International Accounting, 6/e Frederick D.S. Choi Gary K. Meek Chapter 9: International Financial Statement Analysis
Learning Objectives • What is a logical approach to analyzing foreign financial statements? • Why is it difficult to undertake an international business strategy analysis? • What are some steps to examining foreign accounting practices? • How do cross-country variations in accounting measurements, disclosure practices, and auditing standards impact one’s analysis of foreign financial statements? • How can you cope with differences in national accounting measurement practices? • What does international prospective analysis entail and why is it difficult to perform in an international setting? • What are some pitfalls to avoid when conducting cross-country ratio analysis?
What is a Logical Approach to Analyzing Foreign Financial Statements? • Undertake a business strategy analysis. • Conduct an analysis of a firm’s financial reporting practices. • Conduct a financial analysis using ratio and cash flow data. • Do a prospective analysis.
International Business Strategy Analysis • Strategy analysis = getting to know a company and its competition in relation to its economic environment. • Information gathering includes recourse to • Annual reports • Company staff, financial analysts, and other financial professionals • World Wide Web • Trade groups • Competitors • Reporters • Lobbyists • Regulators • Financial press
International Business Strategy Analysis (contin) • Difficulties in undertaking an IB business strategy analysis • Profit drivers and business risks may be country specific. • National business and legal environments differ. • Environmental risks such as changing process and FX risk need to be evaluated. • Information sources may be limited or unreliable.
Steps in Examining Foreign Accounting Practices • Identify key accounting policies. • Assess a firm’s accounting flexibility. • Evaluate the firm’s accounting strategy. • Evaluate the quality of its financial disclosures. • Identify reporting outliers. • Adjust for accounting measurements that distort the underlying economics of a firm’s transactions.
How Does Diversity in International Accounting Impact Financial Statement Analysis? • Measurement differences within and between countries make performance comparisons difficult. • Measurement differences may relate to measurement options permitted by GAAP. • Measurement differences may be due to differences in management discretion. • Measurement difference may be due to differences in financial statement orientation; i.e., creditor vs. shareholder. • Measurement differences may relate to the objectives of financial statements; i.e., oriented toward more macro decisions vs. micro decisions.
How Does Diversity in International Accounting Impact Financial Statement Analysis? (contin) • Differences in corporate transparency make it difficult: • to comprehend what measurement rules are being followed • to estimate future performance metrics • to value forecasted numbers because of large variances of these subjective probability distributions • Auditing differences affect the credibility of reported numbers owing to differences in: • the information content of the auditors report • the source of auditing standards • the enforcement of auditing standards • auditor liability to third parties • auditor qualifications • auditor certification procedures • auditor independence
Coping Mechanisms • For measurement differences: • Adopt a mutual fund (passive) approach to investing. • Restate foreign GAAP to domestic GAAP. • Restate foreign GAAP to IFRS. • Rely on non-accounting data using a dividend discount model or cash flow data. • Immerse yourself in the language, currency and GAAP of the country you are investing in; i.e., develop a multiple-principles capability.
Coping Mechanisms (contin) • For disclosure differences: • Undertake company visitations. • Attend company road shows. • Alter investment classifications from speculative grade (poor disclosure) to investment grade (good disclosure). • Alter investment strategies from active investing (good disclosure) to passive or non-investing (poor disclosure).
Coping Mechanisms (contin) • For audit differences: • Research the auditing environment in the country being analyzed. • Institutional investors ask for a second audit opinion or engage a recognized audit firm when confidence in the integrity of the attest function is in doubt. • Assess a higher risk premium for audit risk.
Prospective Analysis • Prospective analysis: forecasting a firm’s prospects based on an assessment of a firm’s business strategy, accounting policy, and its financial analysis, and arriving at an estimate of the firm’s value. • Complicating factors: • Fluctuating exchange rates make it difficult to forecast a firm’s future costs and revenues when sales/purchases are invoiced in foreign currencies. • National variations in measurement, disclosure, and auditing practices including national enforcement regimes add to the difficulty of achieving forecast accuracy. • National variations in pricing risk make it difficult to select an appropriate discount rate for valuation purposes. • Valuation multiples such as P/E ratios also vary from country to country complicating appropriate corporate valuations.
Pitfalls in Conducting International Ratio Analysis • All of the difficulties mentioned previously in conducting business strategy, accounting, and financial analysis. • A lack of understanding of the political, legal and business environment that affects the analysis of financial ratios generated in that environment.
Pitfalls in Conducting International Ratio Analysis (contin) • Examples of environmental differences: • Government systems • UK and U.S. governments are more laissez-faire; i.e., ensure free markets. Self-regulation is encouraged. • German and Japanese governments are more active in orchestrating growth. Government has a major role in market regulation. • Legal systems • UK and U.S. governments are common law countries where standard-setting is delegated to professional bodies and standards oriented toward investor decisions. • Germany and Japan are code law countries. Government active in standard setting with pronouncements oriented toward societal rights.
Pitfalls in Conducting International Ratio Analysis (contin) • Fiscal systems • UK and U.S. make a distinction between financial reporting and tax reporting. Emphasis on consolidated reporting. • Germany and Japan exhibit a degree of tax-book conformity. Parent company financial statements are important. • Capital markets • UK and U.S. markets oriented more toward equity investors. They’re more equity-oriented with significant individual ownership. Earnings tend to have an optimistic bias. • German and Japanese markets traditionally oriented toward creditors. Earnings tend to have a more conservative bias with more smoothing opportunities.