Tax, Sales Growth, Financial Results
What you'll learn
- LOS 9.hDescribe how multinational operations affect a company’s effective tax rate.
- LOS 9.iExplain how changes in the components of sales affect the sustainability of sales growth.
- LOS 9.jAnalyze how currency fluctuations potentially affect financial results, given a company’s countries of operation.
Tax Implications of Multinational Operations
Multinational corporations are subject to multiple tax jurisdictions with differing laws and tax rates. In the United States, for example, the tax code allows a credit for foreign taxes paid by U.S. companies, effectively taxing the company at the U.S. tax rate.
Effective tax rate is the tax expense in the income statement divided by pretax profit. Statutory tax rate is provided by the tax code of the home country. Accounting standards require companies to provide a reconciliation between the effective tax rate and the statutory tax rate.
This reconciliation disclosure can be used by the analyst to project future tax expense.
Changes in effective tax rate on account of foreign operations can be due to:
Changes in the mix of profits from different countries (with varying tax rates).
Changes in the tax rates.
The reconciliation between the statutory tax rate and effective tax rate for two companies (Amco and Bianco) for 20X4 is provided.
1. Which company benefited from the lowering of tax expense on account of its foreign operations?
2. If the mix of foreign operations for both companies is expected to increase over time, which company is most likely to report lower effective tax rate in the future? Assume that the statutory tax rates do not change.
Solution
1. The effect of foreign operations resulted in an increase in effective tax rate for Amco by 3.4% and a decrease for Bianco by 1.2%. Hence, Bianco benefited from its foreign operations in reducing its effective tax rate and tax expense.
2. If the mix of foreign operations increases, assuming no change to the tax rate, Bianco would see its effective tax rate decrease further and Amco would see its effective tax rate increase.
Financial statements for multinational companies report sales denominated in the reporting currency even though the actual sales may have occurred in many different currencies. Changes in currency values affect the value of translated sales. Sales growth owing to an increase in volumes or prices is considered more sustainable than sales growth due to appreciation of the foreign currencies in which sales were made.
Organic growth in sales is defined as growth in sales excluding the effects of acquisitions/divestitures and currency effects. Companies often report foreign currency effects on sales in the MD&A section of their annual reports. This information can be used by analysts to improve the accuracy of their forecasts of future sales.
BCN, Inc., an American multinational, reported the following in its MD&A for 20X4:
Comment on the growth rates observed in different markets for BCN.
Solution
BCN experienced highest growth in North America ex U.S. Excluding the loss in translation (due to depreciation of the foreign currency in which sales are denominated) for North America ex U.S., the revenue growth would have been 5% due to an increase in volumes and/or price.
In Europe, the revenue growth is 2%, but that was due to appreciation of the currencies in which sales occurred. Excluding the currency effect, sales were down in Europe by 1%.
In Asia, the revenue growth of 2% is solely due to price/volume changes.
Major Sources of Foreign Exchange Risk
Foreign exchange risks reflect the effect of changes in currency values on the assets and liabilities of a business as well as on future sales. We discussed transaction and translation exposure earlier in this topic review and the impact of each on reported profits.
Disclosures as part of MD&A may include the impact of currency value changes on profits. Such disclosures help an analyst estimate the potential impact of currency value changes on a company’s earnings going forward. If such information is not provided, analysts can conduct their own sensitivity analysis to further improve their forecasts and understand risks faced by the company.
Analysts also should inquire about any hedging tools employed by the company to manage its currency exposures.
An excerpt from Walmart’s 2015 Annual Report:
We are exposed to fluctuations in foreign currency exchange rates as a result of our net investments and operations in countries other than the U.S. For fiscal 2015, movements in currency exchange rates and the related impact on the translation of the balance sheets of the Company’s subsidiaries in Canada, the United Kingdom,
Japan (日本), Mexico, and Chile were the primary cause of the $3.6 billion net loss in the currency translation and other category of accumulated other comprehensive income (loss). We hedge a portion of our foreign currency risk by entering into currency swaps and designating certain foreign currency denominated long term debt as net investment hedges. We hold currency swaps to hedge the currency exchange component of our net investments and also to hedge the currency exchange rate fluctuation exposure associated with the forecasted payments of principal and interest of non U.S.- denominated debt.
The aggregate fair value of these swaps was in a liability position of $110 million at January 31, 2015, and in an asset position of $550 million at January 31, 2014.
The change in the fair value of these swaps was due to fluctuations in currency exchange rates, primarily the strengthening of the U.S. dollar relative to other currencies in the latter half of fiscal 2015.
A hypothetical 10% increase or decrease in the currency exchange rates underlying these swaps from the market rate at January 31, 2015, would have resulted in a loss or gain in the value of the swaps of $435 million. A hypothetical 10% change in interest rates underlying these swaps from the market rates in effect at January 31, 2015, would have resulted in a loss or gain in value of the swaps of $20 million.