Currency boards

A  currency board is a monetary institution that only issues currency to the extent that it is fully
backed by foreign reserves. In other words, a currency board is an extreme form of the fixed
exchange rate regime under which local currency is fully backed by the US dollar or any other
chosen currency. Its major attributes include:
1 An exchange rate that is fixed not just by policy, but by law.
2A  reserve requirement to the extent that a country’s reserves are equal to 100 percent of its
notes and coins in circulation.
3A  self-correcting balance-of-payments mechanism, where a payments deficit automatically
contracts the money supply and thus the amount of spending as well.
4No central bank under a currency board system.

Thus, in addition to promoting price stability, a currency board also compels the government to
follow a responsible fiscal policy.
The first currency board was established in Mauritius, which was then a colony of Great
Britain, in 1849. The use of currency boards eventually spread to 70 British colonies. The intro-
duction of currency board like arrangements in Hong Kong (1983), Estonia (1990), Argentina
(1991), Lithuania (1994), Bulgaria (1997), and Bosnia (1998) constitutes a small resurgence in
their use worldwide.
Characteristics of countries that are candidates for currency boards include: a small, open
economy; a desire for further close integration with a particular neighbor or trading partner; a
strong need to import momentary stability; and a well-regulated financial system. During the
Asian financial crisis of 1997–8, advocates of currency boards had pushed for their wider use –
in particular, for Indonesia, Russia, and the Ukraine. A currency board, however, is unlikely to
be successful without the solid fundamentals of adequate reserves, fiscal discipline, and a well-
supervised financial system, in addition to the rule of law.
A recent episode with the Argentine peso shows that even a currency board arrangement
cannot be completely safe from a possible collapse. The currency board structure fixed the
peso–dollar exchange rate at parity through much of the 1990s by requiring that every peso in
circulation be backed by either gold or the US dollar. Argentina’s adoption of a currency board
system in 1991 curtailed its chronic inflation dramatically and attracted a substantial amount of
foreign investment for the first few years. However, a strong dollar eventually hurt exports from
Argentina and caused a protracted economic downturn. Argentina abandoned the peso–dollar
parity in January 2002 by first devaluing the peso to Ps1.40 per dollar and then floating it com-
pletely. As shown in figure 4.1, daily peso changes have become a way of life since then.
Perhaps the most prominent form of a rigidly fixed system is dollarization, the use of the US
dollar as the official currency of the country. Several countries have adopted the US dollar as
their official currency because they have suffered currency devaluation for many years. Panama
has used the dollar as its official currency since 1907. Ecuador adopted the dollar as its official

 currency in January 2000. In January 2001, El Salvador became the third country south of the
Rio Grande to abandon its domestic currency in favor of the dollar. A country that dollarizes
removes any currency volatility, thereby eliminating the possibility of future currency crises. One
major argument against dollarization has to do with the loss of sovereignty over monetary policy.

A Successful Foreign-Exchange System

A multinational company’s access to international capital markets and its freedom to move funds
across national boundaries are subject to a variety of national constraints. These constraints are
frequently imposed to meet international monetary agreements on determining exchange rates.
Constraints may also be imposed to correct the balance-of-payments deficit or to promote
national economic goals.
A successful exchange system is necessary to stabilize the international payment system. To be
successful, an exchange system should meet three conditions:
1Balance-of-payments deficits or surpluses by individual countries should not be too large or
prolonged.
2Such deficits or surpluses should be corrected in ways that do not cause unacceptable infla-
tion or physical restrictions on trade and payments for either individual countries or the
whole world.
3 The maximum sustainable expansion of trade and other international economic activities
should be facilitated.
Theoretically, continuous balance-of-payments deficits and surpluses cannot exist around the
world. Under a system of freely flexible exchange rates, a foreign-exchange market clears itself
in the same way a competitive market for goods does. Just like every commodity price, each
exchange rate moves to a level at which demand and supply are equal. Under a system of fixed
exchange rates, central banks or other designated agencies buy and sell on the open market to
absorb surpluses and to eliminate deficiencies of foreign currencies at the fixed exchange rates.
A  foreign-exchange rate is the price of one currency expressed in terms of another currency. A
fixed exchange rate is an exchange rate that does not fluctuate or that changes within a prede-
termined band. The rate at which the currency is fixed or pegged is called the “ par value .” A
floating orflexible exchange rate is an exchange rate that fluctuates according to market forces.
Although governments do not attempt to prevent fundamental changes in the exchange rate
between their own currency and other currency, they typically attempt to maintain orderly
trading conditions in the market. A flexible exchange system has a number of advantages:
1 Countries can maintain independent monetary and fiscal policies.
2Flexible exchange rates permit a smooth adjustment to external shocks.
3 Central banks do not need to maintain large international reserves to defend a fixed exchange
rate.
Howeve r,   a flexible exchange system has several disadvantages. First, exchange rates under a pure
version of this system are highly unstable, thereby discouraging the flow of world trade and invest-
ment. Second, flexible exchange rates are inherently inflationary, because they remove the exter-
nal discipline on government economic policy.
A system of fixed exchange rates provides the stability of exchange rates, but it has some
disadvantages:
1 The stability of exchange rates may be too rigid to take care of major upheavals such as wars,
re volutions, and widespread disasters.
2 Central banks need to maintain large international reserves to defend a fixed exchange rate.
3Fixed exchange rates may result in destabilizing speculation that causes the exchange rate
to “overshoot” its natural equilibrium level. Overshoot (beyond fair value) is natural after
devaluation. For example, all three developing-country financial crises since 1980 – the Latin
American crisis of the 1980s, the Mexican peso crisis of 1994, and the Asian crisis of 1997–8
– occurred under fixed exchange rate regimes.
Four concepts – appreciation, depreciation, revaluation (upvaluation), and devaluation – are all
related to changing the value of a currency. An appreciationis a rise in the value of a currency
against other currencies under a floating-rate system. A  depreciationis a decrease in the value
of a currency against other currencies under a floating-rate system. Under a system of floating
rates, a country’s exchange rate will appreciate if it raises interest rates to attract capital. Simi-
larly, its exchange rate will “depreciate” if it reduces interest rates.
A  re valuation is an official increase in the value of a currency by the government of that cur-
rency under a fixed-rate system. A devaluation is an official reduction in the par value of a cur-
rency by the government of that currency under a fixed-rate system. Under a system of fixed
rates, a country may “devalue” its exchange rate by setting a lower intervention price at which it
will intervene in the foreign-exchange market. It may “revalue” or “upvalue” its exchange rate by
setting a higher intervention price.

The International Monetary System

On January 1, 2002, the euro (€) officially became the national currency for 300
million people in 12 countries – Austria, Belgium, Finland, France, Germany, Greece,
Ireland, Italy, Luxembourg, Portugal, Spain, and the Netherlands. This move consti-
tuted a major change in the region and has resulted in many fundamental changes.
In this case, the broad changes will be discussed, and then some of the specifics of
the process will be explored by focusing on Italy’s transition from the lira to the euro.
The euro was first used by monetary authorities and businesses on January 1, 1999.
On July 1, 2002, euro coins and notes officially replaced the national coins and notes
of the 12 Euroland countries. In recent years, the euro has been associated with deeper
capital markets and increasing demands by shareholders for better corporate gover-
nance. Steps have also been taken to pool economic data and to better coordinate
banking oversight across national boundaries. And the euro has helped drive long
overdue industry consolidations, from telecommunications to airlines. Overall, the
euro has become the world’s second-largest currency in terms of gross domestic
product and has assisted in the recent trend of slow but sure market-opening liberal-
ization in Europe.
The euro has also resulted in positive daily life benefits for European citizens. For
example, when these citizens travel to other euro countries, they can more easily
compare prices, and they will not have to stop at a foreign-exchange window and
hand over a foreign-exchange commission. Consumers are already gaining from their
new ability to compare prices in one currency. In 2001, the website of the French
national railway system started quoting a single, euro-denominated price, instead of
12 different prices; the result was consumer savings of as much as 20 percent. In short,
economic life in Europe has become simpler, and this is generally good for both con-
sumers and businesses.
To help further examine the impact of the currency change, the history of the euro
in one nation, Italy, will be discussed. Like most of its European Union (EU) partners,
Italy opted to phase in the euro gradually over 2 months. The lira, which traces its
origins back to  AD 794 and Charlemagne’s libra, ran alongside the new currency from
January 2002 until the end of February 2002, before it was officially decommissioned
on March 1, 2002 (although it is still possible to exchange lira for euros at the Bank
of Italy for another 10 years).
This transition period was not easy for Italy. According to the retailers’ association
Confcommercio, only 37 percent of Italians were aware that checks must be written
in euros as of January 1, 2002, while about 80 percent believed that the lira would
continue to circulate after February 28, 2002. Furthermore, a survey conducted in July
2001 by a public think tank showed that 30 percent of Italians were still not sure what
the euro was, about 43 percent were unaware of the timetable for the changeover,
and only 21 percent knew how much a euro would actually be worth (1,936.27 lira).
Beyond these public knowledge problems, the transition was not free. It is esti-
mated that the total changeover cost approximately 5 trillion lira ($2.3 billion). Much
of this expense fell on the business sector, which carried the overall costs of training
and upgrading equipment, estimated at $934 million. Confcommercio figured that big
retailers spent some 0.3 percent of yearly sales preparing for the euro, while small
shopkeepers ended up investing as much as 2 percent of their revenues.
To  combat these problems, the Italian government took some preventive steps.
First, shops and supermarkets were required to offer euro–lira calculators at check-
out points, and special toll-free numbers were created to help customers to report
irregularities. Second, little yellow and blue euro converters were sent to every Italian
home. In the end though, after the anxieties of the first few days of the changeover
had passed, Italians decided that the gadget really was not very useful and became
comfortable with the new currency.
There were also some practical changes that came with the new currency. The
single euro is a coin and the bills are larger than the lira bills. Therefore, the biggest
Christmas present in Italy in 2001 was a euro-sized wallet. Also, vending machines,
which are ubiquitous in Italy, had to be refitted for the euro. This often resulted in
pricing changes. In one humorous example, access to the only public toilet in Voghera,
a small town in northern Italy, now costs almost twice as much as it did before the
changeover. “It is all a question of coins,” the local administrators replied. “It is too
complicated to modify the token dispenser.”
This example also illustrates the single biggest problem Italy has had with the
transition – inflation. Before the euro was implemented, prices for goods could vary
by as much as 50 percent between nations. The transition therefore resulted in price
fluctuations to correct these differences; and it was southern countries such as Italy
in particular, which are poorer than their northern neighbors, that felt the impact of
these fluctuations. Additionally, there was suspicion in Italy, as in other countries, that
prices were raised due to opportunistic rounding during the changeover. With an
official exchange rate fixed at 1,936.27 lira per euro, opportunistic round-number
readjustments were inevitable.
Therefore, the changeover to the euro resulted in inflation, especially for the small
things that people buy every day – food, coffee, and haircuts. Higher-priced items,
such as cars and computers, have held steady or even in some cases declined in price
due to increased competition across the European Union. As the economist Katinka
Barish of the Centre for European Reform noted, “You might have competition on a
Euro-wide basis for cars, but you cannot do that on things like kebabs.” For example,
prices in cafés and restaurants rose 4.3 percent in 2002 – nearly double the general
inflation rate. Importantly, this is the inflation that people notice most, resulting in a
large difference between perceived inflation and actual inflation.
Italian consumers have been particularly indignant about price increases and some
groups have led strikes in which consumers vowed to stop buying things for a day.
One consumer, Jose Elorrieta, a Milan engineer and university professor with two
young daughters, says that the price of the high-end cured ham his family buys for
Christmas nearly doubled in 2002, to 60 euros a kilogram, or about $28 a pound,
compared with 36 euros a kilogram, or $16.80 a pound, at the end of 2001. “It is
the same story with clothes, with shoes – everything has gone up brutally, and it is
almost exclusively due to the introduction of the euro,” complains Mr Elorrieta, who
says he has cut back on holiday spending as a result.
The government has taken steps to combat inflation. The prime minister’s mother
complained that pasta prices had trebled since the euro’s launch and, in response, he
took action. To combat Italy’s fast-rising prices, he called for a 3-month freeze on
electric, gas, and postal prices. Even with these initial hiccups, however, the intro-
duction of the euro should be positive for both Italy and the continent. The move to
a standardized system, cooperation, and more accountability should result in economic
growth for the region. As the examination of Italy’s process shows, the change has
not been completely smooth, but overall it has been positive.

International Taxation

Usually, one of the most important variables in multinational operations is taxation. Perhaps no
environmental variable, with the possible exception of foreign exchange, has such a pervasive
influence on all aspects of multinational operations as taxation: (1) the choice of location in the
investment decision, (2) the form of the new enterprise, (3) the method of finance, and (4) the
method of transfer pricing.
International taxation is complicated because tax laws differ among countries and are con-
stantly changing. Hence, it is not accidental that international taxation still remains somewhat
of a mystery for many international executives. For example, multinational financial managers
need to understand the following:
1Shareholders of foreign and domestic corporations are subject to different rules.
2Accounting for foreign taxes on foreign operations is not identical to that on domestic
operations.
3Bilateral tax treaties and foreign tax credits exist to avoid double taxation of income.
4Many countries offer a number of tax incentives to attract foreign capital and know-how.
5Tax savings realized in low-tax countries may be offset by taxes on undistributed earnings.
There are many such added complexities because governments have failed to come to any general
agreement on tax policies. Each country has its own tax philosophies, tax incentives, transfer
pricing policies, and the like. Multinational financial managers must sort them out in order to
maximize profitability and cash flow. To attain this end, they must acquaint themselves with the
ov erall tax environment.
 Types of taxes
MNCs face a variety of direct and indirect taxes. Direct taxes include corporate income taxes
and capital gains taxes. Indirect taxesinclude value-added taxes, tariffs, and withholding taxes.
In   addition to these direct and indirect taxes, MNCs may have to pay property taxes, payroll
taxes, stamp and registration taxes, taxes on registrations of agreements of various types, sales and
excise taxes (excluding value-added taxes), and taxes on undistributed earnings.
INCOME AND CAPITAL GAINS As with individual income taxes, corporate income taxes are an
important source of revenue for many countries. Because most developing countries have low
per capita income, individual income taxes or sales taxes are not very appropriate. Thus, devel-
oping countries obtain a larger share of government revenues from corporate income taxes than
industrial countries.
Gains and losses on sales of capital assets are called  capital gains and losses . Capital assets
are those assets that are not primarily for resale and not acquired in the ordinary course of busi-
ness. These assets include stocks and bonds. If capital assets are held longer than a specified period
of time, gains on sales of these assets may be subject to preferential tax treatment:
• Value-added taxes are a special type of sales tax. Sales taxes are those taxes assessed at one or
more stages in the production process. In Canada, sales taxes are levied when production is
complete; in England, when products are wholesaled; in the USA, when products are retailed;
and in some European countries, at all stages in the production cycle. Many European coun-
tries have adopted the value-added tax as the major source of revenue to avoid the com-
pounding effect of sales taxes. For example, if a car dealer purchased a car for $10,000 from
a car manufacturing company and then sold it for $15,000, the value added would be $5,000
and the tax would be levied on this $5,000 increment.
• Tariffsare simply taxes assessed on imported goods, which parallel excise and other indirect
taxes paid by domestic producers of similar goods. They may be imposed for purposes of
re venue or protection. When tariffs are employed to increase revenues, they are usually
modest. However, when tariffs are used to protect domestic companies from foreign com-
petition, they are typically high. Although protective tariffs do not eliminate the importation
of foreign products completely, they clearly put foreign sellers at a comparative disadvantage.
In   this instance, consumers must pay more for foreign goods, which in turn would reduce
their consumption of imported commodities.
• Withholding taxes are those taxes imposed by host governments on dividend and interest
payments to foreign investors and debt holders. These taxes are collected before receipt of
the income. In other words, they are usually withheld at the source by the paying corpora-
tion. For example, a 20 percent withholding tax on $10,000 interest payments to foreigners
means that the tax proceeds of $2,000 are deducted from the interest payment made to the
lender and collected by the borrower on behalf of the government. Hence, the purchaser of
the bonds would receive only $8,000, or 80 percent of the $10,000 interest payment. With-
holding taxes are generally modified by bilateral tax treaties, because they frequently restrict
the international movement of long-term investment capital.
 Tax morality
The issue at stake is the conflict between economics (profits) and ethics (corporate morality).
Some business executives think that profits are one thing and corporate morality is another; thus,
they conclude that they have to make a choice. It is well known that in many countries both
corporate and individual taxpayers are not completely honest with their tax authorities. MNCs
must decide whether to comply with the tax laws voluntarily. Although most MNCs comply
fully with the tax laws, some companies feel that they should evade taxes to the same extent as
their competitors in order to protect their competitive position. Ethical standards vary greatly
among people, companies, and societies because business ethics are partly a function of cultural
patterns and historical development. Therefore, there is obviously no universally accepted answer
to the problem.
Host governments also have a similar moral problem. Two basic tax principles are that taxes
should be equitable and neutral. In other words, taxes should be fair to everyone, and they should
not affect decisions in the economic system. Nevertheless, many countries have imposed some
arbitrary tax penalties on MNCs for presumed violations of local tax laws. Many developing
countries have various tax incentive programs for private foreign investments. These tax incen-
tive programs abandon the principle of an economically neutral system. Under a neutral tax
system, if we want the most efficient economic system, supply and demand should be left alone
to determine prices and economic activity.
Tax burdens
Because different countries have varying statutory rates of income tax, differences in overall tax
burdens are another natural feature of international business operations. The corporate tax rate
ranges from zero in such tax-haven countries as the Bahamas to 60 percent in such countries as
Libya.
Differences in definitions of taxable corporate income create greater disparities than dif-ferences in nominal corporate tax rates. Thus, differential tax rates tell us only part of the
story. In one country, taxable income may be computed on a cash basis, while in another
country it may be determined on an accrual basis. Investment allowances and credits, reserves,
the timing of depreciation deductions, and asset valuations vary greatly from country to country.
Some countries provide companies with full credit for taxes on the income paid in other
countries.
Tax systems also affect relative tax burdens internationally. In general, there are three classes
of systems: single tax, double tax, and partial double tax. Under the single tax system, income is
taxed only once. If corporations pay no taxes, their stockholders pay taxes on dividends. Under
the double tax system, corporations pay taxes on profits at a given rate and dividends are then
taxed as income to stockholders at their personal income tax rates. Under the partial double tax
system, taxes are levied on corporate income, but dividends are taxed at a lower rate than other
forms of personal income, or distributed corporate earnings are taxed at a lower rate than undis-tributed earnings (retained earnings).
CARRYBACKS AND CARRYFORWARDS An operating loss is the excess of deductible expenses over
gross income. Operating losses can often be carried back or forward to offset earnings in other
years. Tax provisions for carrybacks and carryforwards vary among countries. Most countries do
not permit operating losses to be carried back. However, virtually all countries allow companies
to carry their losses forward for a limited number of years.
US companies may carry their excess foreign tax credit back 3 years and carry it forward 15
years to offset US tax on foreign-source income. The choice depends largely upon whether a
company has had foreign-source income in the 2 years immediately prior to the excess foreign
tax credit. If this is the case, the company must carry the excess foreign tax credit back in order
to expedite the refund of tax payment.
The purpose of this provision is to allow corporations to average their operating results, which
fluctuate widely from year to year. However, some profitable MNCs have used the carryback and
carryforward feature as a means of reducing their taxable income by merging with other firms
that have considerable operating losses or excess foreign tax credits.

Performance evaluation

Pe r formance evaluation is a central feature of an effective management information system. A
management information system is a comprehensive system to provide all levels of management
in a firm with information so that production, marketing, and financial functions can be effec-
tively performed to achieve the objectives of the firm. Management must plan its economic activ-
ities in advance, carry out its plans, and make sure that deviations are properly evaluated and
handled. Thus, performance evaluation based on the concept of the management information
system relates to the fundamentals of the management process: planning, execution, and control.
Because every subsidiary is unique in many respects, each subsidiary should be evaluated on
the basis of specific targets and individual objectives set for each. A survey of 125 MNCs by
Person and Lessig (1979) identified four purposes of an internal evaluation system: (1) to ensure
adequate profitability; (2) to have an early warning system if something goes wrong; (3) to have
a basis for the allocation of resources; and (4) to evaluate individual managers. The study also
re vealed that MNCs always use more than one criterion to evaluate the results of their foreign
subsidiaries. Of course, the performance evaluation system is designed to measure actual perfor-
mance against budgeted objectives as well as the prior year’s results. In the best of situations, the
evaluation system should monitor and control performance on a year-to-date and regular basis.
PERFORMANCE CRITERIA MNCs use multiple performance evaluation criteria because no
single criterion can capture all facets of performance that interest management at the main head-
quarters. Moreover, no single basis of measurement is equally appropriate for all units of an
MNC. For example, companies can appropriately evaluate their production unit on the basis of
such measures as cost reduction, quality control, and meeting shipment targets. For a sales unit,
however, cost reduction and quality control may be less appropriate than such measures as market
share and number of new customers. Thus, it is highly desirable for companies to use multiple
bases for performance measurement; that is, different ones for different kinds of operations in
different countries.
Two broad groups of performance evaluation criteria – financial criteria and nonfinancial
criteria – are used most widely by companies for evaluating their overseas operations. The  return
on investment relates enterprise income to some specified investment base such as total assets.
Many companies compare their actual operating performance with their budgeted performance;
budgets are pre-established standards against which operations are evaluated, compared, and
adjusted by the exercise of control. Abdallah and Keller (1985) surveyed 64 MNCs to identify
the financial criteria that they used to evaluate the performance of foreign subsidiaries. Accord-
ing to Abdallah and Keller, the four most important criteria were: (1) return on investment (ROI),
(2) profits, (3) budgeted ROI compared to actual ROI, and (4) budgeted profit compared to
actual profit.
Many MNCs do not confine their performance criteria to mere financial considerations. Non-
financial criteria complement financial measures because they account for actions that may not
contribute directly to profits in the short run but may contribute significantly to profits in the
long run. The market share is measured by sales or orders received as a percentage of total sales
in a market. The sales growth is measured by unit volume gains, selling price increases, and
exchange variations. Other important nonfinancial criteria include quality control, productivity
improvement, the relationship with the host-country government, cooperation with the parent
company, employment development, employee safety, and community service.
Once questions of performance criteria have been resolved, companies should ascertain
whether their criteria could be useful in comparing a foreign unit’s performance against its com-
petitors’ performance, either in the same country or across different borders. However, there are
many pitfalls in such comparisons. For example, it is almost impossible to determine the trans-
fer pricing of competitors as well as their accounting principles. Certainly, cross-border compar-
isons would compound the problem even further. Companies with many affiliates – at home or
abroad – must also take caution whenever questions of comparability arise. Differences in sub-
sidiaries would automatically distort performance comparisons unless they are directly accounted
for. Even if subsidiary objectives are the same, differences in country risk profiles, such as exchange
controls and export subsidies, could distort performance comparisons.
PERFORMANCE MEASUREMENT ISSUES There are many crucial, yet perplexing, elements in the
performance evaluation process. As described earlier, two measurement problems unique to
MNCs are exchange rates and inflation.
Perhaps the most critical element in the evaluation process is how to deal with results that are
denominated in currencies other than that of the parent company. The financial performance of
ov erseas operations can be measured in terms of local currency, home-country currency, or both. If
major changes occur in the exchange rates, the choice of currency can have a significant effect on
the assessment of a foreign subsidiary’s performance. For example, a subsidiary could make a profit
in local currency but could incur a loss in the parent company’s currency. Most US companies
analyze the operating results of their foreign operations in dollar terms. However, several of these
companies also use different rates for budgeting and performance tracking, because they recognize
variations between actual and expected results, which arise purely from exchange rate changes.
Fluctuating exchange rates may pose the most significant obstacle to proper evaluation, but
this is certainly not the only environmental factor. Wide variations and rapid changes in infla-
tion rates from country to country also complicate the evaluation process. Generally, accepted
accounting principles in the United States are based on the assumption of price stability. However,
other countries have runaway inflation, thus making it essential to adjust local asset values for
changing prices. Such restatements directly affect the measurement of various ROI components
and performance statistics for budgeting purposes. Because failure to account for inflation may
result in an overstatement of return on investment, company resources may not be channeled to
their most promising use. Unfortunately, solutions to these problems are not readily formulated.
Fur thermore, MNCs must consider two sets of laws, two competitive markets, and two govern-
ments. As a result, pricing considerations in international business are more numerous, more
complex, and more risky than those in purely domestic business.
 Organizational structure
As strictly domestic companies evolve into MNCs, many internal and external pressures strain a
firm’s existing organizational structure. Some responsibilities are changed, new ones are created,
and some existing ones are eliminated. Furthermore, control and finance functions change over
time as changes occur in countries’ socioeconomic environments. Companies must constantly
adjust their organizational structure to deal with new opportunities and challenges as they grow,
diversify, and internationalize.
How should the financial staff of a company with foreign operations organize itself to carry
out tasks that require the specialized expertise of multinational finance? There are three basic
forms of organizational structure: centralization, decentralization, and hybrid structure.
A centralized financial function has a strong staff at the parent company level, which controls
virtually all treasury decisions. The subsidiary financial staff only implements the decisions of
its parent company. In a decentralized financial function, parent-company executives issue a few
guidelines, but most financial decisions are made at the subsidiary level. Many companies split
responsibilities for international financial management between the corporate level and the
regional level. The corporate level typically determines policy and grants ultimate approval on
major financial decisions. However, day-to-day decisions to implement policy are made at
regional headquarters.
Both centralization and decentralization carry advantages. The advantages of a centralized
financial function include close control of financial issues at headquarters, attention of top man-agement to key issues, and an emphasis on parent-company goals. A decentralized company may
argue that these advantages could be disadvantages. Data collection costs may be enormous,
centralized decision-making may stifle flexibility, and many opportunities may be lost because of
slow actions.
DECISION VARIABLES The ultimate choice of a particular organizational structure depends
largely upon the types of decisions one must make: (1) transfer pricing and performance evalu-
ation, (2) tax planning, (3) exchange exposure management, (4) acquisition of funds, and (5)
positioning of funds.
First, transfer pricing decisions made to minimize taxes may ruin the performance evaluation
system for foreign subsidiaries. This problem sometimes forces a company to keep a second set
of books for evaluation purposes. Many MNCs may, in fact, keep three or more sets of books:
one for taxes, one for financial reporting, and one for evaluation purposes. There may be a need
for two transfer prices: one for tax purposes made at headquarters and one for evaluation pur-
poses decided by direct negotiations between affiliates.
Second, the centralized organization usually works well to minimize worldwide taxes. When
tax planning is centralized, it is easier to use tax-haven countries, tax-saving holding companies,
and transfer pricing. Thus, it is more efficient for MNCs to centralize their tax planning func-
tion rather than allow each region to create its own layer of tax havens and holding companies.
Third, most companies centralize their foreign-exchange exposure management, because it is
difficult for regional or country managers to know how their foreign-exchange exposure relates
to other affiliates.
Fourth, many MNCs borrow money from local sources for their working capital. On the
other hand, cheap sources of funds depend upon alternatives in all capital markets and the cost
of exchange gains or losses. Regional managers can hardly know all alternative sources of funds
outside a local market.
Fifth, positioning funds involves paying dividends and making intracompany loans, thereby
reducing consideration of total corporate tax liabilities, foreign-exchange exposure, and the avail-
ability of capital. Consequently, most companies tend to control positioning of funds from a cen-
tralized vantage point rather than from a regional viewpoint.

The Global Control System and Performance Evaluation

In   order to achieve the firm’s primary goal of maximizing stockholder wealth, the financial
manager performs three major functions: (1) financial planning and control, (2) investment deci-
sion-making, and (3) financing decision-making. These financial functions cannot be performed
effectively without adequate, timely accounting information. The two fundamental financial
statements of any company are the balance sheet and the income statement. The  balance sheet
measures the assets, liabilities, and owners’ equity of a business at a particular time. The income
statement matches expenses to revenues in order to determine the net income or net loss for a
period of time. In addition to these two financial statements, a control system is used to relate
actual performance to some predetermined goal.
The actual and potential flows of assets across national boundaries complicate the account-
ing functions of an MNC. The MNC must learn to deal with environmental differences, such
as different rates of inflation and changes in exchange rates. If an MNC is to function in a coor-
dinated manner, it must also measure the performance of its foreign affiliates. Equally impor-
tant, managers of the affiliates must run operations with clearly defined objectives in mind.
An MNC consists of the parent and its subsidiaries in foreign countries. To operate the MNC
as a system, the parent and its subsidiaries need continuing flows of data. Hence, the key element
in the control system is the company’s system for collection and dissemination of data on a world-
wide basis. The company’s information system between the parent and its subsidiaries generally
consists of: (1) impersonal communications such as budgets, plans, programs, electronic mes-
sages, and regular reports; and (2) personal communications such as meetings, visits, and tele-
phone conversations.
Communications essential to evaluating the performance of an enterprise usually follow estab-
lished organizational channels. An effective communication system requires an efficient report-
ing system for collecting information on the results of actual operations and for disclosing
deviations from predetermined standards. The more efficient the system, the more quickly man-
agers may take corrective action.
Financial results of profitability have traditionally provided a standard to evaluate the perfor-
mance of business operations. However, as MNCs expand their operations across national bound-
aries, the standard itself is affected by the environment in which they operate. Inflation and
foreign-exchange fluctuations affect all the financial measures of performance for MNCs. To
compare the results of various affiliates of an MNC, multinational financial managers must
understand the various ways in which inflation and exchange fluctuations affect operations as
measured by traditional financial statements.

 Inflation and exchange rate fluctuations

 Ev ery control system establishes a standard of performance and compares actual performance
with the standard. The most widely used standards are budgeted financial statements. The prepa-
ration of the statements is a planning function, but their administration is a controlling func-
tion. We will compare budgeted financial statements with actual financial statements to determine
the impact of inflation and exchange rate fluctuations on financial statements. Budgeted state-
ments are prepared without anticipated inflation or exchange rate fluctuations, but the actual
statements are prepared after these phenomena have occurred.
THE IMPACT OF INFLATION ON FINANCIAL STATEMENTS Table 20.1 presents the effects of a
10 percent and a 20 percent rate of inflation on the major accounts of the balance sheet and the
income statement. If we assume that one unit is sold every month and that prices increase at an
even rate throughout the year, the annual inflation rates reflected on sales would be 5 percent
and 10 percent instead of 10 percent and 20 percent.
If   we  follow the results of a case having a total annual inflation rate of 10 percent, or 0.83
percent per month, annual sales increase to 2,100 – a 5 percent increase over the budgeted price.
The cost of goods sold increases by only 4 percent from the budgeted cost of 1,500 to the actual
cost of 1,560, because the cost of goods sold is based on historical costs. We assumed that inter-
est expenses remain constant. The budgeted depreciation charges are based on historical costs.
The combination of higher prices in sales and the use of historical costs in the two major accounts
will increase the profits after taxes by 20 percent from 100 to 120.
The effects of inflation on the balance-sheet accounts depend on the date when assets were
acquired or liabilities incurred. Fixed assets and inventory are carried at cost, but accounts receiv-

                  
able and accounts payable are carried at the prices prevailing at the time of the transactions. The
budgeted cash of 400 consists of profits after taxes (100), taxes payable (100), and depreciation
(200).
THE IMPACT OF EXCHANGE RATE FLUCTUATION ON FINANCIAL STATEMENTS Let us assume
that a subsidiary purchases its raw materials from country A and sells its finished products to
country B. Thus, both exports and imports are denominated in foreign currencies. In this case,
exchange rate fluctuations affect the level of both revenues and costs measured in terms of the
domestic currency. Table 20.2 shows that an appreciation in the revenue currency (country B’s
currency) raises profits, assuming that costs remain constant. In contrast, an appreciation in the
cost currency (country A’s currency) reduces profits after taxes unless selling prices are adjusted
to reflect the increase in costs.
There are similarities between the effect of inflation and the effect of exchange rate fluctua-
tions on reported profits. If prices in the local currencies are increased by the same percentage as
the increase in the cost of imports, the effect of exchange rate fluctuations on profits is identical
with the effect of a comparable local inflation rate. A 10 percent increase in export prices, accom-
panied by a proportional increase in import prices, produces profits of 120; this is identical to
the profit obtained when the local inflation rate was 10 percent in the example from table 20.1.
We  cannot determine the true impact of exchange rate fluctuations on foreign operations
unless a parent’s accounts and those of its subsidiaries are expressed in terms of a homogeneous
currency unit. Any changes in the value of the local currency relative to the parent currency will
affect the reported profits when financial statements expressed in the local currency are trans-
lated into the currency of the parent company. The translation procedure, already discussed in
chapter 10, is regulated by the accounting profession.