Chapter 17 International Financial Statement Analysis

FASB, IASB, and IAAER Project on Financial Reporting Questions addressed in this project include 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 Differences and Financial Statement Analysis The key question How do differences in accounting affect earnings and cash flow assessments? These assessments are important to Investors Corporations concerned with foreign direct investment Many companies are listing on international exchanges (London, New York)

Stock Market Comparisons

Accounting Diversity and Economic Environments

International Accounting Differences and Financial Statement Analysis A tendency exists to looks at earnings from a home country perspective 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

Major Differences in Accounting Principles Around the World Inventory measurement Generally based on “lower of cost or market” with market defined as either Net realizable value Replacement cost LIFO is permitted for tax purposes in U.S. and Japan, but not in the EU Construction contracts Wide usage of percentage-of- completion method Completed contract method – Switzerland, China, Japan

Major Differences in Accounting Principles Around the World Measurement basis used 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 Depreciation accounting Useful economic life concept – U.S. and EU Accelerated methods – France, Germany, Switzerland, Japan

Major Differences in Accounting Principles Around the World R&D costs Expensed immediately in Anglo-American and Germanic countries Brazil has a more flexible approach Some countries allow capitalizing the borrowed cost of assets Retirement benefits Generally accounted for on the basis of accrued and/or projected benefits payable to employees Pay-as-you-go approach in Brazil and China

Major Differences in Accounting Principles Around the World Taxation Accounting income strongly influenced by the tax system in France, Germany, Brazil, Switzerland Business Combinations 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.

Major Differences in Accounting Principles Around the World Intangibles Generally are capitalized and subject to amortization or impairment tests Exception – Switzerland Foreign Currency Translation Choice between average or closing rate Generally flexible; actual or average rate allowed Big Question: Do these differences matter?

A Global Perspective on Earnings Management How do Anglo-American earnings compare with continental Europe and Japan? Continental Europe 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

A Global Perspective on Earnings Management Japan 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, cross- holdings, 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

Factors Influencing Measurement Differences U.S. and U.K. Stock market is the dominant influence 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

Factors Influencing Measurement Differences Continental Europe and Japan Taxation and sources of finance are influential Tradition of commercial codes and accounting plans Tendency to report lower earnings for tax purposes

Factors Influencing Measurement Differences Continental Europe and Japan Users of financial information may be more concerned with balance sheet information Black and White (2003) findings  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

Global Accounting Convergence IASB sets IFRS 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?