Enhance sales performance appraisal for accounting and tax

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hello and welcome to the session this is Professor Farhad in this session we would look at the objective of international transfer pricing specifically we're going to be focusing on performance evaluation this topic is covered an international accounting or taxation course as well as on the CPA and ACCA exam as always I would like to remind my viewers to connect with me on LinkedIn if you haven't done so YouTube as well you would need to subscribe I have 1500 plus accounting auditing tax and finance lectures those are this is a list of all the courses that I cover including the number of lectures including CPA material on my website you will have access to additional information and additional material such as PowerPoint slides notes through false multiple-choice quasi CPA simulations and 2000 plus CPA questions so one of the objective of international transfer pricing is you want to make sure you have its it aligned with proper performance evaluation because to fairly evaluate the performance of both parties and an intercompany transaction the transfer price should be acceptable to both parties simply put if you're asking to parties to buy from one another well for both parties to be to be to be evaluated fairly the price should be negotiated you should have the best price now what is the best price the best price should be a market price when does the market price exist a market price exists when you have an outside competitive market or or give both parties the ability to negotiate the price this way Nate neither party will feel they are at a disadvantage and the negotiation okay so policies for establishing prices for domestic transfer generally should be based on objectives that generate reasonable measure for evaluating performance so you gotta let them negotiate or let them use market prices this way you can evaluate them so if they are profitable or not if they are meeting the profit margin for the company if they're meeting to return on investments otherwise what's gonna happen this functional manager behavior could occur in goal congruence will not exist goal congruous is when the when the different subsidiaries all working in the same direction for the overall profit of the company for example forcing one manager of an operating unit to purchase parts from a related operating unit at a price that exceeds the external market price is not a good behavior why if somebody asks you to buy something from another part of the company at a higher price than what you can buy it from an external party well you're also it's gonna be higher simply put let's assume you need raw material and you can buy from an outside party at $8 per unit but the parent company says you need to buy it from inside the company at $10 per unit so you're forcing forcing me to pay two additional dollars where I can get that unit from somewhere else that's gonna result in an unhappy manager unit profit will be less okay because I'm paying $2 more my salary and my bonus will be lower okay in addition what's gonna happen when my division or when my department is show shows less profit because my unit cost is higher I'm gonna have less and less resources allocated to me and as less and less and less resources are allocated to my division I'm gonna be less and less efficient and less profitable most probably so that's why it's very important to let different departments or different division negotiate the price or let them use an external price so the best way to illustrate this is to work with some examples let's assume alpha company and manufacturers and beta company in retailer so alpha manufacturer sells it to b and b sells it to the consumer alpha produces DVD players at a cost of $100 that's the cost for alpha and sells them to beta into unrelated parties so alpha don't only sells to beta which is part of the company its subsidiary but also it sells a to outside party beta purchases DVD players from alpha and from unrelated suppliers and sells and for 160 so beta they sell the each DVD player for 1/6 so the total gross profit for the company is $60 because if we produce at alpha produces it for $100 that's the that's the cost for alpha then beta cells at for 160 so overall this is beta so this is sold at 160 it means the company makes profit of $60 okay that's the overall profit for the company Alpha Company can sell the DVD player to unrelated customers for 127 per unit so alpha they can sell it for 120 750 per unit to underlay the party and beta can purchase the DVD player for 130 250 per unit what does that mean it means we have 127 near 12750 12750 in 13250 okay so alpha they sell it for 120 750 to anyone this is price to anyone so if you want the DVD player from alpha you can buy it for 127 50 beta they can go to alpha and buy for 2127 50 or they can buy it from somewhere else at 132 50 okay so basically what does that mean it's the minimum the minimum we should sell it to beta is 120 750 and the maximum should be 132 50 because if alpha tried to say I'm gonna sell it for 135 to alpha alpha is gonna Adam sorry if alpha says I'm gonna sell it for 135 debate the beta says that's not acceptable because I can buy it for 13250 why are you selling it at 1 135 to me okay so what should be a fair price will be someplace in between that's the fair price okay this is how we determine the fair price or this is what would be considered a fair price so the manager of alpha should be happy selling DVD the DVD to beta for 127 50 or more and the manager of beta should be happy to purchase the DVD player up to 130 250 so anything in between it's acceptable to both because alpha as long as you sell it for more than 120 750 they're happy and beta is happy as long as you sell it for less than 13250 and this is why I said the price between 12750 12750 and 13250 12750 in 132 13250 this is the price that both parties will be happy as long as it's within that price okay so a transfer price somewhere in between will be acceptable to both so let's assume we're gonna sell it we're gonna do it we're gonna determine a transfer price of 130 what would the profit looks like okay let's take a look at the income statement for alpha alpha at cost alpha 100 sells it at 132 beta they have a profit of 30 the income tax effect assuming their pay us rate six six dollars and thirty cent after-tax profit is twenty three dollars and seventy cents for alpha beta they buy it at they buy it at 130 therefore the cost as 130 they sell it at 160 they have a profit of thirty same thing same tax rate in the u.s. six dollars and thirty cents a profit of twenty three seventy together so the total sales for the parent company 160 total cost of goods sold 100 total profit sixty total tax 1260 and a profit of forty seven dollars and forty cents so everything is good DBM is fear now let's change the scenario from a domestic scenario to international scenario let's assume that alpha is located in Taiwan and beta is located in the US the income tax rate and Taiwan is only seventeen percent compared to the US which is 21 okay so the parent company would like to Ma to make as much of the $60 profit gross profit to be earned by alpha as possible so the goal is to do that so rather than allowing the two managers negotiated the price okay assume the parent company intervene and they establish what's called a discretionary transfer price of 150 so now what we're saying is this we want alpha rather than sell it selling it to you for 130 we're gonna change this to 150 what does that mean it means the price of beta we'll be 150 and let's see what happened if we change the transfer price so alpha is gonna sell it for 150 your cost is 50 they make a profit of $50 in Taiwan they are charged 17 percent the after-tax profit is forty one forty one fifty no beta they have a cost of 150 they sold it for 160 they make profit only of ten dollars in the u.s. they are taxed at two dollars and then sent they took the total profit is seven dollars and 99 t sent seven dollars and ninety says let's take a look at the overall 162 overall sales cost of goods sold is 100 total profit of sixty the total tax here is ten sixty so notice the total tax the total taxes than 60 versus versus 1260 earlier versus 1260 earlier which as we made two dollars of extra profit two dollars of extra profit on the bottom line okay so what's gonna so what overall what's the result obviously the chief officer of the parent company is pleased because now we have two extra dollars now at zero status dollars two million or two billion but the point is we have extra money a case of consolidated income for the parent company increased increased by two dollars the cash flow and alpha and beta will remit their after-tax profit it's gonna be higher the dividend will be higher which is good the president of alpha will be happy because of this transfer price because now they're selling everything for 150 rather than 130 their compensation will be higher their bonus will be higher and managers are happy at Alpha Company because it's good now what happened to beta beta will not be happy so beta is less pleased with the situation third profit is less because they have to pay more okay it's less than because they can they can buy it remember data they can buy this DVD at a maximum price of 13250 so now that's why they that's not good they would receive a bonus for the year that's less than what they should and they might be starting to think about leaving the company if that's the case also top management as we said my allocate less resources that so this is the one one objective of international transfer pricing is performance evaluation we want to make sure we don't go into this situation where beta is not happy because now it's not gold congruence in a sense that you want beta to work as hard as possible and everything to be fair okay and the next session would look at the other objective of the second objective of international transfer pricing and we'll talk about cost minimization and when we talk about here we're going to focus more on the taxes in a sense we looked at the taxes but there's other costs we need to look at as as always I would like to remind you to visit my website because I do have additional resources additional lectures not only this course and I suggest you subscribe it's an investment in your career good luck and study hard stay motivated