Analysis of Foreign Financial Statements Chapter 9 Analysis of Foreign Financial Statements

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.

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).

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. International investors, including managers of international mutual fund, rely on foreign financial statements. Learning Objective 1

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. Learning Objective 1

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

Foreign Financial Statement Analysis – Problems and Solutions 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. Learning Objectives 2 and 3

Foreign Financial Statement Analysis – Problems and Solutions 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

Foreign Financial Statement Analysis – Problems and Solutions 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

Foreign Financial Statement Analysis – Problems and Solutions 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. Learning Objectives 2 and 3

Foreign Financial Statement Analysis – Problems and Solutions 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

Foreign Financial Statement Analysis – Problems and Solutions Format 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. 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

Foreign Financial Statement Analysis – Problems and Solutions 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

Foreign Financial Statement Analysis – Problems and Solutions 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

Foreign Financial Statement Analysis – Problems and Solutions 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

Foreign Financial Statement Analysis – Problems and Solutions 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 IFRSs becomes more widespread, many of these problems will abate. Learning Objectives 2 and 3

Foreign Financial Statement Analysis – Problems and Solutions 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

Foreign Financial Statement Analysis – Problems and Solutions 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, 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 investments. Learning Objectives 2 and 3

Restating Foreign Financial Statements to 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. Learning Objective 4

Restating Foreign Financial Statements to 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, 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

Restating Foreign Financial Statements to U.S. GAAP 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

Restating Foreign Financial Statements to 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. Learning Objective 4

Restating Foreign Financial Statements to U.S. GAAP Step one mechanics – Reformatting Begin with 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. Learning Objective 4

Restating Foreign Financial Statements to 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. Learning Objective 4

Restating Foreign Financial Statements to 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 Learning Objective 4

Restating Foreign Financial Statements to 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. Learning Objective 4

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

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

Restating Foreign Financial Statements to U.S. GAAP Partial example – Balance sheet Foreign U.S. U.S. Format GAAP 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 Learning Objective 4