Analysis of Foreign Financial Statement

Chapter 9

Analysis of Foreign Financial Statements

Analysis of Foreign Financial Statements

Chapter Topics Reasons for analyzing foreign financial statements. Problems encountered in analyzing foreign financial

statements. Possible solutions to problems encountered in analyzing

foreign financial statements. Restating foreign financial statements to U.S. GAAP

illustrated.

Reasons to Analyze Foreign Financial Statements

Foreign portfolio investment Investors can diversify away some risk by investing

internationally. While stock returns in many countries are positively correlated

with U.S. returns, these correlations are far from perfect.


International mergers and acquisitions The frequency and size of international corporate

mergers has increased in recent years. Examples include Daimler/Chrysler and acquisitions by Ford

Motor such as Volvo (of Sweden). The purchaser of an international company needs to analyze the

target company’s financial statements to determine the acquisition price.


Other reasons Extending credit for foreign customers. Evaluating foreign vendors. Comparisons to international competitors.

Foreign Financial Statement Analysis – Problems

Data accessibility Relative to the U.S., financial information is

difficult to obtain in many countries. While databases of foreign financial statements do

exist, these can contain errors and present information in a variety of formats.

These databases also do not contain complete disclosure notes.

Another approach is to obtain a copy of the foreign company’s annual report.


Language Many international companies do not produce financial

statements in English. The financial statement user could hire a translator or

develop foreign language capability. Since English is the language of business, companies in

many foreign countries produce convenience translations of their financial statements in English.


Currency Many international companies produce their financial

statements in a currency other than the U.S. dollar. These can be converted to U.S. dollars by translating all

balances at the exchange rate at the end of the current year.

In order to avoid distortions, the current exchange rate should be used for all previous years.

Analysis using ratios is not distorted by different currencies-

Thus currency differences are usually a minor problem.


Terminology Differences in terminology exist between countries using

the same language. For example, sales in the U.S. is normally called turnover

in the UK. In cases of convenience translations, sometimes these

include terminology unfamiliar to English speakers. Knowledge of the business and accounting environment

can help alleviate some of these problems.


Format Some format differences are not problematic because

the information is given, just in a different place. However, other format differences are a problem

because the information is not provided. Example: It is common in Europe to not provide cost of

good sold. This prevents an analyst from determining gross margin

percentage and inventory turnover.


Format Another example: German and other continental

European companies often do not distinguish between current and noncurrent liabilities.

This makes it difficult or impossible to compute a current ratio.


Extent of disclosure Disclosure internationally tends to be limited compared

to the U.S. where full disclosure is fundamental. Some of the most serious disclosure limitations are

information on segments, asset valuation, foreign operations, interim statements, and reserves.

Globalization of capital markets tends to enhance disclosure as companies attempt to attract investors.


Timeliness Timeliness is one aspect of the relevance of information. This varies significantly internationally since filing

deadlines differ from country to country. Among developed countries, the U.S. and Canada are the

most timely whereas continental Europe is the least. Requirements about the frequency of information also vary

internationally from quarterly to annual reporting. There is very little investors can do to overcome these

problems.


Differences in accounting principles Differences in accounting principles often result in

significantly different income and other financial statement amounts.

Some of the biggest problem areas are consolidations, fixed asset valuation and depreciation, and goodwill.

Global context plays a big role in the degree of accounting differences and flexibility.

Examples:Germany- tax/reporting tied together. UK: “True and Fair View”USA-Prescriptive rule-based standards

(leases, pensions, etc.)

Foreign Financial Statement Analysis – Possible Solutions

Differences in accounting principles Possible solutions:

Reframe foreign financial statements to a more familiar GAAP.

Use a stripped down measure of earnings that excludes items most affected by diversity.

Invest using macro indicators and diversification to reduce increased information risk.

Learn the local GAAP and business environment- then use the statements as published.

The impact on Financial Statement Analysis of

Efforts to Harmonize Accounting Differences As the use of the new IFRSs becomes more widespread,

many of these problems will likely abate. However, even if perfectly adopted, IFRSs, as currently

formulated, cannot fully eliminate the increased information risk of international investment.

Example: Japan business forms and consolidation accounting. Consolidation accounting codified into IFRSs was developed to address US/UK entity issues, not those that developed in different cultures around the pacific rim.

Foreign Financial Statement Analysis – Interpretation of accounting ratios.

Business environment differences Differences in culture and economic environments have

an impact on the relevance of ratios. Knowing about these differences is crucial when investing internationally.

A study of companies in Japan, Korea, and the U.S. found significant differences due to business environment.

For example, Japanese and Korean companies borrow much more on a short-term basis than U.S. companies, leading to lower current ratios.

Foreign Financial Statement Analysis – Interpretation of Accounting ratios

Business environment differences Debt ratios also tend to be higher in Japan and Korea

because of government-sanctioned sources of financing. Lower profit margins in Japan, relative to U.S., can be

partly explained by those companies focus on market share as opposed to profits.

In summary, an investor needs to be aware of these differences and not forgo potentially profitable (long-term) investments.

Restating Foreign Financial Statementsto U.S. GAAP

Form 20-F Foreign companies that file non-U.S. GAAP

financial statements with the SEC are required to complete a Form 20-F.

The Form 20-F reconciles net income and stockholders’ equity to U.S. GAAP.

However, there is no requirement to reconcile assets and liabilities.

In essence, this represents a partial restatement from foreign GAAP to U.S. GAAP.


Form 20-F Some ratios, such as return on equity, can be computed

as if under U.S. GAAP. Most other ratios, however, cannot be computed as if

under U.S. GAAP. The analyst can overcome this by performing the

restatement of financial statement items.


Restatement overview – Step one of two The first step, reformatting, involves transforming the

financial statements into a U.S. format. This involves transformation of:

terminology differences, presentation differences, and Item definitions and classifications.


Restatement overview – Step two The second step involves restating the foreign GAAP

amounts to U.S. GAAP amounts. This process is made easier when the company files a

Form 20-F. Sometimes, companies will present a similar

reconciliation without actually filing the Form 20-F. In any case, notes to the financial statements are very

useful in completing this step.


Step one mechanics – Reformatting Begin with setting up a four column worksheet in U.S.

GAAP format. Columns are foreign GAAP, debits, credits, and U.S.

GAAP. Amounts are presented in original currency. Prepare worksheets for income statement, statement of

retained earnings, and balance sheet. Line items in worksheet are presented in terminology of

U.S. account titles.


Step two mechanics – Reformatting The work in this step affects the debit and credit columns

in the worksheet. The nature of these entries is essentially adjusting and

reclassification entries. Some entries affect current net income or beginning

retained earnings, some affect both. Each entry reflects the adjustment needed to reconcile to

U.S. GAAP from foreign GAAP.


Partial example -- restated financial statements Assume that the foreign GAAP column of the financial

statements being restated has already been reformatted into the U.S. GAAP titles and amounts.

These amounts include:

Sales 2,000 Cash 500

Cost of sales 1,100 Inventory 600

SG&A expense 200 Deferred liability 50

Other income 100 Pension liability 800

Retained earnings (beg) 500 Retained earnings (end) 1,300


Partial example -- restated financial statements

Under U.S. GAAP the current pension liability costs are 40 units higher and the beginning balance in pension liability is 100 units higher.These costs are accounted for as SG&A expense.

Cash realized of 20 units during the current year is considered a deferred liability under U.S. GAAP and is other income under foreign GAAP.


Partial example -- Income statementForeign U.S.

U.S. Format GAAP Dr. Cr. GAAPSales 2,000 2,000Cost of sales 1,100 1,100Gross profit 900 900S,G,&A expense 200 40 240Net Operating Income 700 660

Other income 100 20 80Net Income 800 740

Learning Objective 4


Partial example – Retained earnings statement

Foreign U.S.

U.S. Format GAAP Dr. Cr. GAAP

R/E, beginning 500 100 400

Net income 600 580

R/E, ending 1,100 980

Learning Objective 4


Partial example – Balance sheetForeign U.S.

U.S. Format GAAP Dr. Cr. GAAPCash 500 500Inventory 600 600 … … …Deferred liability 50 20 70Pension Liability 800 100 940

40 … … ...Retained Earnings 1,300 1,140

Cross-sectional analysis

Problems with accounting differences are particularly acute when comparing the results of firms domiciled in different countries and reporting under different GAAPs.

Even if they are both using IFRSs, there can be significant differences that, without restatement, make the ratios difficult, is not impossible to compare and interpret.

Example: One firm in the UK revalues its assets, while in the US, another firm does not.

Cross-sectional analysis-restatementmethods

Restate one company’s numbers by placing it the same basis as the other

Example: A uses the LIFO cost flow assumption when valuing inventory

and computing cost of goods sold. B uses FIFO. Use the change in the LIFO reserve to estimate A’s earnings

under FIFO.

Cross-sectional analysis-restatementmethods Restate one company’s numbers by using an assumed

relationship between two accounts. Example:

A uses an the double declining balance method when depreciating property, plant and equipment.

B uses straight line. The industry ratio of depreciation expense/PPE for straight-line

companies is X. Use X to estimate A’s depreciation on a straight-line basis.

Restatement Methods (Cont.)

Restate either/both companies numbers by removing the accounting object that is interfering with comparison.

Example: A capitalizes goodwill and amortizes over 4 years. B writes all goodwill off to equity on the date of acquisition. Remove all deductions for goodwill amortization from A’s

numbers.

Cross-sectional restatement:Candidate Areas

Revenue Recognition-”Front end” loading Inventory valuation Amortization and depreciation Asset capitalization (R&D, Goodwill, impairment

and revaluation) Off balance sheet financing (e.g., leases,

contingencies) Balance sheet reserves

Foreign Currency Effects

Foreign currency effects can make comparisons of the persistent elements of performance of core business operations difficult. Because of this, many analysts remove them, at least for this portion of the analysis.

On the other hand, the effects, while not always associated with cash flow effects, can have major economic relevance.

Oddly, sometimes reported losses predict performance gains and gains predict losses.

The type of exposure usually plays a major role.

Time Series Analysis

Less of a problem since:Both numbers are computed using the same

GAAP, are stated in the same terms, and use the same classification scheme.

Change ratios remove, to some extent, any context-driven differences in the levels of reported numbers.

Economy & Finance

Analysis of Foreign Financial Statement