Multinational Budgeting and Control Systems

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Multinational Budgeting and Control Systems

• Fall, 2006

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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.

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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,

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• 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.

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Managerial Accounting

• Managerial accounting issues may be divided
  into two broad areas
• (1) financial planning and
• (2) financial control

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• 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

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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

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• 3) Developing data sources to support strategic
  choices, and
• 4) Translating selected options into specific
  courses of action.

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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.

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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.

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• 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.

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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.

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• 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.

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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?

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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.

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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.

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• 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.

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• 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.

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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.

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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.
  

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• 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.

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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.

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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.

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• 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.

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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.

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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.

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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.

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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,

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• 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.

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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

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Relevant Return

• Should the international financial manager
  evaluate expected investment returns from the
  perspective of the foreign project or that of the
  parent company?

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• 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...

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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.

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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.

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• 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.

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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.

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• 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?

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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.

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• 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.

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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.

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• 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.

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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

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• 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.

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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.

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• 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.

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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

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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.

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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.

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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.

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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.

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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.

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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.

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• 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

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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.

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• Different corporate objectives require different
  performance evaluation criteria.

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Foreign Corrupt Practices Act

• The FCPA is designed to eliminate 2 problems..
• --poor internal controls
• --bribery

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• 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

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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

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• Bribes may be paid because the receiver has a
  strong market position or control over an aspect
  of the environment that impacts a firms
  operations
• Sometimes payments are made in countries where
  this is an accepted business practice, some in
  countries where such payments are illegal.

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• 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.

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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.

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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

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Extortion

• If a payment is construed as extortion, approval
  may be granted by the Justice Department in the US

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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

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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.

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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.

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Two Issues

• Payment of bribes
• Recording payment of bribes.