

ANALYSIS OF FOREIGN FINANCIAL
STATEMENTS

Chapter 9

McGraw-Hill/Irwin

Copyright © 2009 by The McGraw-Hill Companies, Inc. All



Analysis of Foreign Financial
Statements

Chapter Topics
 Overview of financial statement analysis
 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
9-2



Analysis of Foreign Financial
Statements

Learning Objectives

1. Discuss reasons to analyze financial statements of foreign
companies.
2. Describe potential problems in analyzing foreign financial
statements.
3. Provide possible solutions to problems associated with analyzing
foreign financial statements.
4. Demonstrate an approach for restating foreign financial
statements to U.S. generally accepted accounting principles
(GAAP).

9-3

Prospective analysis—using accounting analysis and financial analysis. along with business environment analysis and company strategy. inconsistent standards. to forecast future cash flow and income 9-4 .g. Accounting analysis—reflection of economic reality (e. estimation errors and intentional manipulation) 2. Analysis of Foreign Financial Statements Overview of Financial Statement Analysis 1. profitability and risk analysis) 3. Financial analysis (cash flow.

Learning Objective 1 9-5 .S. returns. 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. including managers of international mutual funds. rely on foreign financial statements.  International investors. these correlations are far from perfect.

 The purchaser of an international company needs to analyze the target company’s financial statements to determine the acquisition price. Learning Objective 1 9-6 . 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).

 Reasons to Analyze Foreign Financial Statements Other reasons  Extending credit for foreign customers  Evaluating foreign vendors  Comparisons to international competitors Learning Objective 1 9-7 .

com provides reports for companies listed on U.. financial information is difficult to obtain in     many countries..K.S. Canada and Australia stock exchanges by name. Annual Reports. While databases of foreign financial statements do exist. These databases also do not contain complete disclosure notes. Another approach is to obtain a copy of the foreign company’s annual report. these can contain errors and present information in a variety of formats. U. Foreign Financial Statement Analysis – Problems and Data accessibility Solutions Relative to the U. ticker symbol.S. Learning Objectives 2 and 3 9-8 .. stock exchange and industry.

 Foreign Financial Statement Analysis – Problems and Language Solutions Many international companies do not produce financial statements in English. companies in many foreign countries produce “convenience translations” of their financial statements in English.  The financial statement user could hire a translator or develop foreign language capability. Learning Objectives 2 and 3 9-9 .  Since English is the language of business.

S. dollar. Learning Objectives 2 and 3 9-10 . Foreign Financial Statement Analysis – Problems and Currency Solutions Many international companies produce their financial statements in a currency other than the U.  In order to avoid distortions. the current exchange rate should be used for all previous years.S.  Analysis using ratios is not distorted by different currencies. dollars by translating all balances at the exchange rate at the end of the current year.  These can be converted to U.

used to be called “stocks” in the U.K. In cases of convenience translations. Foreign Financial Statement Analysis – Problems and Terminology Solutions Differences in terminology exist between countries using the same     language. sometimes these include terminology unfamiliar to English speakers. For example.K.K. Much of the U. Knowledge of the business and accounting environment. adopted IFRS. Learning Objectives 2 and 3 9-11 . and U. as well as a careful reading of the notes to the financial statements can help alleviate some of these problems. differences were removed in 2005 when the U.S.S. “inventory” in the U.

Learning Objectives 2 and 3 9-12 . just in a different place.  However.  It is common in Europe to not provide cost of good sold.  This prevents an analyst from determining gross margin percentage and inventory turnover. Foreign Financial Statement Analysis – Problems and Format Solutions Some format differences are not problematic because the information is given. other format differences are a problem because the information is not provided.

 Foreign Financial Statement Analysis – Problems and Format Solutions At least one Chinese company does not present sales as a separate item.  This would hinder analysis of top-line growth. Learning Objectives 2 and 3 9-13 .  Problems with format differences can be overcome if sufficient additional financial information is provided in the notes to the financial statements.

interim statements. Foreign Financial Statement Analysis – Problems and Extent of disclosure Solutions Disclosure internationally tends to be limited compared to the U.S. foreign operations. and reserves.  Globalization of capital markets tends to enhance disclosure as companies attempt to attract investors. where full disclosure is fundamental.  Some of the most serious disclosure limitations are information on segments. Learning Objectives 2 and 3 9-14 . asset valuation.  Lack of disclosure contributes to the significance of format problems.

and Canada are the most timely.  There is very little investors can do to overcome these problems. the U. Learning Objectives 2 and 3 9-15 .  This varies significantly internationally since filing deadlines differ from country to country. Foreign Financial Statement Analysis – Problems and Timeliness Solutions Timeliness is one aspect of the relevance of information.  Among developed countries. whereas continental Europe is the least.S.  Requirements about the frequency of information also vary internationally from quarterly to annual reporting.

fixed asset valuation and depreciation. Foreign Financial Statement Analysis – Problems and Differences in accounting principles Solutions Differences in accounting principles often result in significantly different income and other financial statement amounts. and goodwill.  These differences cause some investors to limit the scope of their investments. Learning Objectives 2 and 3 9-16 .  Some of the biggest problem areas are consolidations.

 In summary. many of these problems will abate. Learning Objectives 2 and 3 9-17 . Foreign Financial Statement Analysis – Problems and Differences in accounting principles Solutions Some investors attempt to reframe foreign financial statements to a more familiar GAAP.  Another approach is to use a stripped down measure of earnings that excludes items most affected by diversity. as the use of IFRS becomes more widespread.  Some firms alleviate some of financial statement users’ problems in their convenience translation.

found significant differences due to business environment. Japanese and Korean companies borrow much more on a short-term basis than U. Learning Objectives 2 and 3 9-18 . companies. Korea.S. and the U. leading to lower current ratios. Foreign Financial Statement Analysis – Problems and Business environment differences Solutions Differences in culture and economic environments have an impact on the relevance of ratios.S.  For example.  A study of companies in Japan.

. Learning Objectives 2 and 3 9-19 . relative to the U. can be partly explained by the Japanese companies having their focus on market share as opposed to profits. Foreign Financial Statement Analysis – Problems and Business environment differences Solutions Debt ratios also tend to be higher in Japan and Korea because of the sources of financing. an investor needs to be aware of these differences and not forgo potentially profitable investments.  Lower profit margins in Japan in the late 1970s.  An investor must have a good understanding of the business environment and how to identify the best companies in that environment.S.  In summary.

this represents a partial restatement from foreign GAAP to U. GAAP.  However. Restating Foreign Financial Statements Form 20-F to U. GAAP  Foreign companies that file non-U. Learning Objective 4 9-20 .S.S. there is no requirement to reconcile assets and liabilities. GAAP.  The Form 20-F reconciles net income and stockholders’ equity to U. GAAP financial statements with the SEC are required to complete a Form 20-F.  In essence.S.S.

GAAP  Some ratios.S.  Most other ratios cannot be computed as if under U.S. GAAP.  The analyst can overcome this by performing the restatement of financial statement items. can be computed as if under U.S. Restating Foreign Financial Statements Form 20-F U. Learning Objective 4 9-21 . GAAP. such as return onto equity.

reformatting. format.S.  One part of step one is transforming terminology differences.  Item definitions and classifications are transformed. Learning Objective 4 9-22 . Restating Foreign Financial Statements Restatement overview – Step one of two to U. involves transforming the financial statements into a U.S. GAAP  The first step.  Presentation differences are also transformed.

GAAP amounts.  In any case.  Sometimes.S.  This process is made easier when the company files a Form 20-F. GAAP  The second step involves restating the foreign GAAP amounts to U.S. companies will present a similar reconciliation without actually filing the Form 20-F. Learning Objective 4 9-23 . notes to the financial statements are very useful in completing this step. Restating Foreign Financial Statements Restatement overview – Step two of two to U.

 Restating Foreign Financial Statements Step one mechanics – Reformatting to U.S.S.  Prepare worksheets for income statement. account titles. and balance sheet. GAAP  Begin with a four column worksheet in U. and U. GAAP. debits.S. credits.  Columns are Local GAAP.  Line items in the worksheet are presented in the terminology of U. Amounts are presented in the original currency. Learning Objective 4 9-24 .S. statement of retained earnings. GAAP format.

 Each entry reflects the adjustment needed to reconcile to U. while others affect both. Restating Foreign Financial Statements Step two mechanics – Reformatting todebit U. Learning Objective 4 9-25 . GAAP from local GAAP.  The nature of these entries is essentially adjusting and reclassification entries.  Some entries affect current net income or beginning retained earnings. GAAP  The work in this step affects the and credit columns in the worksheet.S.S.

S. GAAP titles and amounts. GAAP  Assume that the local GAAP column of the financial statements being restated has already been reformatted into the U.restated financial statements to U.000 Cost of sales SG&A expense Other income Retained earnings (beg) Learning Objective 4 Cash 1.  These amounts include: Sales 2. Restating Foreign Financial Statements Partial example -.100 200 100 500 500 Inventory Deferred liability Pension liability Retained earnings (end) 600 50 800 1.300 9-26 .S.

restated financial statements to U.S. Restating Foreign Financial Statements Partial example -.S.S.  Cash realized of 20 units during the current year is considered a deferred liability under U. GAAP and is other income under local GAAP. Learning Objective 4 9-27 . 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. GAAP  Under U.

Format Sales Cost of sales Gross profit S.000 1. GAAPU.G.000 1.S. Restating Foreign Financial Statements Partial example -. 40 20 GAAP 2.100 900 240 80 740 9-28 .Income statement to U. Cr.&A expense Other income Net Income Learning Objective 4 GAAP 2.100 900 200 100 800 Dr.S.S. Local U.

S. Format R/E. Restating Foreign Financial Statements Partial example – Retained earnings statement to U. GAAPU.S. Local U.140 9-29 . beginning Net income R/E. GAAP 400 740 1. 100 Cr.S.300 Dr. ending Learning Objective 4 GAAP 500 800 1.

140 9-30 .. Restating Foreign Financial Statements Partial example – Balance sheet to U. Format Cash Inventory … Deferred liability Pension liability GAAP 500 600 … 50 800 … Retained Earnings … 1.. Cr.S. 1. GAAP 500 600 … 20 100 40 70 940 . GAAPU. Local U.S.300 Learning Objective 4 Dr.S.