1. Chapter 5 International Financial Statement Analysis

2. International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gray, Black International Accounting Differences and Financial Statement Analysis The key question How do differences in accounting affect earnings and cash flow assessments – are the differences material in the decision process These assessments are important to Investors Corporations concerned with foreign direct investment Growing number of companies are listing on international exchanges (London, New York)

3. International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gray, Black Stock Market Comparisons

4. International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gray, Black International Accounting Differences and Financial Statement Analysis A tendency exists to looks at earnings from a home country perspective – that may or may not place a high value on accounting. 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

5. International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gray, Black 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 – is this better / more accurate? Completed contract method – Switzerland, China, Japan

6. International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gray, Black 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

7. International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gray, Black 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

8. International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gray, Black 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.

9. International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gray, Black 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?

10. International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gray, Black The Impact of U.S.-U.K. Accounting Differences- A Quantitative Look Index of conservatism (Gray, 1980) 1 – [RA – RD / l RA l] Where RA = adjusted earnings (or returns) (i.e. earnings converted to an alternate accounting system) RD = disclosed earnings (firm earnings reported on the home countries accounting system). 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” or more optimistic/aggressive If index value < 1, U.K. GAAP earnings are more “conservative”

11. International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gray, Black The Impact of U.S.-U.K. Accounting Differences Example 1 U.K. earnings £110 million U.S. earnings £100 million Index 1 – [100-100]/100 = 1.1 Example 2 U.K. earnings £90 million U.S. earnings £100 million Index 1 – [100-90]/100 = 0.9

12. 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 – to assess the accounting policy you wish to examine. Partial index of “conservatism” - first adjust to overall comparison accounting method Then: analyze the accounting issue in question 1 – [partial adjustment (accounting policy in question) / l U.S. GAAP Earnings l ]

13. 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 120 Adjustments for U.S. GAAP: Deferred taxation (15) Goodwill amortization (less of issue now)(5) Adjusted earnings per U.S. GAAP(100) Overall index of ‘conservatism’1.2 Partial index for deferred taxation1 – [-15/100] = 1.15 Partial index for goodwill1 – [-5/100] = 1.05

14. International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gray, Black The Impact of U.S.-U.K. Accounting Differences 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

15. International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gray, Black 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

16. International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gray, Black 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

17. International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gray, Black 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

18. International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gray, Black 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

19. International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gray, Black 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

20. International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gray, Black 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 nonlisted companies adopt? Will the U.S. accept IFRS?