Chapter 5
International Financial Statement
Analysis
FASB, IASB, and IAAER
Project on Financial Reporting
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Questions addressed in this project include
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Should the performance (income) statement be
the primary focus of financial reporting?
How should the performance statement
complement the other financial statements?
How should the cash flow statement be used?
What information should be presented in the
performance statement?
Is one approach applicable to all countries?
International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gray, Black
International Accounting Differences
and Financial Statement Analysis
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The key question
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These assessments are important to
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How do differences in accounting affect earnings
and cash flow assessments?
Investors
Corporations concerned with foreign direct
investment
Many companies are listing on international
exchanges (London, New York)
International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gray, Black
Stock Market Comparisons
International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gray, Black
Accounting Diversity and
Economic Environments
International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gray, Black
International Accounting Differences
and Financial Statement Analysis
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A tendency exists to looks at earnings from a
home country perspective
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This tendency may ignore accounting differences
A need exists to better understand foreign
accounting principles in the context in which
they are derived
International comparability is important in
considering alternative investments
International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gray, Black
Major Differences in Accounting
Principles Around the World
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Inventory measurement
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Generally based on
“lower of cost or
market” with market
defined as either
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Net realizable value
Replacement cost
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Construction contracts
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Wide usage of
percentage-ofcompletion method
Completed contract
method – Switzerland,
China, Japan
LIFO is permitted for
tax purposes in U.S.
and Japan, but not in
the EU
International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gray, Black
Major Differences in Accounting
Principles Around the World
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Measurement basis
used
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Historical cost is used in
the U.S., Brazil,
Switzerland, China, and
Japan.
More flexible approach
with some restatements
to market value or
replacement cost – U.K.,
Holland
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Depreciation
accounting
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Useful economic life
concept – U.S. and EU
Accelerated methods –
France, Germany,
Switzerland, Japan
International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gray, Black
Major Differences in Accounting
Principles Around the World
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R&D costs
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Expensed immediately in
Anglo-American and
Germanic countries
Brazil has a more flexible
approach
Some countries allow
capitalizing the borrowed
cost of assets
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Retirement benefits
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Generally accounted for
on the basis of accrued
and/or projected benefits
payable to employees
Pay-as-you-go approach
in Brazil and China
International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gray, Black
Major Differences in Accounting
Principles Around the World
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Taxation
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Accounting income
strongly influenced by
the tax system in France,
Germany, Brazil,
Switzerland
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Business Combinations
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Varies with allowance of
pooling-of-interests
Purchase method is
generally required
Goodwill is amortized in
Brazil, China, and Japan
Goodwill impairment
tests are used in U.S.,
U.K.
International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gray, Black
Major Differences in Accounting
Principles Around the World
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Intangibles
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Foreign Currency Translation
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Generally are capitalized and subject to
amortization or impairment tests
Exception – Switzerland
Choice between average or closing rate
Generally flexible; actual or average rate allowed
Big Question: Do these differences matter?
International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gray, Black
The Impact of U.S.-U.K.
Accounting Differences
Index of conservatism (Gray, 1980)
1 – [RA – RD / l RA l]
Where RA = adjusted earnings (or returns)
RD = disclosed earnings
Therefore,
1 – [U.S. GAAP Earnings – U.K. GAAP Earnings /
l U.S. GAAP Earnings l]
If index value > 1, U.K. GAAP earnings are less “conservative”
If index value < 1, U.K. GAAP earnings are more “conservative”
International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gray, Black
The Impact of U.S.-U.K.
Accounting Differences
Example 1
Example 2
U.K. earnings
£110 million
U.K. earnings
£90 million
U.S. earnings
£100 million
U.S. earnings
£100 million
Index
1 – [100-100]/100 = 1.1
Index
1 – [100-90]/100 = 0.9
International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gray, Black
The Impact of U.S.-U.K.
Accounting Differences
It is possible to establish the relative effect of
individual adjustments with partial indices of
adjustment
Partial index of “conservatism”
1 – [partial adjustment / l U.S. GAAP Earnings l ]
International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gray, Black
The Impact of U.S.-U.K.
Accounting Differences
Example
Millions of Pounds
U.K. GAAP earnings
Adjustments for U.S. GAAP:
Deferred taxation
Goodwill amortization
Adjusted earnings per U.S. GAAP
Overall index of ‘conservatism’
120
Partial index for deferred taxation
1 – [-15/100] = 1.15
Partial index for goodwill
1 – [-5/100] = 1.05
(15)
(5)
(100)
1.2
International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gray, Black
The Impact of U.S.-U.K.
Accounting Differences
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Differences between methods are illustrated
in the Form 20-F report
Form 20-F can be used to test how
conservative U.S. and U.K. GAAP are in
comparison with each other
Form 20-F is reliable because it is provided
by the company itself
Research findings show U.K. GAAP to be
less conservative
International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gray, Black
A Global Perspective on
Earnings Management
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How do Anglo-American earnings compare with
continental Europe and Japan?
Continental Europe
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Gray (1980) compared French and German companies to
British companies
 Insert Exhibit 5.8, 5.9
 French and German earnings are more conservative than
British earnings
Weetman and Gray (1991) found that
 Netherlands was less conservative that Sweden, U.K.
 Swedish methods were more conservative than U.S. GAAP
International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gray, Black
A Global Perspective on
Earnings Management
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Japan
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Earnings are relatively understated compared to the U.S.
(33.9%, according to Aron (1991)
Historically high PE ratios were deflated by adjustments for
reserves, consolidation practices, depreciation, crossholdings, and differences in capitalization (Morgan Stanley)
Higher levels of gearing (leverage) and short-term
payables are tolerated because of long-term relationships
with bankers and suppliers
Emphasis tends to be on long-term growth rather than
instant profitability
International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gray, Black
Factors Influencing
Measurement Differences
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U.S. and U.K.
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Stock market is the dominant influence
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Information needs of investors encourage a more
“optimistic” view of earnings and higher share prices
Accounting principles are flexible
Accounting profession is independent
Tax rules have a limited influence
Cultural values motivate a less conservative
approach to measurement
International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gray, Black
Factors Influencing
Measurement Differences
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Continental Europe and Japan
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Taxation and sources of finance are influential
Tradition of commercial codes and accounting
plans
Tendency to report lower earnings for tax
purposes
International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gray, Black
Factors Influencing
Measurement Differences
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Continental Europe and Japan
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Users of financial information may be more
concerned with balance sheet information
 Black and White (2003) findings
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Balance sheet info is more informative in Germany, Japan
Income statement is more relative in the U.S.
Professional influence is low due to legal
requirements related to accounting
Cultural values motivate a more conservative
approach
International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gray, Black
Global Accounting
Convergence
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IASB sets IFRS
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Goal is to develop comparable international standards with
low cost to MNEs
Provides a model for developing countries
More uniform standards have been developed to aid in
capital raisings and stock exchange listings
Core standards program with IOSCO was completed in
1998
May 2000 – IOSCO endorsed IFRS
EU will adopt IFRS in 2005
Will the U.S. accept IFRS?
International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gray, Black