Importance of Cost Accounting

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Cost Accounting 1

Running head: FUNDAMENTALS OF COST ACCOUNTING

Importance of Cost Accounting

April 17, 2014

Abstract

When organizations opt to branch out into international markets there is an added risk with currency fluctuations. The strategies that financial managers undertake to manage and minimize the impact of exchange rates particularly that of translation exposure will be the focus of this paper. Years ago managing this information was simple. Business firms operated for the most part in the country in which they resided and transacted most if not all of their business in their home currency. However, over the years as enterprise has become more global in nature the job of the financial manager has become quite complex. Every approach requires careful attention to marketing, risk, matters of control and management.

Introduction

Finance seeks to address and study how organizations raise, allocate, and use monetary resources over time. It also considers the risk the organization may take when adopting different projects or strategies. Thus, financial managers apply a diverse set of techniques that can be used to determine the risk of investment and help manage organizational funds (Keown et al... 2005).

An additional aspect of risk that global organizations must consider is that of currency exchange rates. As these tend to fluctuate daily for the larger economies, financial managers of large global organizations must be keen to what these currency changes are and how they could influence financial results.

The impact of currency exchange on financial results is not restricted to the organizations current income statement. True multinational organizations also experience devaluations and appreciation in assets and liabilities because of exchange rate fluctuations. Nonetheless, despite the implications that exchange rate risk pose to organizations, firms are motivated by the risk-return trade-off that is associated with doing business globally (Keown et al… 2005).

Millions of U.S. goods are link to trade, both in manufactured goods and in services. Linked to that is a vast inflow of foreign capital, attracted to the relative stability of the U.S. Free trade also implies free movement of capital, something that the American economy has been strong in attracting. While free trade played an important role in developing the U.S. economy, it has also played a significant role in the development of the European Union and much of Asia and helped open up Central and Eastern Europe in the aftermath of the Cold War.

The U.S. dominated many export markets for much of the postwar period - a result of its inherent economic strengths, the fact that its industrial machine was untouched by war, and American advances in technology and manufacturing techniques. By the 1970s, though, the gap between the U.S. and other countries' export competitiveness was narrowing. What's more, oil price shocks, worldwide recession, and increases in the foreign exchange value of the dollar all combined during the 1970s to hurt the U.S. trade balance. U.S. trade deficits grew larger still in the 1980s and 1990s as the American appetite for foreign goods consistently outstripped demand for American goods in other countries (Anonymous, n.d.). This reflected both the tendency of Americans to consume more and save less than people in Europe and Japan and the fact that the American economy was growing much faster during this period than Europe or economically troubled Japan. The dollar is the primary entity of account in global trade. Because U.S. has a large share in the global trade, also third-country trades are priced in U.S. dollars. Importantly, the dollar’s role in global trade will continue to be supported by its dominance as the currency in which most internationally traded commodities are priced. U.S. dollar is also used for international loans and debt securities. Third, the dollar is the most liquid currency by far: According to Bank for International Settlements data, 86% of total foreign exchange turnover during 2007 involved the US dollar. The US Treasury market is the deepest, most homogenous and most liquid in the world, including for shorter-term maturities, which tend to be preferred by foreign exchange reserve managers. In contrast, while European bond markets are almost as liquid and sophisticated as U.S. ones, they are fragmented among 16 member countries, which have different degrees of creditworthiness. The bottom line of this discussion is that the dollar retains a clear lead as the currency of choice in global trade and finance. This, in turn, means that it’s in the interest of central banks to continue to hold a large portion of their foreign exchange reserves in US dollars, given that a large share of their countries’ external obligations is denominated in dollars (Alexandraki, 2009).

The loss of capital inflows would affect U.S. interest rates, domestic investments, and the long-term rate of growth of the economy. The Federal Reserve would have to raise interest rates to attract more capital inflows but raising the interest rate too high could bring on a recession.

U.S. imports, I believe from other countries because the Goods or Services that satisfy domestic needs or wants can be produced more inexpensively or efficiently by other countries and therefore sold at lower prices. The U.S. imports more than they export so there is a deficit to cover the full cost of imports.

The rise in the value of U.S. equities held by foreign investors would increase U.S. gross liabilities and consequently reduce the country’s net investment position, since the change in gross liabilities largely offsets the change in gross assets (Bartolini, Labiri, 2006). According to the U.S. Treasury:

China’s U.S. equity portfolio holdings increased from $1.4 billion in 2000 to $4 billion in 2006, and subsequently swelled to $93 billion in early 2010. The Treasury data capture purchases of U.S. equities by country of origin, not by the nationality of the ultimate purchaser, but the trend is clear, with portfolio investments and mergers-and-acquisitions transactions pointing in the same direction. According to Dealogic, a provider of financial data, Chinese acquisitions of equity stakes in U.S. companies reached $3.9 billion in 2009, climbing past the minimal levels seen a few years ago. And in 2009, Chinese acquisitions of U.S. equity stakes surpassed U.S. acquisitions of Chinese equity stakes for the first time (de Swaan, 2010).

The best solution, from a rights perspective, is total and immediate free trade, regardless of the consequences. This solution is the only one that does not violate the right to contract and property. It also policy that is in keeping with the “servant” theory of government, the view that government should be the servant of the people, the protector of life, liberty and property – and not redistributors of wealth. Total and immediate free trade would also cause resources to reallocate to uses that are more productive faster, whereas a gradualist approach would retard this shifting of resources.

The international mobility of capital and the internationalization of firms’ investor base are creating pressures for accounting standards to be harmonized internationally. Investors and firms need accurate and easily comparable financial information. For investors, comparable information is necessary so that they do not have to incur the cost of familiarizing themselves with financial reporting standards used in other countries or of translating financial results from one set of standards to another in order to make them comparable (Radebaugh, et al…2006). European Union (EU) was the first to adopt the IFRS. EU wanted to make sure that their accounting standards could not be compared to those of the US GAAP by making IFRS its official accounting standards, the EU provided a clear and distinct alternative to US GAAP for international firms and investors. I do not think that EU undermined the IASB because IASB goal is to make convergence international. EU set the pace of global convergence on IFRS but I do not think it has any control over how these standards would be set just the laws in their own countries.

Financial Reporting

Reporting requirements of a MNC

By definition Multinational Corporations, (MNC) operate in a variety of different countries and thus run daily operations in a multitude of currencies. Financial results from operation recorded and maintained in compliance with local fiscal policy for each location or country of operation. Record keeping in the foreign subsidiary requirement to be done in local currency and must meet local Generally Accepted Accounting Principles, (GAAP) for tax and regulatory purposes in the host countries.

In accordance with U.S. GAAP, regulation U.S. corporations must present financial results in U.S. dollars. This requires that each subsidiary overseas formalize their results or general ledger (GL) balances up to the U.S. corporate office. The corporate office will subsequently convert all the overseas account balances into dollar denominated amounts. Once this is complete then the results for each GL balance will be combining for one unified corporate total. The process of converting the subsidiary’s financial results into U.S. denominated results called translation. A name well suited for the function because in essence the organization is literally ‘translating’ the foreign denominated results into a single currency. For U.S. corporations this is of course the dollar. It is during this translation of currency that exchange rates affect the financial results of an organization. The variance that occurs because of translation is referring to as translation exposure (Keown, 2005).

Reference:

Alexandraki, K. (2009). Challenging the US Dollar’s Reserve Currency Status. Alliance Bernstein. Retrieved from http://www.bernstein.com/CmsObjectPC/pdfs/64337_USDollarsReserve.pdf

Anonymous (n.d.). An Introduction to Foreign Trade. U.S. Department of State. Retrieved from http://economics.about.com/od/foreigntrade/a/foreign_trade.htm

Bartolini, L. & Labiri, A. (2006). Twin Deficits, Twenty Years Later. Current Issues in Economics and Finance (12), 7.

de Swaan, J.C. (2010). China Goes to Wall Street. Council on Foreign Relations. Retrieved from http://www.foreignaffairs.com/articles/66398/jc-de-swaan/china-goes-to-wall-street

Radebaugh, L. H., Gray, S. J., & Black, E. L. (2006). International accounting and multinational enterprises (6th ed.). Hoboken, NJ: John Wiley & Sons

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