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.
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.
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