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408 Planning and Forecasting assessment of inflation’s effects, as well as any company circumstances or ac- tions taken which mitigate the negative effects of inflation. A series of these comments are presented in Exhibit 12.32. The examples in Exhibit 12.32 are representative of over 100 such disclosures that were examined. A recurrent theme is that inflation has been low in EXHIBIT 12.32 Management commentary on the effects of inf lation. Low inflation and cost recovery contracts: Air T Inc. (2000) The Company believes that due to the current low levels of inflation the impact of inflation and changing prices on its revenues and net earnings will not have a material effect on its manufacturing operations, or on its air cargo business. This is because the major cost components of its operations, consisting principally of fuel, crew and certain maintenance costs are reimbursed, without markup, under current contract terms. Inflation and fixed-price contracts may create problems: American Pacific Corporation (1999) Inflation may have an effect on gross profit in the future as certain of the Company’s agreements with AP and sodium azide customers require fixed prices, although certain such agreements contain escalation features that should somewhat mitigate the risks associated with inflation. Inflation leaves assets undervalued, but depreciation understated: Hartmarx Corporation (1999) Considering the impact of inflation, the current value of net assets would be higher than the Company’s $189 million book value after reflecting the Company’s use of the LIFO inventory method and increases in the value of properties since acquisition. Earnings would be lower than reported, assuming higher depreciation expense without a corresponding reduction in taxes. Cost reduction programs, productivity improvements, and periodic price increases maintain profit margins: Johnson & Johnson Inc. (1999) Inflation rates, even though moderate in many parts of the world during 1999, continue to have an effect on worldwide economies and, consequently, on the way companies operate. In the face of increasing costs, the Company strives to maintain its profit margins through cost reduction programs, productivity improvements and periodic price increases. Inflation impact affected by ability to pass on cost increases to customers: Pegasus Systems Inc. (1999) Substantial increases in cost and expenses could have a significant impact on results of operations to the extent such increases are not passed along to customers. Pricing strategy and efficiency improvements offset inflation: Polaroid Corporation (1999) Inflation continues to be a factor in many countries in which the Company does business. The Company’s pricing strategy and continuing efficiency improvements have offset to a considerable degree inflation and normal cost increases. The overall inflationary impact on the Company’s earnings has not been material. Inflation increases borrowing costs: Silgan Holdings Inc. (1999) Historically, inflation has not had a material effect on the Company, other than to increase its cost of borrowing. In general, the Company has been able to increase the sales prices of its products to reflect any increases in the prices of raw materials. SOURCES : Companies’ annual reports. The year following each company name designates the annual report from which each example is drawn. Global Finance 409 recent years and, therefore, inflation has not been a significant issue. However, other firms with substantial international activity point out that inflation re- mains a significant issue in a number of countries where they are located or in which they do business. The disclosed measures taken to mitigate the effects of inflation were very consistent and included: • Selective price increases. • Productivity improvements. • Cost-containment efforts. • Cost reimbursement. • Price escalation agreements. Some of the disclosures indicated protection from inflationary cost increases because of the presence of fixed-price contracts and escalation features in business agreements. Concern is frequently expressed about the ability to pass on the effects of inflationary cost increases in the form of higher product prices. Some protection from cost inflation of commodities is often achieved through the use of the same types of hedging vehicles employed to avoid cost increases created by exchange rate movements. For example, airlines and public transit systems routinely hedge the cost of fuel in order to avoid the erosion of profits from increases in petroleum prices. A traditional concern, highlighted by the Hartmarx commentary in Ex- hibit 12.32, is the overstatement of profits in periods of significant inflation. The LIFO inventory method has traditionally been viewed as a method that reduces such profit overstatements. LIFO ensures that cost of sales approximates replacement cost. Profit overstatement is also avoided in cases where most depreciable assets are relatively new. In this circumstance depreciation is closer to replacement cost than if depreciation were based principally on the lower costs of older assets. The use of accelerated depreciation, especially for income tax purposes, is also seen to offset some of the potential profit overstatement associated with inflation. The revision of traditional cost-based statements to reflect the effects of either general inflation or specific cost increases is a more comprehensive approach to assessing the effects of inflation upon measures of financial performance. The approach is illustrated next. Adjusting Financial Statements for the Effects of Inf lation The use of LIFO and the reliance upon relatively new depreciable assets or accelerated depreciation to cause expenses to approximate current (replacement) costs is only a partial adjustment for the impact of inflation. Historically, the comprehensive restatement of results for the effects of general as well as specific price increases has been emphasized. In fact, in 1979 the FASB issued a 410 Planning and Forecasting statement that called for the disclosure of supplemental information on price- level adjusted earnings. 52 A subsequent statement, issued in 1986, held that these price-level adjusted disclosures, while still recommended, would no longer be required. 53 There was opposition by the business community to the requirements of SFAS No. 33, and efforts to demonstrate that the new disclosures were either used or useful were not successful. While principally of historical interest in this period of very modest inflation, some of the disclosures required by SFAS No. 33 are discussed and presented. 54 SFAS No. 33, Price-Level Adjusted Disclosures Beginning in 1979, certain large U.S. firms were required to provide supplemental information on the effect of inflation on financial performance. The disclosures included new information on earnings computed on both a constant-dollar and a current-cost basis. The constant-dollar method retains historical cost as the basis of financial measurement. However, it does make selected restate- ments so that all financial statement balances are presented in units of the same purchasing power, that is, expressed in the same price index. The current-cost method replaces historical cost balances with current (replacement) costs as the basis for financial statement measurement. Exhibit 12.33 provides an example of disclosures of price-level adjusted results under the requirements of SFAS No. 33. 55 A very different message about profitability is conveyed by the adjusted information in Exhibit 12.33. A significant level of historical-cost profits is al- most eliminated when current-cost adjustments are applied, and profit turns into loss under the constant-dollar alternative. The purchasing power of the re- sources invested in producing the 1980 results, as represented by the constant- dollar amount of expenses, exceeded Tiger’s constant-dollar revenues. Closer EXHIBIT 12.33 Income statements adjusted for changing prices: Tiger International Inc., December 31, 1980 (in thousands). Historical Current Constant Financials Cost Dollar Revenues $1,562,270 $1,562,270 $1,562,270 Cost and Expenses Cost of operations 1,104,672 1,108,673 1,109,324 Selling, general, and administrative 139,462 139,462 139,462 Depreciation and amortization 118,332 151,924 171,096 Interest, net 140,929 140,929 140,929 Income tax provision 16,500 16,500 16,500 1,519,895 1,557,488 1,577,311 Net income (loss) $ 42,375 $ 4,782 $ (15,041) SOURCE : Tiger International Inc., annual report, December 1980, 39. Global Finance 411 study of these data is necessary to understand the reasons behind these quite different messages. The revenues in each of the three income statements are measured in the average price level for the year based upon the Consumer Price Index for All Urban Consumers. Tiger’s revenues are earned fairly evenly across the year, and therefore, the revenues in the historical-cost income statement are already expressed in average prices for the year. Accordingly, the same revenue amount can be used in both the constant-dollar and current-cost statements. The same applies to the amounts for selling, general and administrative; interest, net; and the income tax provision. Modest adjustments were made to cost of operations to convert them to constant dollars and current costs, respectively. The constant-dollar adjustment requires multiplying the historical cost of operations by a ratio of price indices. The index in the numerator is average price index for the current year, and in the denominator, is the value of the index at the date closest to the date on which the expense was incurred. To illustrate, assume that a $1,000 expense was recorded on January 1, 2002, when the price index was 100; the average price index for 2002 was 110. Adjustment to constant dollars is: The same methodology is applied in adjusting historical cost of operations to current-cost amounts. The difference is that specific indices of replacement cost, or alternative measures of replacement cost, are used in place of a general price index. Tiger reported that increases in inventory costs, included in cost of operations, accounted for the adjustments to historical cost of operations. In general, adjustments to the historical cost of sales will be small if the LIFO inventory valuation method is used; the LIFO cost flow ensures that cost of sales already approximates current costs. Adjustments will generally be greater where the FIFO or average cost methods are in use. Impact of Differences in General and Specific Price Index Movements The major Tiger cost adjustments were to depreciation and amortization. De- preciation and amortization represent the conversion to expense of asset balances. In many cases these balances were recorded years earlier when the price indices were far lower. Notice that the percentage increase in the current-cost and constant-dollar depreciation and amortization over the historical-cost amount is 28% and 45%, respectively. Tiger’s disclosures explain the reason for the differences: “Depreciation expense is greater when adjusted for general inflation than when adjusted for changes in specific prices. The difference re- flects the Consumer Price Index (general inflation) rising faster than the $, $,1 000 110 100 1 100×       = 412 Planning and Forecasting increase of costs over the last several years of the type of property, plant and equipment used in the Company’s various businesses.” 56 Impact of Monetary Balances on Adjusted Results In addition to the above two inflation-adjusted income presentations, Tiger provided additional income data because it did not feel that the required disclosures, adjusting mainly depreciation and cost of sales, were adequate. These adjustments, in Exhibit 12.34, expand upon the information in Exhibit 12.33. The final adjusted net incomes above tell a totally different story from the initial display in Exhibit 12.33. Both measures of adjusted profits are sharply higher than the unadjusted historical-cost results. The new income element results from the impact of changes in the general price level on the purchasing power of monetary assets and liabilities. Tiger explains the impact of price changes on monetary balances as follows: A monetary asset represents money or a claim to receive money without refer- ence to future changes in prices. Similarly, a monetary liability represents an obligation to pay a sum of money that is fixed or determinable without refer- ence to changes in future prices. Holding a monetary asset during periods of inflation results in a decline in the value of the asset since the dollar loses purchasing power when it is held. Conversely, holders of monetary liabilities benefit during inflationary periods because less purchasing power is required to satisfy future obligations when they can be paid with less valuable dollars. 57 Under the above reasoning, Tiger earned an unrealized purchasing- power gain because its monetary liabilities exceeded its monetary assets. This gain represents the reduction in the purchasing power that Tiger would need to expend to discharge its net monetary-liability position. The impact of both inflation and deflation on purchasing-power gains, under conditions of both monetary assets exceeding monetary liabilities (net asset exposure) and EXHIBIT 12.34 Earnings adjusted for purchasing power gains from monetary position: Tiger International Inc., (in thousands). Historical Current Constant Financials Cost Dollar Net income $42,375 $ 4,782 $(15,041) Decrease in depreciation and interest expense from the decline in the purchasing power of the net liabilities — 82,195 82,195 Net income adjusted for the decrease in depreciation and interest expense $42,375 $86,977 $(67,154 SOURCE : Tiger International Inc., annual report, December 1980, 39. Global Finance 413 monetary liabilities exceeding monetary assets (net liability exposure), are summarized in Exhibit 12.35. Tiger treated the purchasing power gain as an adjustment to depreciation and interest expense based upon the following reasoning: “Because Tiger fi- nances substantially all of its fixed assets with long-term debt, it effectively hedges against the impact of inflation on depreciation and interest expense.” Tiger’s liability exposure serves as a hedge because it produces a gain under inflationary conditions, to offset increases in the cost of asset replacement and interest expense, which go hand in hand with inflation. 58 The price-level adjusted reporting illustrated above proved to be a very controversial requirement. It proved difficult to document that the price-level adjusted data were used by either creditors or investors, or that they aided analysis and decision making in any significant way. In 1986, SFAS No. 89: Fi- nancial Reporting and Changing Prices was issued, which eliminated manda- tory disclosure of price-level adjusted data. 59 The Statement did encourage continued disclosure on a voluntary basis. U.S. firms have, however, not re- sponded to this encouragement and the price-level adjusted disclosures have not been continued. U.S. GOVERNMENT RESTRICTIONS ON BUSINESS PRACTICES ASSOCIATED WITH FOREIGN SUBSIDIARIES AND GOVERNMENT 60 The last issue raised in the opening Fashionhouse scenario dealt with U.S. governmental restrictions on business practices associated with overseas operations. Recall that in reviewing the possible relocation of manufacturing to a high inflation/low labor-cost country, Fashionhouse management became aware of potential ethical and legal issues. Over the years the U.S. government became concerned with the practices sometimes followed by U.S. firms doing business overseas. Of special concern were payments to foreign governmental officials made to obtain business. From hearings over a number of years, which focused on such incidents, a recurring theme emerged: Even though such payments did take place, key members of management were often unaware that the payments were being made. EXHIBIT 12.35 Purchasing power gains and losses and net monetary position. Net Monetary Position Price Movement Asset Liability Inflation Loss Gain Def lation Gain Loss 414 Planning and Forecasting The U.S. Congress addressed the issue of controlling what they saw to be improper activities, by passing the Foreign Corrupt Practices Act of 1977. The key features of this law were: 1. The prohibition of bribery of foreign governmental or political officials in order to promote business. 2. The requirement that firms (a) keep accurate and detailed records of the company financial activities and (b) maintain a system of internal accounting controls sufficient to provide reasonable assurance that transactions are properly authorized, recorded, and accounted for. The above requirements are incorporated as amendments to Section 13(b) of the Securities Exchange Act of 1934, and apply to all publicly held companies. The record-keeping and internal control features of the Act were a response to claims that companies had been unaware of bribery payments, because their internal control systems had failed to detect or prevent them. In a report addressed to the SEC, the National Commission on Fraudu- lent Financial Reporting, made the following recommendation: All public companies should be required by SEC rule to include in their annual reports to stockholders management reports signed by the chief executive officer EXHIBIT 12.36 Report of management: Delta Air Lines Inc., year ended June 30, 2000. The integrity and objectivity of the information presented in this Annual Report are the responsibility of Delta management. The financial statements contained in this report have been audited by Arthur Andersen LLP, independent public accountants, whose report appears below. Delta maintains a system of internal financial controls that are independently assessed on an ongoing basis through a program of internal audits. These controls include the selection and training of Delta’s managers, organizational arrangements that provide a division of responsibilities, and communication programs explaining our policies and standards. We believe that this system provides reasonable assurance that transactions are executed in accordance with management’s authorization; that transactions are appropriately recorded to permit preparation of financial statements that, in all material respects, are presented in conformity with accounting principles generally accepted in the United States; and that assets are properly accounted for and safeguarded against loss from unauthorized use. The Board of Directors pursues its responsibilities for these financial statements through its Audit Committee, which consists solely of directors who are neither officers nor employees of Delta. The Audit Committee meets periodically with the independent public accountants, the internal auditors and representatives of management to discuss internal control, accounting, auditing and financial reporting matters. M. Michele Burns Leo F. Mullin Executive Vice President and Chairman and Chief Financial Officer Chief Executive Officer SOURCE : Delta Air Lines Inc., annual report, June 2000, 53. Global Finance 415 and the chief accounting officer and/or the chief financial officer. The management report should acknowledge management’s responsibilities for the financial statements and internal control, discuss how these responsibilities were fulfilled, and provide management’s assessment of the effectiveness of the company’s internal controls. 61 While the SEC has not adopted the Commission’s recommendation, many companies have elected to provide voluntarily a report of management’s responsibilities. While the precise title of the report may vary, representative titles include, Report of Management Responsibility for Financial Statements and Internal Control and Financial Reporting Responsibility. Although the precise language of the report differs from company to company, Exhibit 12.36 provides a representative example from the 2000 annual report of Delta Air Lines. The precise meaning of the provisions of the Foreign Corrupt Practices Act continues to evolve. However, in considering expansion into a country, where improper payments have a long and durable tradition, Fashionhouse must pay special attention to the existence and requirements of the Act. SUMMARY The evolution of Fashionhouse from a purely domestic firm to a truly global entity continues to confront it with new and increasingly complex problems of accounting, finance, and management. This chapter has followed Fashionhouse through this evolution and attempted to help the reader become aware of the problems faced and how they might be addressed. The range of issues addressed is broad and can become quite complex. It has not been possible, nor would it have been appropriate in a chapter such as this, to deal with all aspects of every issue raised. The reader should consult the books and articles cited throughout the chapter and in the list of “additional readings” for additional background. The following are some key points for the reader to consider: • International business and international operations raise challenges that transcend those of a strictly domestic operation. • Exposure to potentially adverse movements of foreign-currency exchange rates is a key challenge for firms that engage in international business. This currency risk can arise from both transactional and translational exposure. • Both transactional and translational currency risk can be managed or hedged to some extent by relying on aspects of a firm’s own operations. This is normally referred to as employing natural hedges. • Beyond the use of natural hedges, it is common for firms to use a variety of foreign-currency derivatives. Forward contracts and currency options are currently the most popular. 416 Planning and Forecasting • Most hedging activity centers around efforts to protect cash flows and earnings from the volatility that would be produced by the combination of unhedged currency exposure and fluctuations in exchange rates. Transla- tion exposure, which does not pose the same threat to cash flows and earnings, is hedged far less frequently than transaction exposure. • Note all of the effects of changes in exchange rates are reflected in transaction and translation gains and losses. The strength of the U.S. dollar in recent years has both reduced the dollar value of foreign sales as well as the competitiveness of U.S. products. • The emergence of the Euro has the potential to reduce both the cost and complexity of hedging because many European currencies are replaced by a single currency, the Euro. However, some companies express concern about possible adverse competitive effects associated with the pricing transparency that results from a common currency. • Substantial differences continue to exist between GAAP in the U.S. and that in other countries. However, the International Accounting Standards Committee (IASC) continues its efforts to create more harmony in GAAP across the world. These GAAP differences create substantial challenges when analyzing the financial performance of foreign firms. • The evaluation of the performance of foreign subsidiaries and their management can be affected by exchange-rate changes. A common response is to remove the effects of exchange rate changes from key performance in- dicators. Another approach is to evaluate performance using budgeted exchange rates. The extent to which the responsibility for hedging currency exposure is delegated to management of these entities should affect deci- sions about how to deal with the effects of exchange-rate changes. Re- moving the effects of exchange rate changes is consistent with an absence of responsibility for the hedging of currency risk. • Recent changes in the accounting for derivative instruments and hedging activities call for the recording of all foreign-currency derivatives at their fair values. In some cases, gains and losses from the revaluation of currency derivatives will initially be included in other comprehensive income. However, these gains and losses will subsequently be included in net income when the related hedged transaction is included in earnings. The deferral of foreign-currency gains and losses on the balance sheet is no longer permitted. • Transfer pricing policies between U.S. parents and their foreign subsidiaries create challenges in terms of both performance evaluation and worldwide tax minimization. • Modest levels of inflation in the U.S. in recent years has meant that increases in the general price level have not been a major management issue. However, inflation continues to present issues for global firms because of substantial inflation in some of their foreign markets. Global Finance 417 • The international expansion of business activities can create potential problems because of different business and cultural norms. Practices that may be common in some countries may be in direct conflict with U.S. law. Firms should be certain that they are familiar with and in compliance with the provisions of the Foreign Corrupt Practices Act of 1977. FOR ADDITIONAL READING Beaver, W., and W. Landsman, Incremental Information Content of Statement 33 Disclosures (Stamford, CT: FASB, 1983). Choi, F., ed., Handbook of International Accounting (New York: John Wiley, 1991). Comiskey, E., and C. Mulford, Guide to Financial Reporting and Analysis (New York: John Wiley, 2000). Epstein, B., and A. Mirza, Interpretation and Application of International Account- ing Standards 2001 (New York: John Wiley, 1997). SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities (Nor- walk, CT: FASB, June, 1998). Financial Accounting Standards Board, The IASC-U.S. Comparison Project: A Re- port on the Similarities and Differences between IASC Standards and U.S. GAAP (Norwalk, CT: FASB, November, 1996). , Financial Reporting in North America—Highlights of a Joint Study (Nor- walk, CT: FASB, December, 1994). Frishkoff, P., Financial Reporting and Changing Prices: A Review of Empirical Re- search (Stamford, CT: FASB, 1982). Goodwin, J., S. Goldberg, and C. Tritschler, “Understanding Foreign Currency De- rivative Measurements as FASB Moves Toward Fair Value Reporting,” The Journal of Corporate Accounting and Finance, 7, (spring 1996): 75–84. Goldberg, S., and J. Godwin, “Foreign Corrupt Practices Act: Some Pitfalls and How to Avoid Them,” The Journal of Corporate Accounting and Finance , 7, (winter 1995–1996): 35–43. Haskins, M., K. Ferris, and T. Selling, International Financial Reporting and Analy- sis (Chicago: Richard D. Irwin, 1996). Kim, H., Fundamental Analysis Worldwide (New York: John Wiley, 1996). Mulford, C., and E. Comiskey, Financial Warnings (New York: John Wiley, 1996). Radebaugh, L., and S. Gray, International Accounting for Multinational Enterprises, 3rd ed. (New York: John Wiley, 1993). Shapiro, A., Multinational Financial Management, 5th ed. (Upper Saddle River, NJ: Prentice-Hall, 1996). ANNUAL REPORTS REFERENCED IN THE CHAPTER Adobe Systems Inc. (1999) AGCO Corporation (1999) . profit margins: Johnson & Johnson Inc. (1999) Inflation rates, even though moderate in many parts of the world during 1999, continue to have an effect on worldwide economies and, consequently,. accelerated depreciation, especially for income tax purposes, is also seen to offset some of the potential profit overstatement associated with inflation. The revision of traditional cost-based. accelerated depreciation to cause expenses to approximate current (replacement) costs is only a partial adjustment for the impact of inflation. Historically, the comprehensive restatement of results