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LECTURE 10

INTERNATIONAL FINANCIAL STATEMENT ANALYSIS
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International Accounting Differences and Financial Statement Analysis


As business and financial markets have become increasingly internationalized, there also arise significant differences in international accounting especially in the perspective of international financial statement analysis. The key question concerns the extent to which international accounting differences impact assessments of earnings and future cash flows and their associated risks and uncertainties. These assessments are important to portfolio investors making their share valuations. They are also important to corporations concerned with foreign direct investment (FDI) which involves the valuation of potential acquisitions and participating interest/joint ventures or the raising of capital and trading are listed internationally.
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International Accounting Differences and Financial Statement Analysis
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International accounting differences create a number of problems from a financial analysis perspective. First, in attempting to value a foreign corporation, there is a tendency to look at earnings and other financial data from a home country perspective, and hence there is a danger of overlooking the effects of accounting differences. Second, an awareness of international differences suggests the need to become familiar with foreign accounting principles in order to better understand earnings data in the context in which such measures are derived. Third, issues of international comparability and accounting harmonization become highlighted in the context of considering alternative investment opportunities.
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in many emerging market economies. 4 . disclosure quality. legal and regulatory systems.Challenges and Opportunities in Cross-Border Analysis Challenges     Nations vary dramatically in their accounting and auditing practices. there are many countries still continue to publish highly suspect information. As a result. This variation means that analytical tools that are effective in one jurisdiction may be less so in another. nature and extent of business risk. The analyst often faces challenges in obtaining credible information. financial analyses often have limited reliability. and modes of conducting business. Even though now information may be access freely by analyst on the internet.

Globalization of capital markets. 5 . the environment of international financial analysis and valuation are improving and the overall outlook for the analyst is positive.Challenges and Opportunities in Cross-Border Analysis Opportunities      Despite such challenges. and increasing competition among national governments. stock exchanges and companies for investors and trading activity continue. Globalization also means that strictly domestic analyses are becoming less relevant. Together these forces are creating incentives for companies to voluntarily improve their external financial reporting practices. Interdependencies are growing and no company is insulated from events happening worldwide. advances in information technology..

Accounting Analysis 3.Business Analysis Framework There are 4 stages of business analysis provided by Palepu. Bernard and Healy: 1. Prospective Analysis (forecasting and valuation) 6 . Financial Analysis (ratio analysis and cash flow analysis) 4. Business Strategy Analysis 2.

By identifying key profit drivers and business risks. It provides a qualitative understanding of a company and its competitors in relation to its economic environment. business strategy analysis helps the analyst make realistic forecasts. 7 . This ensures that qualitative analysis is performed using a holistic perspective.Business Analysis Framework Business Strategy Analysis     It an important first step in financial statement analysis.

regulators and trade press is becoming more common. customers. and other financial professionals. 8 . trade groups. and speaking with company staff. The use of additional information sources. lobbyists. analysts. such as the Worldwide Web. competitors.Business Analysis Framework Business Strategy Analysis   Standard procedures for gathering information for business strategy analysis include examining annual reports and other company publications. reporters.

one reason the 1994/1995 Mexican currency crisis was a surprise was that the government concealed information about its shrinking foreign reserves and exploding money supply. Some countries delay publishing statistics when the numbers are unfavorable.Business Analysis Framework Business Strategy Analysis      Business strategy analysis is especially difficult in some countries due to a lack of reliable information about macroeconomic development. Government in developed countries is sometimes accused of publishing faulty or misleading economic statistics. For example. or even falsify their economic figures. 9 . This situation is much worst in many emerging economies.

the analyst must adjust reported accounting amounts to remove distortions caused by the use of accounting methods the analyst deems inappropriate. Examples might include marking trading assets to market and not recording the gains or losses in income but in an allowance account. and assess the nature and extent of a firm’s accounting flexibility. To reach reliable conclusions.Business Analysis Framework Accounting Analysis     The purpose of accounting analysis is to asses the extent to which a firm’s reported results reflect economic reality. The analyst needs to evaluate the firm’s accounting policies and estimates. 10 .

Flexibility in financial reporting is important because it allows managers to use accounting measurements that best reflect the company’s particular operating circumstances. However. 11 .Business Analysis Framework Accounting Analysis    Corporate managers are allowed to make many accountingrelated judgments because they know the most about their firm’s operations and financial condition. One reason is that reported earnings are often used to evaluate their managerial performance. managers have incentives to distort operating reality by using their accounting discretion to distort reported profits.

which provides information about a firm’s cash inflows and outflows. 12 . Ratio analysis and cash flow analysis are important tools in financial analysis. investing and financing activities and disclosures about periodic non-cash investing and financing activities. Cash flow analysis focuses on the cash flow statement. financing and earnings retention policies. It provides insights on the comparative and relative significance of financial statement items and can help evaluate the effectiveness of managements’ operating. Ratio analysis involves comparison of ratios across years or other firms in the same industry. investing. classify among operating.Business Analysis Framework Financial Analysis      It’s goal is to evaluate a firm’s current and past performance and to judge whether its performance can be sustained.

and investment? 13 . and cost of sales in particular? What have been the cash flow consequences of management decisions about financial policy. sales.Business Analysis Framework Financial Analysis  Analysts can use cash flow analysis to address many questions about the firm’s performance and management. has the firm generated positive cash flows from operations? How has cash flow components changed across time in relation to changes in income statement components.    For example. dividend policy.

Business Analysis Framework Prospective Analysis      Prospective analysis involves 2 steps: forecasting and valuation. how will a company’s change in business strategy affect future sales volume and profits? Has the company recently adopted new accounting policies that will make current earnings appear stronger. accounting and financial analysis. perhaps at the cost of lower earnings next year? Will financial relationship evidenced in an analyst’s ratio analysis continue? 14 . In forecasting. It addresses questions such as. analyst make explicit forecasts of a firm’s prospects based on its business strategy.

15 . valuation is the basis of equity analysts’ investment recommendations. analysts convert quantities forecasts into an estimate of a firm’s value. For example. ranging from discounted cash flow analysis to simpler techniques based on price-based multiples such as PE ratio and price-to-book ratio. Valuation is used implicitly or explicitly in many business decisions. the potential acquirer will estimate the value of the target firm.Business Analysis Framework Prospective Analysis     In valuation. Many different valuation approaches are used in practices. In analyzing a possible merger.

Foreign currency issues 5. Timeliness of information 3. Differences in Accounting Principles 8. International Ratio Analysis 16 . All four issues of business analysis may be affected by the following factors: 1. Language and terminology barriers 4. Information access 2. Differences in types and formats of financial statements 6. Extent of Disclosure 7.

Many commercial databases provided access to financial and stock market data for thousands of companies around the world. However. 17 . Companies covered by commercial databases tend to be large companies that are of most interest to financial statement users and investors. Companies around the world now have Web sites. the amount of information available varies considerably from country to country. Many companies also respond to written and telephone requests for their annual reports and other financial documents. and their annual reports are available free of charge from various Internet and other sources.Information access       Information about thousands of companies from around the world has become more widely available in recent years.

Highlights from the Bloomberg news service Many useful links and resources on Asia. Africa and Europe.Information access Name of Web Site Annual reports Library Web Site Address zpub.com/sf/arl/ What it Provides Alphabetical listing of US corporations with links to home pages and annual reports that can be downloaded free of charge with Adobe Acrobat Reader. Bloomberg News Service Emerging markets companies Bloomberg. Latin America.com/ 18 .com/ Emgmkts.

there are strict regulations on the timing and manner of dissemination of financial information. Companies are required to publish quarterly financial reporting. In countries such as the US. regulatory filings. annual reports.Timeliness of information    The timeliness of financial statements. an analyst would prefer to receive financial information sooner rather than later. and accounting-related press releases varies dramatically by country. Clearly. 19 .

Singapore. South Korea. Austria. Sweden. India. UK. Canada.Timeliness of information  Also related to timeliness is the lag between the company’s year and the publication of its audited financial statements and annual report. and the US. New Zealand. Japan. Day after year end Countries 30 – 60 Brazil. France. Mexico. Italy. Malaysia. Germany.90 91 – 120 121 and over Argentina. Netherlands. Hong Kong. Nigeria Pakistan 20 . 61 . Australia.

The vast majority of companies around the world denominate their financial accounts in the currency of their national domicile.Foreign Currency Consideration     Accounts denominated in foreign currency present financial analysts with two types of problems. To a US reader accustomed to dealing in dollars. The first relates to reader convenience. 21 . analysis of accounts expressed in euros may be discomforting. the second to information content.

use of convenience rate to translate foreign currency accounts can distort underlying financial pattern in local currency. when analysing translated trend data. 22 .Foreign Currency Consideration   Users who prefer a domestic currency framework when analyzing foreign currency accounts may apply a “convenience translation” using year-end exchange rates. One must be careful. however.

$2. assume the following three-year sales revenue patterns for UK concern: 2006 2007 2008 Sales revenues £23.350)/$49. $2. and $1.e.160 .350} over the three-year period.500}.Foreign Currency Consideration  To illustrate.500) / £23. The sales gain in pounds.160 Convenience translations using the year-end exchange rate employed earlier (i.20 for 2007. 23 . is 41% : {(£33.500 £28.10 for 2006.$49.056 .60 for 2008) yield a US dollar sales increase of 7.£23. however.650 £33.5% {($53.

Differences in Statement Format    Balance sheet and income statement formats vary from country to country. in Germany and the UK. 24 . the balance sheet items are listed in increasing order of liquidity.  However. Another example is that German companies tend to list the shareholders’ equity section before the liabilities on the equity side of the balance sheet. in the US. the balance sheet is organized in order of declining liquidity with current assets and liabilities listed before long-lived assets and long-term liabilities. with most liquid items appearing at the bottom of the balance sheet. For example.

growing numbers of the relatively large companies provide English-language versions in their annual reports for the convenience of foreign audiences of interest. However. For example companies in Japan use Japanese language and it scripts which are different with English language. then the latter must find ways to overcome the language barriers in order to make sense of the company’s financial statements. Most companies domiciled in non-English-speaking countries publish their annual reports in the home country language. If the language differs for the preparer and the user. 25 .Language and Terminology Barriers Language      Language differences among countries can present information barriers to financial statements users.

4. Differences in terminology between British and American companies are well-known and at first may cause some problems.Language and Terminology Barriers Terminology    Even if different countries use the same language but there are also differences in accounting terminology used in the financial statements. 3. Turnovers Account Receivables Account Payable Sales Debtors Creditors 26 . Inventory UK Stock 2. Examples are as follows: US 1.

Extent of Disclosure      Adequate information required by analyst to reformat and adjust foreign financial statement. IFRS requires disclosure of operating lease payments to be made in the next year. US GAAP and other national accounting standards require leases to be capitalised when certain criteria are met. Example 1: Lease IFRS. treat as operating lease. US GAAP. requires the disclosure of future minimum lease payments in each of the next 5 years and all years thereafter. 27 . Otherwise. for the next 2-5 years.

Eg. In years which profits are below expectations.Extent of Disclosure      Example 2: Provision Many European companies used provisions (accrual liabilities) to conceal profits and create hidden reserves. In 1989.8 billion rather than DM1. 28 .9 billion through reversal of provision for pension. Daimler-Benz reported income as DM6. reserves are released with an offsetting increase in income. In profitable years – provisions are created for items such as deferred maintenance and uncertain liabilities.

8% -4.8% -58. Country Company Reconciliation from local GAAP to US GAAP % Difference in Net Income United Kingdom Netherlands Australia Ireland Switzerland Acambis Crucell Prana Biotech Trinity Biotech Serono +24.8% 29 .6% % Difference on Stockholders’ Equity -5.1% -102.6% -6.8% No difference -0.Differences in Accounting Principles  Differences in accounting have a significant impact on the reported amount in financial statement.1% -10.6% -51.

lease. inventory valuation and provisions.Differences in Accounting Principles  The most troublesome areas in which accounting differences existed were consolidations. goodwill. valuation and depreciation of fixed assets. pensions. 30 . long-term construction contracts. deferred income taxes. marketable securities. foreign currency transactions and translation.

Korea and US. 31 . debt ratio and profit margin across 3 countries – Japan. economic and social environments.International Ratio Analysis   The ratios analysis are different across countries due to significant differences in accounting diversity. Illustrations the effect of environmental difference on current ratio.

013 Inventory turnover 5.80 3.074 32 .46 1.00 6.80 Return on assets 0.10 Japan 86 Korea US 33 43 2.84 0.78 0.90 1.50 Profit margin 0.012 1.60 1.47 Total asset turnover 0.023 0.93 Times interest earned 1.10 Fixed asset turnover 3.60 6.80 0.054 0.80 6.15 1.13 1.94 Average Collection period 0.028 0.20 1.40 0.International Ratio Analysis Year: 1978 Japan Korea US Current ratio Quick ratio Debt turnover ratio 0.

International Ratio Analysis Current Ratio:  Japan and Korea – less likely to meet their short term obligations than US firms. repay the borrowing when it came due. They would borrow on a short term basis.  Japan and Korea firms – used short-term debt to finance fixed assets. As a result. 33 . and then negotiate a new short-term loan. a series of 20 three-months loans became five-year financing.

34 .  In Korea – bank loans tended to be influenced by the government in order to boost the economy.International Ratio Analysis Debt Ratio:  Japan – high debt ratios in Japan resulted from the reliance on bank financing.

 Korea – firms bought new fixed assets at high price.International Ratio Analysis Profit Margin:  Japan and Korea . resulted in high depreciation expense. 35 .Lower profit margin is due to higher amounts of debt causes a high amount of interest expense resulted to low net income.

FINISH 36 .