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Chapter 10:�Analysis of Foreign�Financial Statements

Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

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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

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Learning Objectives

  1. Discuss reasons to analyze financial statements of foreign companies
  2. Describe potential problems in analyzing foreign financial statements
  3. Provide possible solutions to problems associated with analyzing foreign financial statements
  4. Demonstrate an approach for restating foreign financial statements to U.S. generally accepted accounting principles (GAAP)

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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

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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

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�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

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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

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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 industry

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Potential Problems in Analyzing Foreign Financial Statements

  • Language
    • 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

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Potential Problems in Analyzing Foreign Financial Statements

  • 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
    • 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

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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 2005 when the U.K. adopted IFRS

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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

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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

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Potential Problems in Analyzing Foreign Financial Statements

  • Timeliness
    • 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

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Potential Problems in Analyzing Foreign Financial Statements

  • Differences in accounting principles
    • 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

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Potential Problems in Analyzing Foreign Financial Statements

  • International Ratio Analysis
    • 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

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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

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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

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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

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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

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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

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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 2,000 Cash 500

Cost of sales 1,100 Inventory 600

SG&A expense 200 Deferred liability 50

Other income 100 Pension liability 800

Retained earnings (beg) 500 Retained earnings (end) 1,300

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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

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Restating Foreign Financial Statements to U.S. GAAP

  • Partial example -- Income statement

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  • 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

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Restating Foreign Financial Statements to U.S. GAAP

  • Partial example – Retained earnings statement

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  • 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

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Restating Foreign Financial Statements to U.S. GAAP

  • Partial example – Balance sheet

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  • 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

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End of Chapter 10

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