A fellow student of yours who has just completed a course in cost accounting recently made the following comment to you regarding the establishment of transfer prices for transnational transfers of goods and services within the same company: "In the process of preparing consolidated financial statements,all profit and loss attributable to internal transfers of goods and services are removed.The amount of profit a company reports is therefore affected only by transactions with external parties.Therefore,the subject of transfer pricing may be important for motivational purposes or some other managerial objective,but the choice of a transfer pricing system has no effect on the bottom line,even when transfers are made between units of a company operating in different countries."
Required: Critically analyze and respond to the above assertion.

Question

Quizplus · Accepted Answer

Feedback: The above comment may have some validity if there were no income tax effects associated with transnational exchanges of goods and services,or if the tax rates were relatively equal across tax jurisdictions (which they are not).However,the existence of income tax differentials and import duties in the real world provides opportunities for tax planning and therefore optimization of after-tax earnings and cash flows.That is,alternative transfer pricing methods can result in sizable differences in the reported operating income of divisions in different income tax jurisdictions.If these jurisdictions have different tax rates or deductions,the net income of the company as a whole can be affected by the choice of the transfer pricing method.The above comment can also be challenged because it ignores incentive or other decision effects associated with income tax differentials.(In technical terms,the argument assumes a static analysis. )For example,to the extent that a company is able to achieve reductions in worldwide taxes (and duties),it may be able to lower its selling price.Depending on the price elasticity of demand for the product (or service)in question,this reduction in selling price could affect total sales,thereby affecting in a positive way the bottom line worldwide income of the organization.

A Fellow Student of Yours Who Has Just Completed a Course