Week Nine

Analysis of Foreign
Financial Statements

McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Analysis of Foreign Financial Statements

Chapter Topics
 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.

9-2
 Analysis of Foreign Financial Statements

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).

9-3
 Reasons to Analyze Foreign Financial Statements

Foreign portfolio investment

 Investors can diversify away 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 fund, rely on foreign financial statements.

Learning Objective 1 9-4

 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 Daimler/Chrysler and acquisitions by Ford
Motor such as Volvo (of Sweden).
 The purchaser of an international company needs to analyze
the target company’s financial statements to determine the
acquisition price.

Learning Objective 1 9-5

 Reasons to Analyze Foreign Financial Statements

Other reasons
 Extending credit for foreign customers.
 Evaluating foreign vendors.
 Comparisons to international competitors.

Learning Objective 1 9-6

 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
company’s annual report.

Learning Objectives 2 and 3 9-7

 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.

Learning Objectives 2 and 3 9-8

 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.
 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.

Learning Objectives 2 and 3 9-9

 Foreign Financial Statement Analysis –
Problems and Solutions
Terminology
 Differences in terminology exist between countries using the
same language.
 For example, sales in the U.S. is normally called turnover in
the UK.
 In cases of convenience translations, sometimes these include
terminology unfamiliar to English speakers.
 Knowledge of the business and accounting environment can
help alleviate some of these problems.

Learning Objectives 2 and 3 9-10

 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.

Learning Objectives 2 and 3 9-11

 Foreign Financial Statement Analysis –
Problems and Solutions
Format
 German and other continental European companies often do
not distinguish between current and noncurrent liabilities.
 This makes it difficult or impossible to compute a current
ratio.
 At least one Chinese company does not present sales as a
separate item.
 This would hinder analysis of top-line growth.

Learning Objectives 2 and 3 9-12

 Foreign Financial Statement Analysis –
Problems and Solutions
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.

Learning Objectives 2 and 3 9-13

 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.

Learning Objectives 2 and 3 9-14

 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.

Learning Objectives 2 and 3 9-15

 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.
 Some firms alleviate some of financial statement users’
problems in their convenience translation.
 In summary, as the use of IFRSs becomes more widespread,
many of these problems will abate.

Learning Objectives 2 and 3 9-16

 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.

Learning Objectives 2 and 3 9-17

 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, relative to U.S., can be partly
explained by those companies 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.

Learning Objectives 2 and 3 9-18

 Restating Foreign Financial Statements 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.
 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.

Learning Objective 4 9-19

 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.

Learning Objective 4 9-20

 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.

Learning Objective 4 9-21

 Restating Foreign Financial Statements
to U.S. GAAP
Restatement overview – Step 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.

Learning Objective 4 9-22

 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 foreign GAAP, debits, credits, and U.S. GAAP.
Amounts are presented in original currency.
 Prepare worksheets for income statement, statement of
retained earnings, and balance sheet.
 Line items in worksheet are presented in terminology of U.S.
account titles.

Learning Objective 4 9-23

 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, some affect both.
 Each entry reflects the adjustment needed to reconcile to U.S.
GAAP from foreign GAAP.

Learning Objective 4 9-24

 Restating Foreign Financial Statements
to U.S. GAAP
Partial example -- restated financial statements
 Assume that the foreign 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

Learning Objective 4 9-25

 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 foreign GAAP.

Learning Objective 4 9-26

 Restating Foreign Financial Statements
to U.S. GAAP
Partial example -- Income statement
Foreign 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

Learning Objective 4 9-27

 Restating Foreign Financial Statements
to U.S. GAAP
Partial example – Retained earnings statement
Foreign 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

Learning Objective 4 9-28

 Restating Foreign Financial Statements
to U.S. GAAP
Partial example – Balance sheet
Foreign 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

Learning Objective 4 9-29