1. Chapter 10: Analysis of Foreign Financial Statements

2. 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

3. 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

4. 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

5. 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

6. 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

7. 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

8. Potential Problems in Analyzing Foreign Financial Statements
Language (Exhibit )
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

9. 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

10. 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 when the U.K. adopted IFRS

11. 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

12. 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

13. 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

14. 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

15. 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

16. 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

17. 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

18. 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

19. 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

20. 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

21. 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 ,000 Cash
Cost of sales 1,100 Inventory
SG&A expense Deferred liability
Other income Pension liability
Retained earnings (beg) Retained earnings (end) ,300

22. 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

23. 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
Cost of sales 1, ,100
Gross profit
S,G,&A expense
Other income
Net Income

24. 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
Net income
R/E, ending 1, ,140

25. Restating Foreign Financial Statements to U.S. GAAP
Partial example – Balance sheet
Local U.S.
U.S. Format GAAP Dr. Cr. GAAP
Cash
Inventory
Deferred liability
Pension liability 40
Retained Earnings 1, ,140