Chapter 17

International Financial Statement Analysis

FASB, IASB, and IAAER Project on Financial Reporting

Questions addressed in this project include Should the performance (income) statement be

the primary focus of financial reporting? How should the performance statement

complement the other financial statements? How should the cash flow statement be used? What information should be presented in the

performance statement? Is one approach applicable to all countries?

International Accounting Differences and Financial Statement Analysis

The key question How do differences in accounting affect earnings

and cash flow assessments? These assessments are important to

Investors Corporations concerned with foreign direct

investment Many companies are listing on international

exchanges (London, New York)

Stock Market Comparisons

Accounting Diversity and Economic Environments

International Accounting Differences and Financial Statement Analysis

A tendency exists to looks at earnings from a home country perspective 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

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

Completed contract method – Switzerland, China, Japan

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

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

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.

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?

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

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

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

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

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

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 the U.S. accept IFRS?