Chapter 10: Analysis of Foreign Financial Statements

Chapter Topics Overview of financial statement analysis Reasons for analyzing foreign financial statements Potential problems in analyzing foreign financial statements Possible solutions to problems associated with analyzing foreign financial statements Restating foreign financial statements to U.S. GAAP illustrated

Overview of Financial Statement Analysis Accounting analysis Reflection of economic reality Sources of distortion in financial statements:(e.g. inconsistent standards, estimation errors and intentional manipulation) Financial analysis Cash flow, profitability and risk analysis Prospective analysis Combining results of accounting analysis and financial analysis, along with business environment analysis and company strategy, to forecast future cash flow and income

Reasons to Analyze Foreign Financial Statements Foreign portfolio investment Investors can diversify 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

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 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 for determining how much to pay

Reasons to Analyze Foreign Financial Statements Other reasons Making credit decisions about foreign customer Evaluating the financial health of foreign suppliers Benchmarking against global competitors

Potential Problems in Analyzing Foreign Financial Statements 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 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 industry7

Potential Problems in Analyzing Foreign Financial Statements Language (Exhibit 10.1-10.2) Many international companies do not produce financial statements in English The financial statement user could hire a translator or develop multilingual capability Since English is the language of business, companies in many foreign countries produce “convenience translations” of their financial statements in English

Potential Problems in Analyzing Foreign Financial Statements Currency (Page 499) 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

Potential Problems in Analyzing Foreign Financial Statements 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 problems in understanding odd terminology Much of the U.S. and U.K. differences were removed in 2005 when the U.K. adopted IFRS

Potential Problems in Analyzing Foreign Financial Statements Format Most 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 report the amount of cost of goods sold This prevents an analyst from determining gross profit margin

Potential Problems in Analyzing Foreign Financial Statements 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

Potential Problems in Analyzing Foreign Financial Statements Timeliness (Page 503) Aspect of the relevance of information Varies significantly internationally since filing deadlines differ from country to country 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

Potential Problems in Analyzing Foreign Financial Statements Differences in accounting principles (Exhibit 10.6) Often result in significantly different income and other financial statement amounts Some of the most troublesome areas are consolidations, fixed asset valuation, depreciation, and goodwill Cause some investors to limit the scope of their investments 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

Potential Problems in Analyzing Foreign Financial Statements International Ratio Analysis (Exhibit 10.7) 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 Japanese and Korean companies borrow much more on a short-term basis than U.S. companies, leading to lower current ratios Debt ratios also tend to be higher in Japan and Korea because of the sources of financing Lower profit margins in Japan in 1978, relative to the U.S., can be partly explained by the Japanese companies having their focus on market share as opposed to profits

Restating Financial Statements Form 20-F Foreign companies that file non-U.S. GAAP financial statements with the SEC are required to complete a Form 20-F, with the exception of those that use IFRS 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

Restating Financial Statements 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 Analysts can overcome this by performing the restatement of financial statement items

Restating Financial Statements Restatement overview – Step one of two Reformatting Involves transforming the financial statements into a U.S. format One part is transforming terminology differences Presentation differences are also transformed Item definitions and classifications are transformed Restatement overview – Step two of two Involves restating the foreign GAAP amounts to U.S. GAAP amounts Easier when the company files a Form 20-F Sometimes, companies will present a similar reconciliation without actually filing the Form 20-F

Restating Financial Statements Restatement overview – Step two of two Notes to the financial statements are very useful in completing this step 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

Restating Financial Statements Step two mechanics – Restating Affects the debit and credit columns in the worksheet The nature of these entries is essentially adjusting and reclassification 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

Restating Financial Statements 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 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

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 local GAAP

Restating Foreign Financial Statements to U.S. GAAP Partial example -- Income statement Local 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

Restating Foreign Financial Statements to U.S. GAAP Partial example – Retained earnings statement Local 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

Restating Foreign Financial Statements to U.S. GAAP Partial example – Balance sheet Local 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