Effects of Exchange Rates in International Transfer Pricing Decisions

Events leading to the passing of the Sarbanes-Oxley Act have led to increased concern with and scrutiny of potential management manipulation of financial statements. From an agency theory perspective, managers have incentives to manipulate organizational methods and choices in order to produce financial statements that those managers believe will maximize their incentive compensation. Transfer pricing represents one possible choice that managers can manipulate. This paper investigates whether exchange rates affect transfer pricing particularly as it relates to maximizing overall corporate profitability. The effects of taxes and government regulations have been explored in considerable depth in the transfer pricing literature. However, while transfer prices should also be affected by exchange rates in predictable ways, this variable has received comparably little attention in the literature. Inclusion of exchange rates in an analysis of transfer pricing and corporate profitability presents an opportunity to add to the literature. We conducted an experiment to examine how managers set transfer prices. We found that, while individuals were influenced by managerial incentives, they seemed genuinely concerned with firm profitability. We found that individuals, and therefore possibly managers, consider the effects of exchange rates on their transfer pricing decisions, even in the absence of incentives. This is an important finding not only with relation to the transfer pricing literature but also with regard to the underlying agency theory literature