Chapter Ten

Analysis of Foreign Financial Statements

Analysis of Foreign Financial Statements
What are areas of concern when attempting to analyze foreign
financial statements?
Analysis of Foreign Financial Statements
Chapter Topics
Overview of financial statement analysis.
Reasons for analyzing foreign financial statements.
Problems encountered in analyzing foreign financial
statements.
Possible solutions to problems encountered in analyzing
foreign financial statements.
Restating foreign financial statements to U.S. GAAP illustrated.
Analysis of Foreign Financial Statements
Overview of Financial Statement Analysis


1. Accounting analysisreflection of economic reality (e.g.
inconsistent standards, estimation errors and intentional
manipulation)

2. Financial analysis (cash flow, profitability and risk analysis)

3. Prospective analysisusing accounting analysis and
financial analysis, along with business environment
analysis and company strategy, to forecast future cash
flow and income
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 Chinas
Zhejiang Geely Holding Group. Ford purchased Volvo for
$6.5b in 1999..and sold it for $1.5b in 2010.
The purchaser of an international company needs to
analyze the target companys financial statements to
determine the acquisition price. Sounds basic enough..
Reasons to Analyze Foreign Financial
Statements
Other reasons

Extending credit for foreign customers.

Evaluating foreign vendors.

Comparisons to international competitors.

Foreign Financial Statement Analysis Problems
and Solutions
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 information in a variety of
formats.
These databases also do not contain complete disclosure notes.
Another approach is to obtain a copy of the foreign companys
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 industry.



Foreign Financial Statement Analysis Problems and
Solutions
Language

Many international companies do not produce financial
statements in English.

The financial statement user could hire a translator or
develop foreign language capability.

Since English is the language of business, companies in
many foreign countries produce convenience
translations of their financial statements in English.


Foreign Financial Statement Analysis Problems and
Solutions
Currency

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. Is that optional?
Hmmm havent we dealt with this headache? But we were on the
inside of the company (owners)..what can outsiders do?

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.

Foreign Financial Statement Analysis Problems and
Solutions
Terminology
Differences in terminology exist between countries using
the same language. HW problem #3
For example, inventory in the U.S. can 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 some of these problems.
Much of the U.S. and U.K. differences were removed in
2005 when the U.K. adopted IFRS.


Foreign Financial Statement Analysis Problems and
Solutions
Format

Some format 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 provide cost of good sold.

This prevents an analyst from determining gross margin
percentage and inventory turnover.

Foreign Financial Statement Analysis Problems and
Solutions
Extent of disclosure remember that we are not just
referring to IFRS countries. And even within IFRS
countries they alter the rules

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.
Foreign Financial Statement Analysis Problems and
Solutions
Timeliness
Timeliness is one aspect of the relevance of information.
This varies significantly internationally since filing deadlines
differ from country to country.
Among developed countries, the U.S. and Canada are the
most timely, whereas continental Europe is the least.
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. Its up to the regulators.

Foreign Financial Statement Analysis Problems and
Solutions
Differences in accounting principles

Differences in accounting principles often result in significantly
different income and other financial statement amounts.

Some of the biggest problem areas are consolidations, fixed
asset valuation and depreciation, and goodwill.

These differences cause some investors to limit the scope of
their investments!!!


Foreign Financial Statement Analysis Problems and
Solutions
Differences in accounting principles

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.
EBIMABD???? We use EBIT, etcbut EBIMABD seems extreme!

Some firms alleviate some of financial statement users
problems in their convenience translation.

In summary, as the use of IFRS becomes more widespread,
many of these problems will abate.

Foreign Financial Statement Analysis Problems and Solutions
Business environment differences

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.

For example, Japanese and Korean companies borrow much
more on a short-term basis than U.S. companies, leading to
lower current ratios.
Foreign Financial Statement Analysis Problems and Solutions
Business environment differences

Debt ratios also tend to be higher in Japan and Korea because of the
sources of financing.

Lower profit margins in Japan in the late 1970s, relative to the U.S., can
be partly explained by the Japanese companies having their focus on
market share as opposed to profits.

In summary, an investor needs to be aware of these differences and not
forgo potentially profitable investments.

An investor must have a good understanding of the business
environment and how to identify the best companies in that
environment. It isnt just about the $$$$ on the financial statements.
Restating Foreign Financial Statement to U.S. GAAP
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.

The Form 20-F 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.

Restating Foreign Financial Statements to U.S. GAAP
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.

The analyst can overcome this by performing the restatement
of financial statement items.
Restating Foreign Financial Statements to U.S. GAAP
Restatement overview Step one of two

The first step, reformatting, involves transforming the
financial statements into a U.S. format.

One part of step one is transforming terminology
differences.

Presentation differences are also transformed.

Item definitions and classifications are transformed.
Restating Foreign Financial Statements to U.S. GAAP
Restatement overview Step two of two

The second step involves restating the foreign GAAP
amounts to U.S. GAAP amounts.

This process is made easier when the company files a Form
20-F.

Sometimes, companies will present a similar reconciliation
without actually filing the Form 20-F.

In any case, notes to the financial statements are very
useful in completing this step.

Restating Foreign Financial Statements to U.S. GAAP
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.
Restating Foreign Financial Statements to U.S. GAAP
Step two mechanics Reformatting

The work in this step affects the debit and credit columns
in the worksheet.

The nature of these entries is essentially adjusting and
reclassification entries.

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.

CH 10 assignment
Exercises and Problems to be turned in (showing all work):
1 (a-c)
3
4

Let pages 514-515 become your best friend
24
Restating Foreign Financial Statements to U.S. GAAP
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 2,000 Cash 500
Cost of sales 1,100 Inventory 600
SG&A expense 200 Deferred liability 50
Other income 100 Pension liability 800
Ret earnings (beg) 500 Ret earnings (end) 1,300
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.
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 2,000
Cost of sales 1,100 1,100
Gross profit 900 900
S,G,&A expense 200 40 240
Other income 100 20 80
Net Income 800 740
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 500 100 400
Net income 800 740
R/E, ending 1,300 1,140
Restating Foreign Financial Statements to U.S. GAAP
Partial example Balance sheet

Local U.S.
U.S. Format GAAP Dr. Cr. GAAP
Cash 500 500
Inventory 600 600

Deferred liability 50 20 70
Pension liability 800 100 940
40
...
Retained Earnings 1,300 1,140