Accounting in the International Business

Country Differences in Accounting Standards

Accounting is shaped by the environment in which it operates. Just as different countries have different political systems, economic systems, and cultures, they also have different accounting systems. In each country, the accounting system has evolved in response to the demands for accounting information.

Despite attempts to harmonize standards by developing internationally acceptable accounting conventions , a myriad of differences between national accounting systems still remain.

Although many factors can influence the development of a country's accounting system, there appear to be five main variables:

1. The relationship between business and the providers of capital.

2. Political and economic ties with other countries.

3. The level of inflation.

4. The level of a country's economic development.

5. The prevailing culture in a country.

Relationship between Business and Providers of Capital

The three main external sources of capital for business enterprises are individual investors, banks, and government. In most advanced countries, all three sources are important. In the United States, for example, business firms can raise capital by selling shares and bonds to individual investors through the stock market and the bond market. They can also borrow capital from banks and, in rather limited cases, from the government. The  importance of each source of capital varies from country to country.

In countries such as Switzerland, Germany, and Japan, a few large banks satisfy most of the capital needs of business enterprises. Individual investors play a relatively minor role. In these countries, the role of the banks is so important that a bank's officers often have seats on the boards of firms to which it lends capital. In such circumstances, the information needs of the capital providers are satisfied in a relatively straightforward way--through personal contacts, direct visits, and information provided at board meetings. Consequently, although firms still prepare financial reports, because government regulations in these countries mandate some public disclosure of a firm's financial position, the reports tend to contain less information than those of British or US firms. Because banks are the major providers of capital, financial accounting practices are oriented toward protecting a bank's investment. Thus, assets are valued conservatively and liabilities are overvalued  to provide a cushion for the bank in the event of default.

Political and Economic Ties with Other Countries

Similarities in the accounting systems of countries are sometimes due to the countries' close political and/or economic ties. Similarly, the European Union has been attempting to harmonize accounting practices in its member countries. The accounting systems of EU members such as Great Britain, Germany, and France are quite different now, but they may all converge on some norm eventually.

Inflation Accounting

In many countries, including Germany, Japan, and the United States, accounting is based on the historic cost principle. This principle assumes the currency unit used to report financial results is not losing its value due to inflation. Firms record sales, purchases, and the like at the original transaction price and make no adjustments in the amounts later. The appropriateness of this principle varies inversely with the level of inflation in a country.Called current cost accounting, it adjusts all items in a financial statement--assets, liabilities, costs, and revenues--to factor out the effects of inflation. The method uses a general price index to convert historic figures into current values.

Level of Development

Developed nations tend to have large, complex organizations, whose accounting problems are far more difficult than those of small organizations. Developed nations also tend to have sophisticated capital markets in which business organizations raise funds from investors and banks. These providers of capital require that the organizations they invest in and lend to provide comprehensive reports of their financial activities. The work forces of developed nations tend to be highly educated and skilled and can perform complex accounting functions.

Culture

A number of academic accountants have argued that the culture of a country has an important impact upon the nature of its accounting system. Using the cultural typologies developed by Hofstede, researchers have found that the extent to which a culture is characterized by uncertainty avoidance seems to have an impact on accounting systems. Uncertainty avoidance refers to the extent to which cultures socialize their members to accept ambiguous situations and tolerate uncertainty.

Accounting Clusters

Few countries have identical accounting systems. Notable similarities between nations do exist, however, and three groups of countries with similar standards are identified in Map 19.1. One group might be called the British-American-Dutch group. Great Britain, the United States, and the Netherlands are the trendsetters in this group. All these countries have large, well-developed stock and bond markets where firms raise capital from investors. A second group might be called the Europe-Japan group. Firms in these countries have very close ties to banks, which supply a large proportion of their capital needs. third group might be the South American group. The countries in this group have all experienced persistent and rapid inflation.

National and International Standards

Consequences of the Lack of Comparability

An unfortunate result of national differences in accounting and auditing standards is the general lack of comparability of financial reports from one country to another. For example:

·                 Research and development costs must be written off in the year they are incurred in the United States, but in Spain they may be deferred as an asset and need not be amortized as long as benefits that will cover them are expected to arise in the future.

·                 German accountants treat depreciation as a liability, whereas British companies deduct it from assets.

Transnational financing occurs when a firm based in one country enters another country's capital market to raise capital from the sale of stocks or bonds. Transnational investment occurs when an investor based in one country enters the capital market of another nation to invest in the stocks or bonds of a firm based in that country.

The rapid expansion of transnational financing and investment in recent years has been accompanied by a corresponding growth in transnational financial reporting. The lack of comparability between accounting standards in different nations can lead to confusion.

In addition to the problems this lack of comparability gives investors, it can give the firm major headaches. The firm has to explain to its investors why its financial position looks so different in the two accountings. Also, an international business may find it difficult to assess the financial positions of important foreign customers, suppliers, and competitors.

International Standards

Substantial efforts have been made in recent years to harmonize accounting standards across countries. The International Accounting Standards Committee (IASC) is a major proponent of standardization. Other areas of interest to the accounting profession worldwide, including auditing, ethical, educational, and public-sector standards, are handled by the International Federation of Accountants (IFAC), which has the same membership.

Another hindrance to the development of international accounting standards is that compliance is voluntary; the IASC has no power to enforce its standards.

Despite this, support for the IASC and recognition of its standards is growing. Increasingly, the IASC is regarded as an effective voice for defining acceptable worldwide accounting principles. Japan, for example, began requiring financial statements to be prepared on a consolidated basis after the IASC issued its initial standards on the topic.

The impact of the IASC standards has probably been least noticeable in the United States because most of the standards issued by the IASC have been consistent with opinions already articulated by the US Financial Accounting Standards Board (FASB). Another body that promises to have substantial influence on the harmonization of accounting standards, at least within Europe, is the European Union (EU). In  accordance with its plans for closer economic and political union, the EU is attempting to harmonize the accounting principles of its 15 member countries. The EU does this by issuing directives that the member states are obligated to incorporate into their own national laws. Because EU directives have the power of law, we might assume the EU has a better chance of achieving harmonization than the IASC does, but the EU is experiencing implementation difficulties. These difficulties arise from the wide variation in accounting practices among EU member countries.

Multinational Consolidation and Currency Translation

Consolidated Financial Statements

Many firms find it advantageous to organize as a set of separate legal entities. Multinationals are often required by the countries in which they do business to set up a separate company. However, although the subsidiaries may be separate legal entities, they are not separate economic entities. Economically, all the companies in a corporate group are interdependent.

Preparing consolidated financial statements is becoming the norm for multinational firms. Investors realize that without consolidated financial statements, a multinational firm could conceal losses in an unconsolidated subsidiary, thereby hiding the economic status of the entire group.

Currency Translation

The Current Rate Method

Under the current rate method, the exchange rate at the balance sheet date is used to translate the financial statements of a foreign subsidiary into the home currency of the multinational firm. Although this may seem logical, it is incompatible with the historic cost principle, which, as we saw earlier, is a generally accepted accounting principle in many countries.

The Temporal Method

One way to avoid this problem is to use the temporal method to translate the accounts of a foreign subsidiary. The temporal method translates assets valued in a foreign currency into the home-country currency using the exchange rate that exists when the assets are purchased. Because the various assets of a foreign subsidiary will in all probability be acquired at different times and because exchange rates seldom remain stable for long, different exchange rates will probably have to be used to translate those foreign assets into the multinational's home currency.

Although the balance sheet balances in yen, it does not balance when the temporal method is used to translate the yen-denominated balance sheet figures back into dollars.

Current US Practice

US-based multinational firms must follow the requirements of Statement 52, According to Statement 52, the local currency of a self-sustaining foreign subsidiary is to be its functional currency. The balance sheet for such subsidiaries is translated into the home currency using the exchange rate in effect at the end of the firm's financial year, whereas the income statement is translated using the average exchange rate for the firm's financial year. But the functional currency of an integral subsidiary is to be US dollars. The financial statements of such subsidiaries are translated at various historic rates using the temporal method, and the dangling debit or credit increases or decreases consolidated earnings for the period.

Accounting Aspects of Control Systems

In the typical firm, the control process is annual and involves three main steps:

1.              Head office and subunit management jointly determine subunit goals for the coming year.

2.              Throughout the year, the head office monitors subunit performance against the agreed goals.

3.              If a subunit fails to achieve its goals, the head office intervenes in the subunit to learn why the shortfall occurred, taking corrective action when appropriate.

The accounting function plays a critical role in this process. Most of the goals for subunits are expressed in financial terms and are embodied in the subunit's budget for the coming year. The budget is the main instrument of financial control. The budget is typically prepared by the subunit, but it must be approved by headquarters management. During the approval process, headquarters and subunit managements debate the goals that should be incorporated in the budget.

Exchange Rate Changes and Control Systems

The Lessard - Lorange Model

Lessard and Lorange point out three exchange rates that can be used to translate foreign currencies into the corporate currency in setting budgets and in the subsequent tracking of performance:

·                 The initial rate, the spot exchange rate when the budget is adopted.

·                 The projected rate, the spot exchange rate forecast for the end of the budget period (i.e., the forward rate).

·                 The ending rate, the spot exchange rate when the budget and performance are being compared.

These three exchange rates imply nine possible combinations . Lessard and Lorange ruled out four of the nine combinations as illogical and unreasonable.

With three of these five combinations-II, PP, and EE-the same exchange rate is used for translating both budget figures and performance figures into the corporate currency. All three combinations have the advantage that a change in the exchange rate during the year does not distort the control process. This is not true for the other two combinations, IE and PE. The projected rate in such cases will typically be the forward exchange rate as determined by the foreign exchange market  or some company-generated forecast of future spot rates, which Lessard and Lorange refer to as the internal forward rate. The internal forward rate may differ from the forward rate quoted by the foreign exchange market if the firm wishes to bias its business in favor of, or against, the particular foreign currency.

Transfer Pricing and Control Systems

Two of these strategies, the global strategy and the transnational strategy, give rise to a globally dispersed web of productive activities. Firms pursuing these strategies disperse each value creation activity to its optimal location in the world. The volume of intrafirm transactions in such firms is very high.

The choice of transfer price can critically affect the performance of two subsidiaries that exchange goods or services.

International businesses often manipulate transfer prices to minimize their worldwide tax liability, minimize import duties, and avoid government restrictions on capital flows.

Separation of Subsidiary and Manager Performance

Many accountants, however, argue that although it is legitimate to compare subsidiaries against each other on the basis of return on investment (ROI) or other indicators of profitability, it may not be appropriate to use these for comparing and evaluating the managers of different subsidiaries. Accordingly, it has been suggested that the evaluation of a subsidiary should be kept separate from the evaluation of its manager.¹⁶ The manager's evaluation should consider how hostile or benign the country's environment is for that business.

Chapter Twenty

Financial Management in the International Business

Introduction

Included within the scope of financial management are three sets of related decisions:

·                 Investment decisions, decisions about what activities to finance.

·                 Financing decisions, decisions about how to finance those activities.

·                 Money management decisions, decisions about how to manage the firm's financial resources most efficiently.

In an international business, investment, financing, and money management decisions are complicated by the fact that countries have different currencies, different tax regimes, different regulations concerning the flow of capital across their borders, different norms regarding the financing of business activities, different levels of economic and political risk, and so on. Good financial management can be an important source of competitive advantage.

Investment Decisions

A decision to invest in activities in a given country must consider many economic, political, cultural, and strategic variables..

Capital Budgeting

Capital budgeting quantifies the benefits, costs, and risks of an investment. This enables top managers to compare, in a reasonably objective fashion, different investment alternatives within and across countries so they can make informed choices about where the firm should invest its scarce financial resources. Capital budgeting for a foreign project uses the same theoretical framework that domestic capital budgeting uses. Once the cash flows have been estimated, they must be discounted to determine their net present value using an appropriate discount rate. The most commonly used discount rate is either the firm's cost of capital or some other required rate of return.

Among the factors complicating the process for an international business are these:

1.              A distinction must be made between cash flows to the project and cash flows to the parent company.

2.              Political and economic risks, including foreign exchange risk, can significantly change the value of a foreign investment.

3.              The connection between cash flows to the parent and the source of financing must be recognized.

Project and Parent Cash Flows

A theoretical argument exists for analyzing any foreign project from the perspective of the parent company because cash flows to the project are not necessarily the same thing as cash flows to the parent company. The project may not be able to remit all its cash flows to the parent for a number of reasons. When evaluating a foreign investment opportunity, the parent should be interested in the cash flows it will receive--as opposed to those the project generates--because those are the basis for dividends to stockholders, investments elsewhere in the world, repayment of worldwide corporate debt, and so on.

But the problem of blocked earnings is not as serious as it once was. The worldwide move toward greater acceptance of free market economics has reduced the number of countries in which governments are likely to prohibit the affiliates of foreign multinationals from remitting cash flows to their parent companies.

Adjusting for Political and Economical Risk

Political Risk

We defined it as the likelihood that political forces will cause drastic changes in a country's business environment that hurt the profit and other goals of a business enterprise. Political risk tends to be greater in countries experiencing social unrest or disorder and countries where the underlying nature of the society makes the likelihood of social unrest high. When political risk is high, there is a high probability that a change will occur in the country's political environment that will endanger foreign firms there.

In extreme cases, political change may result in the expropriation of foreign firms' assets. In less extreme cases, political changes may result in increased tax rates, the imposition of exchange controls that limit or block a subsidiary's ability to remit earnings to its parent company, the imposition of price controls, and government interference in existing contracts.

Economic Risk

We defined it as the likelihood that economic mismanagement will cause drastic changes in a country's business environment that hurt the profit and other goals of a business enterprise. This can be a serious problem for a foreign firm with assets in that country because the value of the cash flows it receives from those assets will fall as the country's currency depreciates on the foreign exchange market. The likelihood of this occurring decreases the attractiveness of foreign investment in that country.

Risk and Capital Budgeting

In analyzing a foreign investment opportunity, the additional risk that stems from its location can be handled in at least two ways. The first method is to treat all risk as a single problem by increasing the discount rate applicable to foreign projects in countries where political and economic risks are perceived as high.

Financing Decisions

Source of Financing

If the firm is going to seek external financing for a project, it will want to borrow funds from the lowest-cost source of capital available. The cost of capital is typically lower in the global capital market, by virtue of its size and liquidity, than in many domestic capital markets, particularly those that are small and relatively illiquid. However, host-country government restrictions may rule out this option. The governments of many countries require, or at least prefer, foreign multinationals to finance projects in their country by local debt financing or local sales of equity. In addition to the impact of host-government policies on the cost of capital and financing decisions, the firm may wish to consider local debt financing for investments in countries where the local currency is expected to depreciate on the foreign exchange market. The amount of local currency required to meet interest payments and retire principal on local debt obligations is not affected when a country's currency depreciates.

Financial Structure

There is a quite striking difference in the financial structures of firms based in different countries. By financial structure we mean the mix of debt and equity used to finance a business. It is not clear why the financial structure of firms should vary so much across countries. One possible explanation is that different tax regimes determine the relative attractiveness of debt and equity in a country.

The interesting question for the international business is whether it should conform to local capital structure norms. One advantage claimed for conforming to host-country debt norms is that management can more easily evaluate its return on equity relative to local competitors in the same industry. However, this seems a weak rationale for what is an important decision. Another point often made is that conforming to higher host-country debt norms can improve the image of foreign affiliates that have been operating with too little debt and thus appear insensitive to local monetary policy.

Global Money Management: the Efficiency Objective

Minimizing Cash Blanances

For any given period, a firm must hold certain cash balances. This is necessary for serving any accounts and notes payable during that period and as a contingency against unexpected demands on cash. In contrast, the firm could earn a higher rate of interest if it could invest its cash resources in longer-term financial instruments.

Reducing Transaction Costs

Transaction costs are the cost of exchange. Every time a firm changes cash from one currency into another currency it must bear a transaction cost--the commission fee it pays to foreign exchange dealers for performing the transaction. Most banks also charge a transfer fee for moving cash from one location to another; this is another transaction cost. The commission and transfer fees arising from intrafirm transactions can be substantial.

Global Money Management: the Tax Objective

Many nations follow the worldwide principle that they have the right to tax income earned outside their boundaries by entities based in their country. Double taxation occurs when the income of a foreign subsidiary is taxed both by the host-country government and by the parent company's home government. A tax credit allows an entity to reduce the taxes paid to the home government by the amount of taxes paid to the foreign government. A tax treaty between two countries is an agreement specifying what items of income will be taxed by the authorities of the country where the income is earned. A deferral principle specifies that parent companies are not taxed on foreign source income until they actually receive a dividend. For the international business with activities in many countries, the various tax regimes and the tax treaties have important implications for how the firm should structure its internal payments system among the foreign subsidiaries and the parent company. A tax haven is a country with an exceptionally low, or even no, income tax. International businesses avoid or defer income taxes by establishing a wholly owned, nonoperating subsidiary in the tax haven. The tax haven subsidiary owns the common stock of the operating foreign subsidiaries. This allows all transfers of funds from foreign operating subsidiaries to the parent company to be funneled through the tax haven subsidiary.

Moving Money Across Borders:
Attaining Efficiencies and Reducing Taxes

Dividend Remittances

Payment of dividends is probably the most common method by which firms transfer funds from foreign subsidiaries to the parent company. The dividend policy typically varies with each subsidiary depending on such factors as tax regulations, foreign exchange risk, the age of the subsidiary, and the extent of local equity participation. With regard to foreign exchange risk, firms sometimes require foreign subsidiaries based in "high-risk" countries to speed up the transfer of funds to the parent through accelerated dividend payments. This moves corporate funds out of a country whose currency is expected to depreciate significantly.

Royalty Payments and Fees

Royalties represent the remuneration paid to the owners of technology, patents, or trade names for the use of that technology or the right to manufacture or sell products under those patents or trade names. It is common for a parent company to charge its foreign subsidiaries royalties for the technology, patents, or trade names it has transferred to them. Royalties may be levied as a fixed monetary amount per unit of the product the subsidiary sells or as a percentage of a subsidiary's gross revenues.

A fee is compensation for professional services or expertise supplied to a foreign subsidiary by the parent company or another subsidiary. Royalties and fees have certain tax advantages over dividends, particularly when the corporate tax rate is higher in the host country than in the parent's home country. Royalties and fees are often tax deductible locally  so arranging for payment in royalties and fees will reduce the foreign subsidiary's tax liability. If the foreign subsidiary compensates the parent company by dividend payments, local income taxes must be paid before the dividend distribution, and withholding taxes must be paid on the dividend itself.

Transfer Prices

In any international business, there are normally a large number of transfers of goods and services between the parent company and foreign subsidiaries and between foreign subsidiaries. This is particularly likely in firms pursuing global and transnational strategies because these firms are likely to have dispersed their value creation activities to various "optimal" locations around the globe . As noted in Chapter 19, the price at which goods and services are transferred between entities within the firm is referred to as the transfer price. Transfer prices can be used to position funds within an international business.

Benefits of Manipulating Transfer Prices

At least four gains can be derived by manipulating transfer prices.

1.              The firm can reduce its tax liabilities by using transfer prices to shift earnings from a high-tax country to a low-tax one.

2.              The firm can use transfer prices to move funds out of a country where a significant currency devaluation is expected, thereby reducing its exposure to foreign exchange risk.

3.              The firm can use transfer prices to move funds from a subsidiary to the parent company  when financial transfers in the form of dividends are restricted or blocked by host-country government policies.

4.              The firm can use transfer prices to reduce the import duties it must pay when an ad valorem tariff is in force--a tariff assessed as a percentage of value.

Problems with Transfer Pricing

Significant problems are associated with pursuing a transfer pricing policy. Few governments like it. When transfer prices are used to reduce a firm's tax liabilities or import duties, most governments feel they are being cheated of their legitimate income. Similarly, when transfer prices are manipulated to circumvent government restrictions on capital flows, governments perceive this as breaking the spirit--if not the letter--of the law. A number of governments limit international businesses' ability to manipulate transfer prices in the manner described. Transfer pricing is inconsistent with a policy of treating each subsidiary in the firm as a profit center. When transfer prices are manipulated by the firm and deviate significantly from the arm's-length price, the subsidiary's performance may depend as much on transfer prices as it does on other pertinent factors, such as management effort. A subsidiary told to charge a high transfer price for a good supplied to another subsidiary will appear to be doing better than it actually is, while the subsidiary purchasing the good will appear to be doing worse..

Fronting Loans

A fronting loan is a loan between a parent and its subsidiary channeled through a financial intermediary, usually a large international bank. In a direct intrafirm loan, the parent company lends cash directly to the foreign subsidiary, and the subsidiary repays it later. From the bank's point of view, the loan is risk free because it has 100 percent collateral in the form of the parent's deposit. The bank "fronts" for the parent, hence the name. The bank makes a profit by paying the parent company a slightly lower interest rate on its deposit than it charges the foreign subsidiary on the borrowed funds.

Under this arrangement, interest payments net of income tax will be as follows:

1.              The foreign operating subsidiary pays $90,000 interest to the London bank. Deducting these interest payments from its taxable income results in a net after-tax cost of $45,000 to the foreign operating subsidiary.

2.              The London bank receives the $90,000. It retains $10,000 for its services and pays $80,000 interest on the deposit to the Bermuda subsidiary.

3.              The Bermuda subsidiary receives $80,000 interest on its deposit tax free.

Techniques For Global Money Management

Centralized Depositories

Every business needs to hold some cash balances for servicing accounts that must be paid and for insuring against unanticipated negative variation from its projected cash flows. The critical issue for an international business is whether each foreign  subsidiary should hold its own cash balances or whether cash balances should be held at a centralized depository. First, by pooling cash reserves centrally, the firm can deposit larger amounts. Cash balances are typically deposited in liquid accounts, such as overnight money market accounts. Because interest rates on such deposits normally increase with the size of the deposit, by pooling cash centrally. Second, if the centralized depository is located in a major financial center , it should have access to information about good short-term investment opportunities that the typical foreign subsidiary would lack. Third, by pooling its cash reserves, the firm can reduce the total size of the cash pool it must hold in highly liquid accounts, which enables the firm to invest a larger amount of cash reserves in longer-term, less liquid financial instruments that earn a higher interest rate.

Multilateral Netting

Multilateral netting allows a multinational firm to reduce the transaction costs that arise when many transactions occur between its subsidiaries. These transaction costs are the commissions paid to foreign exchange dealers for foreign exchange transactions and the fees charged by banks for transferring cash between locations. The volume of such transactions is likely to be particularly high in a firm that has a globally dispersed web of interdependent value creation activities. Netting reduces transaction costs by reducing the number of transactions.

Multilateral netting is an extension of bilateral netting. Under multilateral netting, this simple concept is extended to the transactions between multiple subsidiaries within an international business.

Managing Foreign Exchange Risk

Types Of Foreign Exchange Exposre

When we speak of foreign exchange exposure, we are referring to the risk that future changes in a country's exchange rate will hurt the firm.

Transaction Exposure

Transaction exposure is typically defined as the extent to which the income from individual transactions is affected by fluctuations in foreign exchange values. Such exposure includes obligations for the purchase or sale of goods and services at previously agreed prices and the borrowing or lending of funds in foreign currencies.

Translation Exposure

Translation exposure is the impact of currency exchange rate changes on the reported consolidated results and balance sheet of a company. Translation exposure is basically concerned with the present measurement of past events. The resulting accounting gains or losses are said to be unrealized--they are "paper" gains and losses--but they are still important.

Economic Exposure

Economic exposure is the extent to which a firm's future international earning power is affected by changes in exchange rates. Economic exposure is concerned with the long-run effect of changes in exchange rates on future prices, sales, and costs. This is distinct from transaction exposure, which is concerned with the effect of exchange rate changes on individual transactions, most of which are short-term affairs that will be executed within a few weeks or months.

Tactics and Strategies for Reducing Foreign exchange Risk,

Reducing Transaction and Translation Exposure

A number of tactics can help firms minimize their transaction and translation exposure. These tactics primarily protect short-term cash flows from adverse changes in exchange rates. In addition to buying forward and using swaps, firms can minimize their foreign exchange exposure through leading and lagging payables and receivables--that is, collecting and paying early or late depending on expected exchange rate movements. A lead strategy involves attempting to collect foreign currency receivables early when a foreign currency is expected to depreciate and paying foreign currency payables before they are due when a currency is expected to appreciate. A lag strategy involves delaying collection of foreign currency receivables if that currency is expected to appreciate and delaying payables if the currency is expected to depreciate. Leading and lagging involves accelerating payments from weak-currency to strong-currency countries and delaying inflows from strong-currency to weak-currency countries.

We have explained that:

·                 Transfer prices can be manipulated to move funds out of a country whose currency is expected to depreciate.

·                 Local debt financing can provide a hedge against foreign exchange risk.

·                 It may make sense to accelerate dividend payments from subsidiaries based in countries with weak currencies.

·                 Capital budgeting techniques can be adjusted to deflect the negative impact of adverse exchange rate movements on the current net value of a foreign investment.

Reducing Economic Exposure

Reducing economic exposure requires strategic choices that go beyond the realm of financial management. The key to reducing economic exposure is to distribute the firm's productive assets to various locations so the firm's long-term financial well- being is not severely affected by adverse changes in exchange rates.

Developing Policies for Managing Foreign Exchange Exposure

The firm needs to develop a mechanism for ensuring it maintains an appropriate mix of tactics and strategies for minimizing its foreign exchange exposure. Although there is no universal agreement as to the components of this mechanism, a number of common themes stand out. First, central control of exposure is needed to protect resources efficiently and ensure that each subunit adopts the correct mix of tactics and strategies. Many companies have set up in-house foreign exchange centers. Second, firms should distinguish between, on one hand, transaction and translation exposure and, on the other, economic exposure. Third, the need to forecast future exchange rate movements cannot be overstated, though. Fourth, firms need to establish good reporting systems so the central finance function can regularly monitor the firm's exposure positions.

Finally, on the basis of the information it receives from exchange rate forecasts and its own regular reporting systems, the firm should produce monthly foreign exchange exposure reports. These reports should identify how cash flows and balance sheet elements might be affected by forecasted changes in exchange rates.