5 October 2012

The accounting pitfalls of cross-border commerce

Cross-border commerce is a rapidly growing global market and an increasing area of focus for many businesses. However, there are complexities and challenges involved for merchants selling overseas. It is well known that more and more multinational companies are moving to a cost center accounting method. In a multi layered company structure ,and when goods or services are transferred internally, a transfer price should be calculated  in order to fairly distribute the costs against  earned revenue. Retailers and general ecommerce merchants might find it difficult to define the appropriate transfer pricing method, due to the complexity of their value-chain; some might be purchasing products from third party producers, others might be directly related to producers or manufacturers, or be a distribution unit themselves. In addition, the multi-currency processing and related currency foreign exchange exposure risks for merchants accepting foreign payments have to be considered as well, and will be dealt with in a subsequent article.

First of all, it should be noted that the main principle underlying the choice of a transfer pricing method is the arm’s length principle, which is based upon the assumption that “the parties to a transaction are independent and on an equal footing”. When looking at a transfer pricing model for example the Organization for Economic Co-operation and Development (OECD) has adopted that principle that transfer prices between companies of multinational enterprises are established on a market value basis. Therefore, for determining the most appropriate measure of an arm’s length value, the following two methods are considered as most popular: the Cost Plus Method and the Transactional Net Margin Method.

The Cost Plus Method according to OECD  begins with the costs incurred by the supplier of goods or services.. An appropriate cost plus mark up is then added to this cost, to arrive at a transfer value having in mind any additional value added during the process,  and the market conditions. The value can then be regarded as an arm’s length one.The cost plus method is most often used to assess the markup earned by retailers or manufacturers selling to related parties. This method requires detailed comparisons of products produced, functions performed, risks borne, manufacturing complexity, cost structures and intangibles to arrive at a reasonable value in line with real market values or the real cost.Comparisons should be made with the pricing of other third party providers to ensure the pricing is reasonable bearing in mind, as far as is possible, differences between the cost structures, products, capacity or volumes. One of the drawbacks of this pricing method to be considered is that (gross) cost plus from third parties is generally difficult to obtain. It could also be difficul to obtain reliable cost of goods sold figures due to differences in accounting standards .  Therefore, the Cost Plus Method might not appear to be a reliable benchmarking method for some multinational businesses.

Another option is the Transactional Net Margin Method. According to the OECD the transactional net margin method examines the net profit margin relative to an appropriate base (e.g., costs, sales, assets) of a transaction. This means in particular that the net margin for the  transaction should ideally be established by reference to the net margin of similar  transactions. Where this is not possible, the net margin that would have been earned in comparable transactions by an independent enterprise may serve as a guide. A functional analysis of associated enterprises and, in the latter case, the independent enterprise is required to determine whether the transactions are comparable and what adjustments may be necessary to obtain reliable results.

This method requires the detection or estimate of the net (operating) profit level that would be earned by third parties on similar transactions. It is reasonable to conclude that the TNMM could be considered as a reliable test to demonstrate that the transactions under review are priced at arm’s length by selecting a set of comparable independent companies in the same industry.