LECTURE 10

INTERNATIONAL FINANCIAL STATEMENT ANALYSIS

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International Accounting Differences and Financial Statement Analysis

As business and financial markets have become increasingly internationalized, there also arise significant differences in international accounting especially in the perspective of international financial statement analysis. The key question concerns the extent to which international accounting differences impact assessments of earnings and future cash flows and their associated risks and uncertainties. These assessments are important to portfolio investors making their share valuations. They are also important to corporations concerned with foreign direct investment (FDI) which involves the valuation of potential acquisitions and participating interest/joint ventures or the raising of capital and trading are listed internationally.
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International Accounting Differences and Financial Statement Analysis

International accounting differences create a number of problems from a financial analysis perspective. First, in attempting to value a foreign corporation, there is a tendency to look at earnings and other financial data from a home country perspective, and hence there is a danger of overlooking the effects of accounting differences. Second, an awareness of international differences suggests the need to become familiar with foreign accounting principles in order to better understand earnings data in the context in which such measures are derived. Third, issues of international comparability and accounting harmonization become highlighted in the context of considering alternative investment opportunities.
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Challenges and Opportunities in Cross-Border Analysis

Challenges

Nations vary dramatically in their accounting and auditing practices, disclosure quality, legal and regulatory systems, nature and extent of business risk, and modes of conducting business. This variation means that analytical tools that are effective in one jurisdiction may be less so in another. The analyst often faces challenges in obtaining credible information. As a result, in many emerging market economies, financial analyses often have limited reliability. Even though now information may be access freely by analyst on the internet, there are many countries still continue to publish highly suspect information.
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Challenges and Opportunities in Cross-Border Analysis

Opportunities

Despite such challenges, the environment of international financial analysis and valuation are improving and the overall outlook for the analyst is positive,. Globalization of capital markets, advances in information technology, and increasing competition among national governments, stock exchanges and companies for investors and trading activity continue. Together these forces are creating incentives for companies to voluntarily improve their external financial reporting practices. Globalization also means that strictly domestic analyses are becoming less relevant. Interdependencies are growing and no company is insulated from events happening worldwide. 5

Business Analysis Framework

There are 4 stages of business analysis provided by Palepu, Bernard and Healy: 1. Business Strategy Analysis 2. Accounting Analysis 3. Financial Analysis (ratio analysis and cash flow analysis) 4. Prospective Analysis (forecasting and valuation)

Business Analysis Framework

Business Strategy Analysis

It an important first step in financial statement analysis. It provides a qualitative understanding of a company and its competitors in relation to its economic environment. This ensures that qualitative analysis is performed using a holistic perspective. By identifying key profit drivers and business risks, business strategy analysis helps the analyst make realistic forecasts.
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Business Analysis Framework

Business Strategy Analysis

Standard procedures for gathering information for business strategy analysis include examining annual reports and other company publications, and speaking with company staff, analysts, and other financial professionals. The use of additional information sources, such as the Worldwide Web, trade groups, competitors, customers, reporters, lobbyists, regulators and trade press is becoming more common.
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Business Analysis Framework

Business Strategy Analysis

Business strategy analysis is especially difficult in some countries due to a lack of reliable information about macroeconomic development. Government in developed countries is sometimes accused of publishing faulty or misleading economic statistics. This situation is much worst in many emerging economies. For example, one reason the 1994/1995 Mexican currency crisis was a surprise was that the government concealed information about its shrinking foreign reserves and exploding money supply. Some countries delay publishing statistics when the numbers are unfavorable, or even falsify their economic figures.
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Business Analysis Framework

Accounting Analysis

The purpose of accounting analysis is to asses the extent to which a firms reported results reflect economic reality. The analyst needs to evaluate the firms accounting policies and estimates, and assess the nature and extent of a firms accounting flexibility. To reach reliable conclusions, the analyst must adjust reported accounting amounts to remove distortions caused by the use of accounting methods the analyst deems inappropriate. Examples might include marking trading assets to market and not recording the gains or losses in income but in an allowance account.
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Business Analysis Framework

Accounting Analysis

Corporate managers are allowed to make many accountingrelated judgments because they know the most about their firms operations and financial condition. Flexibility in financial reporting is important because it allows managers to use accounting measurements that best reflect the companys particular operating circumstances. However, managers have incentives to distort operating reality by using their accounting discretion to distort reported profits. One reason is that reported earnings are often used to evaluate their managerial performance.
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Business Analysis Framework

Financial Analysis

Its goal is to evaluate a firms current and past performance and to judge whether its performance can be sustained. Ratio analysis and cash flow analysis are important tools in financial analysis. Ratio analysis involves comparison of ratios across years or other firms in the same industry. It provides insights on the comparative and relative significance of financial statement items and can help evaluate the effectiveness of managements operating, investing, financing and earnings retention policies. Cash flow analysis focuses on the cash flow statement, which provides information about a firms cash inflows and outflows, classify among operating, investing and financing activities and disclosures about periodic non-cash investing and financing activities. 12

Business Analysis Framework

Financial Analysis

Analysts can use cash flow analysis to address many questions about the firms performance and management.

For example, has the firm generated positive cash flows from operations? How has cash flow components changed across time in relation to changes in income statement components, sales, and cost of sales in particular? What have been the cash flow consequences of management decisions about financial policy, dividend policy, and investment?
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Business Analysis Framework

Prospective Analysis

Prospective analysis involves 2 steps: forecasting and valuation. In forecasting, analyst make explicit forecasts of a firms prospects based on its business strategy, accounting and financial analysis. It addresses questions such as, how will a companys change in business strategy affect future sales volume and profits? Has the company recently adopted new accounting policies that will make current earnings appear stronger, perhaps at the cost of lower earnings next year? Will financial relationship evidenced in an analysts ratio analysis continue? 14

Business Analysis Framework

Prospective Analysis

In valuation, analysts convert quantities forecasts into an estimate of a firms value. Valuation is used implicitly or explicitly in many business decisions. For example, valuation is the basis of equity analysts investment recommendations. In analyzing a possible merger, the potential acquirer will estimate the value of the target firm. Many different valuation approaches are used in practices, ranging from discounted cash flow analysis to simpler techniques based on price-based multiples such as PE ratio and price-to-book ratio. 15

All four issues of business analysis may be affected by the following factors: 1. Information access 2. Timeliness of information 3. Language and terminology barriers 4. Foreign currency issues 5. Differences in types and formats of financial statements 6. Extent of Disclosure 7. Differences in Accounting Principles 8. International Ratio Analysis
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Information access

Information about thousands of companies from around the world has become more widely available in recent years. Companies around the world now have Web sites, and their annual reports are available free of charge from various Internet and other sources. Many companies also respond to written and telephone requests for their annual reports and other financial documents. However, the amount of information available varies considerably from country to country. Many commercial databases provided access to financial and stock market data for thousands of companies around the world. Companies covered by commercial databases tend to be large companies that are of most interest to financial statement users and investors.
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Information access
Name of Web Site Annual reports Library Web Site Address zpub.com/sf/arl/ What it Provides Alphabetical listing of US corporations with links to home pages and annual reports that can be downloaded free of charge with Adobe Acrobat Reader. Highlights from the Bloomberg news service Many useful links and resources on Asia, Latin America, Africa and Europe.

Bloomberg News Service Emerging markets companies

Bloomberg.com/

Emgmkts.com/

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Timeliness of information

The timeliness of financial statements, annual reports, regulatory filings, and accounting-related press releases varies dramatically by country. In countries such as the US, there are strict regulations on the timing and manner of dissemination of financial information. Companies are required to publish quarterly financial reporting. Clearly, an analyst would prefer to receive financial information sooner rather than later.
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Timeliness of information

Also related to timeliness is the lag between the companys year and the publication of its audited financial statements and annual report.
Day after year end Countries 30 60 Brazil, Canada, Mexico, South Korea, and the US.

61 - 90
91 120 121 and over

Argentina, Australia, Netherlands, New Zealand, Singapore, Sweden, Japan, UK.

Malaysia, Hong Kong, Austria, France, Germany, India, Italy, Nigeria Pakistan
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Foreign Currency Consideration

Accounts denominated in foreign currency present financial analysts with two types of problems. The first relates to reader convenience, the second to information content. The vast majority of companies around the world denominate their financial accounts in the currency of their national domicile. To a US reader accustomed to dealing in dollars, analysis of accounts expressed in euros may be discomforting.
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Foreign Currency Consideration

Users who prefer a domestic currency framework when analyzing foreign currency accounts may apply a convenience translation using year-end exchange rates. One must be careful, however, when analysing translated trend data, use of convenience rate to translate foreign currency accounts can distort underlying financial pattern in local currency.
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Foreign Currency Consideration

To illustrate, assume the following three-year sales revenue patterns for UK concern: 2006 2007 2008 Sales revenues 23,500 28,650 33,160
Convenience translations using the year-end exchange rate employed earlier (i.e. $2.10 for 2006, $2.20 for 2007, and $1.60 for 2008) yield a US dollar sales increase of 7.5% {($53,056 - $49,350)/$49,350} over the three-year period. The sales gain in pounds, however, is 41% : {(33,160 - 23,500) / 23,500}.
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Differences in Statement Format

Balance sheet and income statement formats vary from country to country. For example, in the US, the balance sheet is organized in order of declining liquidity with current assets and liabilities listed before long-lived assets and long-term liabilities. However, in Germany and the UK, the balance sheet items are listed in increasing order of liquidity, with most liquid items appearing at the bottom of the balance sheet. Another example is that German companies tend to list the shareholders equity section before the liabilities on the equity side of the balance sheet.

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Language and Terminology Barriers

Language

Language differences among countries can present information barriers to financial statements users. Most companies domiciled in non-English-speaking countries publish their annual reports in the home country language. If the language differs for the preparer and the user, then the latter must find ways to overcome the language barriers in order to make sense of the companys financial statements. However, growing numbers of the relatively large companies provide English-language versions in their annual reports for the convenience of foreign audiences of interest. For example companies in Japan use Japanese language and it scripts which are different with English language.
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Language and Terminology Barriers

Terminology

Even if different countries use the same language but there are also differences in accounting terminology used in the financial statements. Differences in terminology between British and American companies are well-known and at first may cause some problems. Examples are as follows:

US 1. Inventory

UK Stock

2. 3. 4.

Turnovers Account Receivables Account Payable

Sales Debtors Creditors

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Extent of Disclosure

Adequate information required by analyst to reformat and adjust foreign financial statement. Example 1: Lease IFRS, US GAAP and other national accounting standards require leases to be capitalised when certain criteria are met. Otherwise, treat as operating lease. IFRS requires disclosure of operating lease payments to be made in the next year, for the next 2-5 years. US GAAP, requires the disclosure of future minimum lease payments in each of the next 5 years and all years thereafter.
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Extent of Disclosure

Example 2: Provision Many European companies used provisions (accrual liabilities) to conceal profits and create hidden reserves. In profitable years provisions are created for items such as deferred maintenance and uncertain liabilities. In years which profits are below expectations, reserves are released with an offsetting increase in income. Eg. In 1989, Daimler-Benz reported income as DM6.8 billion rather than DM1.9 billion through reversal of provision for pension.

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Differences in Accounting Principles

Differences in accounting have a significant impact on the reported amount in financial statement.
Country Company Reconciliation from local GAAP to US GAAP % Difference in Net Income United Kingdom Netherlands Australia Ireland Switzerland Acambis Crucell Prana Biotech Trinity Biotech Serono +24.8% -58.1% -10.6% -51.1% -102.6% % Difference on Stockholders Equity -5.8% -4.8% No difference -0.6% -6.8%

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Differences in Accounting Principles

The most troublesome areas in which accounting differences existed were consolidations, valuation and depreciation of fixed assets, deferred income taxes, pensions, marketable securities, foreign currency transactions and translation, lease, goodwill, long-term construction contracts, inventory valuation and provisions.
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International Ratio Analysis

The ratios analysis are different across countries due to significant differences in accounting diversity, economic and social environments. Illustrations the effect of environmental difference on current ratio, debt ratio and profit margin across 3 countries Japan, Korea and US.
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International Ratio Analysis

Year: 1978 Japan Korea US Current ratio Quick ratio Debt turnover ratio 0.84 0.78 0.47 Total asset turnover 0.93 Times interest earned 1.60 1.80 6.50 Profit margin 0.013 Inventory turnover 5.00 6.60 6.80 Return on assets 0.012

1.15 1.13 1.94 Average Collection period

0.80 0.46 1.10 Fixed asset turnover 3.10

Japan

86

Korea US

33 43

2.80 3.90

1.20 1.40

0.023 0.054

0.028 0.074
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International Ratio Analysis

Current Ratio: Japan and Korea less likely to meet their short term obligations than US firms. Japan and Korea firms used short-term debt to finance fixed assets. They would borrow on a short term basis, repay the borrowing when it came due, and then negotiate a new short-term loan. As a result, a series of 20 three-months loans became five-year financing.
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International Ratio Analysis

Debt Ratio: Japan high debt ratios in Japan resulted from the reliance on bank financing. In Korea bank loans tended to be influenced by the government in order to boost the economy.

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International Ratio Analysis

Profit Margin: Japan and Korea - Lower profit margin is due to higher amounts of debt causes a high amount of interest expense resulted to low net income. Korea firms bought new fixed assets at high price, resulted in high depreciation expense.

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FINISH

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