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Multinational Budgeting and Control Systems Fall, 2006 Multinational Budgeting and Control Systems Planning and control are not new... domestic corporations have been doing them for years. However, the development of comprehensive MNC international planning and control systems with long- range strategic focus is new. Examples of Variables Calling for Specialized Knowledge Foreign currency exchange risks, Restrictions on fund remittances across national borders, Diverse national tax laws, Interest rate differentials between various national financial markets, The global shortage of money capital, The effects of worldwide inflation on enterprise assets, earnings, and capital costs A direct response to such environmental complexities is the emergence of the international financial management function. Managerial Accounting Managerial accounting issues may be divided into two broad areas: (1) financial planning and (2) financial control These may be broken into specific subtopics, including strategic planning foreign investment analysis (capital budgeting) foreign exchange risk management management information systems and control profitability analysis performance evaluation of foreign operations Strategic Planning As a process, strategic planning involves four critical dimensions: 1) Identifying key factors relevant to the future progress of the company 2) Formulating appropriate techniques to forecast future development states and assessing the company's ability to adapt to or exploit such future developments 3) Developing data sources to support strategic choices, and 4) Translating selected options into specific courses of action. Complexities in Developing Global Business Strategies Planning in the international arena can be more complex than in the domestic arena. The international environment may be more susceptible to change than the domestic environment, and this could severely complicate business planning, particularly long-range planning. This makes planning even more critical in the international environment. Variables Important in Global Planning Economic and legal environments differ from country to country. Each country has its own business regulatory framework, tax system, financial reporting requirements, inflation rates, and currency with fluctuation exchange rates. Political environments are different worldwide. Often the political system has a direct impact on the business operations. Lack of political stability increases the political risk for foreign-based enterprises, as does the abrupt change in governmental policies in countries that do not have a long-standing tradition of free market economy. Variables Important in Global Planning Labor considerations are different for each country. Labor laws may have an impact on the ability of a multinational company to hire and terminate workers. Labor productivity and the availability of skilled workforce vary in different parts of the world. Language and cultural differences may create problems in communication strategies and plans. Some cultures make the acceptance of planning difficult because of a cultural sense of fatalism regarding the future. The degree of reliance on trust and on long- standing traditions also varies among cultures. Formulating International Business Strategies MNCs must answer questions such as: In which countries should the company expand or curtail its operations? What should be the scope of operations in a new country? Should it be a sales operation? A manufacturing operation? Or both? Should the entry in a new country be in the form of a joint venture or should it be as a wholly-owned subsidiary? Added Risk The strategic planning process of a multinational corporation takes into account the external as well as the internal environmental factors of a company. Prediction of external environmental factors is difficult even within the boundaries of one nation. The task is inherently more complex when many countries are involved. Geographical Distance and Planning Horizon Most foreign affiliates of MNCs are farther removed geographically from central headquarters than the domestic companies and affiliates are; This can also present problems for the budgeting process. The time required for approval of the budget may need to be lengthened, and great uncertainty or instability in some nations may necessitate that a high priority be given to reducing the time horizon for planning. A great distance between the operating units of a MNC may lead to severe problems and complication in communication and logistics, as there may be increased transportation costs, longer delivery times, and a greater frequency of delays in the intracompany movement of materials and other goods. Frequency of Revision Uncertainty in the international environment usually means that the budgets of foreign divisions need to be evaluated and revised more frequently than do those of domestic division. Planning requires, traditionally, a stable basis on which to build assumptions and forecasts. Where such a stable basis does not exist, the planner must look for other means of locating the company's position and of setting the course for the future. Management Quality and Subsidiary Sophistication A potential problem facing the multinational corporation is the quality of management at the foreign affiliate. Some companies use foreign nationals to staff the top management positions in foreign subsidiaries. Many countries discourage the use of foreign expatriates, and some have passed laws restricting them. Even if the foreign nationals are fully versed in the customs and language of the local country, there may still be problems in communication and differences in management practices, and directives may be misunderstood. Management Quality and Subsidiary Sophistication There may be important differences among nationalities in: the attitudes toward risk; relation to government; delegation of authority; disclosure of information and ideas; acceptance of criticism and authority; openness in discussing business problems; and methods of dealing with lending institutions, suppliers, and various service organizations. Management Quality and Subsidiary Sophistication These differences must be considered when developing the management control system. No control system is going to be of any benefit to a company if it cannot be comprehended and accepted by the people to whom the budget pertains. It is unreasonable to expect that all subsidiaries will maintain homogeneous technology and functional skills, or will operate in local markets and operating environments of the same relative sophistication. Other Environmental Factors Environmental factors can affect the MNCs control system. Government regulations and restrictions on the movement of goods and personnel across national boundaries can complicate the planning and control process. Foreign Investment Analysis The decision to invest abroad is a principal means of implementing the global strategy of a multinational company. Direct investment beyond national boundaries, however, typically involves an enterprise in a commitment of enormous sums of capital to an uncertain future. Risk is compounded by an unfamiliar international environment that is distant and complex and in a constant state of change. Foreign Investment Analysis The capital budgeting framework compares the benefits and costs of any contemplated activity. While capital expenditures of sufficient size normally constitute part of a firm's strategic plans, capital budgeting analysis helps to ensure that the implementation of strategic plans is financially feasible and desirable. Foreign Investment Analysis The following all introduce a degree of complexity not usually found under more homogeneous and stable domestic conditions. Different tax laws and accounting measurement rules, differential rates of inflation, risks of expropriation , exchange controls, fluctuating exchange rates, restrictions on the transferability of foreign earnings, language and intercultural differences Because of these complications, modification of traditional investment planning models is necessary. Foreign Investment Analysis Specifically, adaptations have occurred in 3 major areas: 1) determination of the relevant return from a multinational investment 2) measurement of expected cash flows, and 3) calculation of the multinational cost of capital Relevant Return Should the international financial manager evaluate expected investment returns from the perspective of the foreign project or that of the parent company? Returns could differ dramatically because of governmental restrictions on repatriation of earnings and capital license fees, royalties, and other payments that provide income to the parent but are expenses from the project viewpoint differential rates of national inflation changing foreign currency values and differential taxes, to name a few... Relevant Return One might argue that, ultimately, return and risk considerations of a foreign investment should be on behalf of the parent company's stockholders. This is consistent with domestic capital budgeting doctrine, as cash flows to the parent ultimately provide the basis for dividend payments and other uses that support parent company objectives. Relevant Return On the other hand, arguments can be made that such an ethnocentric posture is no longer appropriate. Investors in the parent company are increasingly drawn from a worldwide community, so investment objectives should reflect a more cosmopolitan outlook than before. Funds generated abroad tend to be reinvested there rather than repatriated to the parent, so returns from a host country perspective may be more appropriate. Emphasis on local project returns is consistent with the objective of maximizing consolidated earnings of the group. Relevant Return A dual rate of return calculation would provide a basis for evaluating this component of the capital budgeting process. However, the numbers cannot be looked at without considering the environment. For example: Would the project rate of return calculations really reflect the host country's opportunity costs? Are the expected returns limited to projected cash flows or are there additional social externalities to be considered? Can externalities be measured? Does a foreign investment require any special overhead expenditures by the host country? Measurement of Cash Flows An issue with predicting cash flows is the impact of changing prices and fluctuating currency values on expected foreign currency returns. A parent company is concerned with the parent-currency utility of foreign cash flows. Estimates of future inflation and the relationship between inflation and exchange rates used to convert foreign cash flows to parent currency are needed. Provisions relating to the taxation of foreign source income must also be considered. Multinational Cost of Capital Some factors that can influence the multinational cost of capital that need to be considered: The availability of capital. The availability of capital is assumed in some economies, but it may be an important variable in an international context. Segmented national capital markets. In some markets, required returns of securities of comparable risk and return can differ, which may distort capital costs. Investor demands. Some investors may be willing to pay a premium for shares of an MNC because it can satisfy their international portfolio diversification needs. Multinational Cost of Capital The cost of capital may be adjusted to reflect foreign exchange and political risks International tax considerations may significantly affect the after-tax rate of return Financial disclosure may affect a company's access to international capital markets and consequently, the cost of capital Multinational operations may change a firm's optimal financial structure. Specifically, the added international availability of capital and the ability to diversify cash flows internationally may affect a firm's optimal debt ratio. Foreign Exchange Management Risk Foreign exchange risk refers to the risk of loss due to changes in the international exchange value of national currencies. Fluctuating exchange rates can affect the values of a firm's foreign assets and liabilities, its current profits and future cash flows. Now that foreign currencies of most major industrial nations are relatively free to find their own value levels in the international marketplace, the frequency of exchange rate changes has almost become a daily occurrence, and the magnitude of rate changes is significant. Foreign Exchange Management Risk In view of currency instability, a major objective of financial management is to minimize financial losses. This requires: forecasting exchange rate movements measuring a firm's exposure to the risks of loss caused by currency movements designing strategies to hedge exchange risks assessing performance Foreign Exchange Management Risk Those supporting exchange rate forecasting as a valid risk management tool operate on the premise that decisions makers in the firm have the capability of outperforming the market as a whole when it comes to predicting exchange rate behavior. This is based on the existence of timely and comprehensive information on which to base such predictions. Foreign Exchange Management Risk This information includes changes in the following: Inflation differentials Monetary policy Balance of trade Balance of payments International monetary reserves National budget Forward exchange quotations Unofficial rates Behavior of related currencies Interest rate differentials. Translation Exposure Translation exposure stems from the preparation of consolidated accounts. Foreign currency assets and liabilities that are translated at the current rate are subject to exchange rate risk. Translation exposure is the difference between the relevant assets and liabilities. Translation Exposure A net asset position is called a positive exposure. Devaluation of the foreign currency relative to the domestic currency produces a loss. A net liability position is called a negative exposure, and a devaluation of the foreign currency relative to the domestic currency produces a gain. Hedging activities can minimize the risk. One possibility is to take steps to come up with equal foreign currency assets and liabilities. Transaction Exposure Transaction exposure refers to exchange gains and losses that rise from the settlement of transactions denominated in foreign currencies. Unlike translation gains and losses, transaction gains and losses have a direct effect on cash flows. Again, once the exposure is identified, hedging activities can minimize the risk. One possibility is to hedge purchase commitments with forward contracts. Management Information Systems and Control Once questions of strategy have been decided, attention generally focuses on the areas of financial control and performance evaluation. as effectively and efficiently as possible. This enables financial mangers to: Implement the global financial strategy of the multinational enterprise Evaluate the degree to which the chosen strategies contribute to the attainment of enterprise objectives Motivate management and employees to achieve the financial goals of the enterprise Management Information Systems and Control Goals and objectives often differ among international subsidiaries and thus uniform performance criteria for all subsidiaries would not be appropriate. A foreign subsidiary may be established to manufacture a component for other subsidiaries. Another subsidiary may be formed to take advantage of certain advanced technology in the host country. Yet a third subsidiary may be established to take advantage of tax incentives granted by the local government. Different corporate objectives require different performance evaluation criteria. Foreign Corrupt Practices Act The FCPA is designed to eliminate 2 problems.. --poor internal controls --bribery SEC was astounded at the extent to which corporate executives and employees falsified books and records and circumvented internal control systems to make foreign bribes The SEC response was the FCPA Problems for MNCs Operate in a variety of countries with different business practices and laws Compete with companies from other countries that have different sets of laws and customs Bribes may be paid because the receiver has a strong market position or control over an aspect of the environment that impacts a firm’s operations Sometimes payments are made in countries where this is an accepted business practice, some in countries where such payments are illegal. Sometimes payments are made without the knowledge of headquarters. If a fee is paid to a local agent, it may not known how that fee is then used. A local subsidiary may choose to “play the game.” Nature of Payments The FCPA made it illegal to pay or to offer to pay money or anything of value to a foreign government official to get them to abuse their power to benefit the firm for business purposes. The FCPA excluded “grease payments.” Grease payments Payments to foreign officials with little decision-making authority and if they have little impact on the relations between the US and the local government, assuming the payments are made to expedite trade. Parent may be exonerated if a NON-wholly owned subsidiary engages in payments above the protest of the parent corporation Extortion If a payment is construed as extortion, approval may be granted by the Justice Department in the US US Corporate Reaction 78% felt that the FCPA made it difficult to sell in countries where bribery is a way of life 55% felt that unless the law was tough, small payments would escalate into major payments Penalties Fines of up to $1,000,000 for a company Fines of up to $10,000 and five years in prison for an individual. Only civil, rather than criminal, penalties for negligent or unintentional violators of the law. FCPA A good accounting control system is designed to safeguard corporate assets and to enhance fair presentation of financial accounting information. Firms were falsifying records to disguise improper transactions. Some transactions were not recorded. Two Issues Payment of bribes Recording payment of bribes.
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