Chapter 9

1. Chapter 9 Analysis of Foreign Financial Statements

2. 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.

3. 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.

4. Reasons to Analyze Foreign Financial Statements 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.

5. Reasons to Analyze Foreign Financial Statements Other reasons • Extending credit for foreign customers. • Evaluating foreign vendors. • Comparisons to international competitors.

6. 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.

7. Foreign Financial Statement Analysis – Problems 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.

8. Foreign Financial Statement Analysis – Problems 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.

9. Foreign Financial Statement Analysis – Problems 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.

10. Foreign Financial Statement Analysis – 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.

11. Foreign Financial Statement Analysis – Problems 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.

12. Foreign Financial Statement Analysis – Problems 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.

13. Foreign Financial Statement Analysis – Problems 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.

14. Foreign Financial Statement Analysis – 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.

15. 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.)

16. 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.

17. 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.

18. 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.

19. 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.

20. 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.

21. Restating Foreign Financial Statementsto 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.

22. Restating Foreign Financial Statementsto U.S. GAAP 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.

23. Restating Foreign Financial Statementsto U.S. GAAP 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.

24. Restating Foreign Financial Statementsto U.S. GAAP 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.

25. Restating Foreign Financial Statementsto U.S. GAAP 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.

26. Restating Foreign Financial Statementsto U.S. 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

27. Restating Foreign Financial Statementsto U.S. GAAP 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.

28. Restating Foreign Financial Statementsto U.S. GAAP Partial example -- Income statement Foreign U.S. U.S. FormatGAAP Dr. Cr. GAAP Sales 2,000 2,000 Cost of sales 1,1001,100 Gross profit 900 900 S,G,&A expense 200 40 240 Net Operating Income 700 660 Other income 100 20 80 Net Income 800 740 Learning Objective 4

29. Restating Foreign Financial Statementsto U.S. GAAP Partial example – Retained earnings statement Foreign U.S. U.S. FormatGAAP Dr. Cr. GAAP R/E, beginning 500 100 400 Net income 600 580 R/E, ending 1,100980 Learning Objective 4

30. Restating Foreign Financial Statementsto U.S. GAAP Partial example – Balance sheet Foreign U.S. U.S. FormatGAAP Dr. Cr. GAAP Cash 500 500 Inventory 600 600 … … … Deferred liability 50 20 70 Pension Liability 800 100 940 40 … … ... Retained Earnings 1,300 1,140

31. 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.

32. 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.

33. 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.

34. 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.

35. 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

36. 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.

37. 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.