting Practices
Other external users
1. Creditors
2. Institutional investors
3. Noninstitutional investors
4. Securities exchange
Enterprise users
1. Management
2. Employees
3. Supervisors
4. Board of directors
*The importance of any of these
environmental influences on
accounting practices varies by
country.
Accounting profession
1. Nature and extent of
profession
2. Professional associations
3. Auditing
Nature of the enterprise
1. Form of business
organization
2. Operating characteristics
Characteristics of the
local environment
1. Rate of economic growth
2. Inflation rate
3. Public versus private
ownership and control
of the economy
4. Cultural attitudes
Development
of accounting
objectives,
standards, and
practices
(GAAP)
International influences
1. Colonial history
2. Foreign investors
3. International committees
4. Regional cooperation
5. Regional capital markets
Government
1. User and tax planners
2. Regulators
Academic influences
1. Educational infrastructure
2. Basic and applied research
3. Academic associations
Cultural Differences in Measurement and Disclosure for Accounting Systems
SECRECY
LESS DEVELOPED
LATIN
GERMANIC
NEAR
EASTERN
D
I
S
C
L
O
S
U
R
E
LESS
DEVELOPED
ASIAN
JAPAN
MORE
DEVELOPED
LATIN
AFRICAN
T
O
ASIAN
COLONIAL
P
U
B
L
I
C
NORDIC
ANGLOSAXON
TRANSPARENCY
OPTIMISM
CONSERVATISM
CAUTION IN ASSESSMENT
Classification of Accounting Systems of Developed Western Countries
CLASS
SUBCLASS
FAMILY
Government,
economics
SPECIES
Sweden
Japan
Law-based
Macro-uniform
Germany
Continental:
government,
tax, legal
Spain
Belgium
Tax-based
France
Italy
Developed
Western
Countries
Pragmatic
business
practices,
British origin
United
Statesinfluenced
United States
Ireland
United
Kingdominfluenced
Micro-based
Canada
United Kingdom
New Zealand
Australia
Business,
economics
theory
Netherlands
Selection of Translation Method
Functional
Currency
(of the primary economic environment
not necessarily parents home currency)
Local
currency
Reporting
currency of
parent
Current-rate
method
Temporal
method
Use current or average rates
Use historical rates
Summary Table:
Foreign Currency Translation
Method of Translation
CURRENT-RATE
TEMPORAL
Functional Currency
Local Operating Entity
Parent Companys Home
Monetary Assets
Inventory
Fixed Assets: Property,
Plant & Equipment
Current exchange rate
Current exchange rate
Current exchange rate
Current exchange rate
Historical exchange rate
Historical exchange rate
Monetary Liabilities
Current exchange rate
Current exchange rate
Capital Stock
Retained Earnings
Historical exchange rate
N/A (various)
Historical exchange rate
N/A (various)
Revenues
Cost of Sales
Depreciation Expense
Other expenses, Taxes
Average exchange rate
Average exchange rate
Average exchange rate
Average exchange rate
Average exchange rate
Historical exchange rate
Historical exchange rate
Average exchange rate
(spot exchange rate)
* Accumulated translation
adjustment will balance
the balance sheet
(a gain or loss arises
because the inventory and
fixed assets are not
matched with the cost of
sales and depreciation.
Summary Table
Taxation
FORM OF BUSINESS
TAXATION ON INCOME
1. Export of goods and services:
Foreign Sales Corporation (FSC)
Foreign management; foreign
corporation; foreign sales
A portion of its income is exempt from
U.S. corporate income tax; dividends to
parent are exempt up to 15% of export
earnings as long as it is foreign trade
income (contested by the WTO as
requested by the EU)
2. Foreign Branch extension of parent
company; not an independent legal entity
Any income is taxable to the parent;
any loss is deductible from its (parents)
taxable income
3. Foreign Subsidiary independent
legal entity incorporated in another
country
ACTIVE
PASSIVE
Direct conduct of
trade
Other than direct
conduct of business
ex. Sales
a) Controlled Foreign Corporation
(CFC) more than 50% of voting
stock is held by U.S.
shareholders (each owning 10%
or more of voting stock)
b) Joint-Venture Company (JVC)
does not own more than 50% of
stock or U.S. shareholders
(those owning each 10% or more
of voting stock dont)
Income not
remitted as a
dividend to the
parent company is
not yet taxed (tax
deferred)
ex. Holding company
income such as
dividends, interest,
rent, royalties, stock
sale gains; income
from services to
affiliates in other
countries or sales to
affiliates abroad
Cannot be
deferred;
immediately
taxable (Subpart F
Income)
All income can be deferred, as long as it
is not remitted to the parent company;
not immediately taxable (tax deferred)
Exceptions:
1) If income is lower of $1MM or 5% of gross
income, none of it is treated as passive.
[Tax is deferred.]
2) If income is 70% of total gross income, all
of gross income is treated as Subpart F
Income, or immediately taxable.
4. Tax-Haven Subsidiary in low tax
country investment company, sales
agent or distributor, licensing agent,
holding company over other countries
(with grandchild subsidiaries)
3) If subject to high tax rates (> 90% of max.
U.S. corporate income tax rate of 35%
[=31.5%], not considered as passive; can be
deferred.
A Tax-Haven Subsidiary as a Holding Company
*A parent company can shelter income
from U.S. income taxation
by using a tax-haven subsidiary
located in a low-tax country:
examples:
Bahamas
Netherlands Antilles
Panama
Switzerland
Parent Company
in the United
States
Tax-Haven Subsidiary
Grandchild
Subsidiary
Grandchild
Subsidiary
Grandchild
Subsidiary
TRANSFER PRICES
Example:
- High currency-control subsidiary will receive high prices to pay more hard
currency out for imports from the parent; it will also set low prices to the parent
on its sales to the parent, in order not to bring in too much hard currency into the
country.
Summary Table
Pay high prices
Charge low prices
Transfer profits out of
country
Pay low prices
Charge high prices
Keep profits in the
country
TAXES
High-tax
(subsidiary)
Low-tax
(subsidiary)
CURRENCY
CONTROLS
High currency controls
Low currency controls
COMPETITION
Low level of competition
(high costs mean high
sales prices)
High level of competition
(low costs mean low
sales prices)
