McGraw-Hill/Irwin
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
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.
10-2
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).
10-3
Overview of Financial Statement Analysis
1.
Accounting analysis—reflection of economic reality (e.g.
inconsistent standards, estimation errors and intentional
manipulation)
2. Financial analysis (cash flow, profitability and risk analysis)
3. Prospective analysis—using accounting analysis and financial
analysis, along with business environment analysis and
company strategy, to forecast future cash flow and income
10-4
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 investors, including managers of international
mutual funds, rely on foreign financial statements.
Learning Objective 1
10-5
International mergers and acquisitions

The frequency and size of international corporate mergers
has increased in recent years.

Examples include Ambev/Anheuser-Busch; BP/Amoco; and
acquisitions by Ford Motor such as Volvo (of Sweden), who,
in 2010, reached a deal to sell Volvo to China’s Zhejiang Geely
Holding Group.

The purchaser of an international company needs to analyze
the target company’s financial statements to determine the
acquisition price.
Learning Objective 1
10-6
Other reasons

Extending credit for foreign customers.

Evaluating foreign vendors.

Comparisons to international competitors.
Learning Objective 1
10-7
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.
Annual Reports.com provides reports for companies listed on U.S.,
U.K., Canada and Australia stock exchanges by name, ticker
symbol, stock exchange and industry.
Learning Objectives 2 and 3
10-8
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.
Learning Objectives 2 and 3
10-9
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.
Learning Objectives 2 and 3
10-10
Terminology



Differences in terminology exist between countries using the
same language.
For example, “inventory” in the U.S. used to be called
“stocks” in the U.K.
In cases of convenience translations, sometimes these
include terminology unfamiliar to English speakers.
Knowledge of the business and accounting environment, as
well as a careful reading of the notes to the financial
statements can help alleviate some of these problems.
 Much of the U.S. and U.K. differences were removed in 2005
when the U.K. adopted IFRS.

Learning Objectives 2 and 3
10-11
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.

It is common in Europe to not provide cost of good sold.

This prevents an analyst from determining gross margin
percentage and inventory turnover.
Learning Objectives 2 and 3
10-12
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.

Lack of disclosure contributes to the significance of format
problems.

Globalization of capital markets tends to enhance disclosure
as companies attempt to attract investors.
Learning Objectives 2 and 3
10-13
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.
Learning Objectives 2 and 3
10-14
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.

These differences cause some investors to limit the scope of
their investments.
Learning Objectives 2 and 3
10-15
Differences in accounting principles

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.

Some firms alleviate some of financial statement users’
problems in their convenience translation.

In summary, as the use of IFRS becomes more widespread,
many of these problems will abate.
Learning Objectives 2 and 3
10-16
Business environment differences

Differences in culture and economic environments have an
impact on the relevance of ratios.

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.
Learning Objectives 2 and 3
10-17
Business environment differences

Debt ratios also tend to be higher in Japan and Korea
because of the sources of financing.

Lower profit margins in Japan in the late 1970s, relative to
the U.S., can be partly explained by the Japanese companies
having their focus on market share as opposed to profits.

In summary, an investor needs to be aware of these
differences and not forgo potentially profitable investments.

An investor must have a good understanding of the business
environment and how to identify the best companies in that
environment.
Learning Objectives 2 and 3
10-18
Form 20-F

Foreign companies that file non-U.S. GAAP financial
statements with the SEC are required to complete a Form 20F, with the exception of those that use IFRS.

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.
Learning Objective 4
10-19
Form 20-F

Some ratios, such as return on equity, can be computed as if
under U.S. GAAP.

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.
Learning Objective 4
10-20
Restatement overview – Step one of two

The first step, reformatting, involves transforming the
financial statements into a U.S. format.

One part of step one is transforming terminology
differences.

Presentation differences are also transformed.

Item definitions and classifications are transformed.
Learning Objective 4
10-21
Restatement overview – Step two of 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.
Learning Objective 4
10-22
Step one mechanics – Reformatting

Begin with a four column worksheet in U.S. GAAP format.

Columns are Local GAAP, debits, credits, and U.S. GAAP.

Amounts are presented in the original currency.

Prepare worksheets for income statement, statement of
retained earnings, and balance sheet.

Line items in the worksheet are presented in the
terminology of U.S. account titles.
Learning Objective 4
10-23
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, while others affect both.

Each entry reflects the adjustment needed to reconcile to
U.S. GAAP from local GAAP.
Learning Objective 4
10-24
Partial example -- restated financial statements
Assume that the local 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
Cost of sales
1,100
SG&A expense
200
Other income
100
Retained earnings (beg) 500
500
Inventory
Deferred liability
Pension liability
Retained earnings (end)
600
50
800
1,300
Learning Objective 4
10-25
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 local GAAP.
Learning Objective 4
10-26
Partial example -- Income statement
U.S. Format
Sales
Cost of sales
Gross profit
S,G,&A expense
Other income
Net Income
Local
GAAP
2,000
1,100
900
200
100
800
Dr.
Cr.
40
20
U.S.
GAAP
2,000
1,100
900
240
80
740
Learning Objective 4
10-27
Partial example – Retained earnings statement
U.S. Format
R/E, beginning
Net income
R/E, ending
Local
GAAP
500
800
1,300
Dr.
100
Cr.
U.S.
GAAP
400
740
1,140
Learning Objective 4
10-28
Partial example – Balance sheet
U.S. Format
Cash
Inventory
…
Deferred liability
Pension liability
Local
GAAP
500
600
…
50
800
…
Retained Earnings
…
1,300
Dr.
Cr.
20
100
40
U.S.
GAAP
500
600
…
70
940
...
1,140
Learning Objective 4
10-29