Chapter 03 – International Accounting International Financial Statement Analysis 1

Choi/Meek, 6/e2 What is a Logical Approach to Analyzing Foreign Financial Statements? Undertake a business strategy analysis. Conduct an analysis of a firm’s financial reporting practices. Conduct a financial analysis using ratio and cash flow data. Do a prospective analysis.

3 International Business Strategy Analysis Strategy analysis = getting to know a company and its competition in relation to its economic environment. Information gathering includes recourse to Annual reports Company staff, financial analysts, and other financial professionals World Wide Web Trade groups Competitors Reporters Lobbyists Regulators Financial press

4 International Business Strategy Analysis (contin) Difficulties in undertaking an IB business strategy analysis Profit drivers and business risks may be country specific. National business and legal environments differ. Environmental risks such as changing process and FX risk need to be evaluated. Information sources may be limited or unreliable.

5 Steps in Examining Foreign Accounting Practices Identify key accounting policies. Assess a firm’s accounting flexibility. Evaluate the firm’s accounting strategy. Evaluate the quality of its financial disclosures. Identify reporting outliers. Adjust for accounting measurements that distort the underlying economics of a firm’s transactions.

6 How Does Diversity in International Accounting Impact Financial Statement Analysis? Measurement differences within and between countries make performance comparisons difficult. Measurement differences may differ due to 1. measurement options permitted by GAAP. 2. differences in management discretion. 3. differences in financial statement orientation; i.e., creditor vs. shareholder 4. the objectives of financial statements; i.e., oriented toward more macro decisions vs. micro decisions.

7 How Does Diversity in International Accounting Impact Financial Statement Analysis? (contin) Differences in corporate transparency make it difficult: to comprehend what measurement rules are being followed to estimate future performance metrics to value forecasted numbers because of large variances of these subjective probability distributions Auditing differences affect the credibility of reported numbers owing to differences in: the information content of the auditors report the source of auditing standards the enforcement of auditing standards auditor liability to third parties auditor qualifications auditor certification procedures auditor independence

8 Coping Mechanisms For measurement differences: Adopt a mutual fund (passive) approach to investing. Restate foreign GAAP to domestic GAAP. Restate foreign GAAP to IFRS. Rely on non-accounting data using a dividend discount model or cash flow data. Immerse yourself in the language, currency and GAAP of the country you are investing in; i.e., develop a multiple-principles capability.

9 Coping Mechanisms (contin) For disclosure differences: Undertake company visitations. Attend company road shows. Alter investment classifications from speculative grade (poor disclosure) to investment grade (good disclosure). Alter investment strategies from active investing (good disclosure) to passive or non-investing (poor disclosure).

10 Coping Mechanisms (contin) For audit differences: Research the auditing environment in the country being analyzed. Institutional investors ask for a second audit opinion or engage a recognized audit firm when confidence in the integrity of the attest function is in doubt. Assess a higher risk premium for audit risk.

11 Prospective Analysis Prospective analysis: forecasting a firm’s prospects based on an assessment of a firm’s business strategy, accounting policy, and its financial analysis, and arriving at an estimate of the firm’s value. Complicating factors: Fluctuating exchange rates make it difficult to forecast a firm’s future costs and revenues when sales/purchases are invoiced in foreign currencies. National variations in measurement, disclosure, and auditing practices including national enforcement regimes add to the difficulty of achieving forecast accuracy. National variations in pricing risk make it difficult to select an appropriate discount rate for valuation purposes. Valuation multiples such as P/E ratios also vary from country to country complicating appropriate corporate valuations.

12 Difficulties in Conducting International Ratio Analysis All of the difficulties mentioned previously in conducting business strategy, accounting, and financial analysis. A lack of understanding of the political, legal and business environment that affects the analysis of financial ratios generated in that environment.

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