ANALYSIS OF FOREIGN FINANCIAL

STATEMENTS

Chapter 9

McGraw-Hill/Irwin

Copyright 2009 by The McGraw-Hill Companies, Inc. All

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
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

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
9-4

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
funds, rely on foreign financial statements.

Learning Objective 1

9-5

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 companys financial statements to determine the acquisition
price.

Learning Objective 1

9-6

Reasons to Analyze Foreign

Financial
Statements

Other reasons

Extending credit for foreign customers

Evaluating foreign vendors
Comparisons to international competitors

Learning Objective 1

9-7

Foreign Financial Statement

Analysis
Problems and
Data accessibility
Solutions
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.

Learning Objectives 2 and 3

9-8

Foreign Financial Statement

Analysis
Problems and
Language
Solutions
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

9-9

Foreign Financial Statement

Analysis
Problems and
Currency
Solutions
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

9-10

Foreign Financial Statement

Analysis
Problems and
Terminology
Solutions
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
some of these problems.
Much of the U.S. and U.K. differences were removed in 2005 when the
U.K. adopted IFRS.

Learning Objectives 2 and 3

9-11

Foreign Financial Statement

Analysis
Problems and
Format
Solutions
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

9-12

Foreign Financial Statement

Analysis
Problems and
Format
Solutions
At least one Chinese company does not present sales as a
separate item.
This would hinder analysis of top-line growth.
Problems with format differences can be overcome if sufficient
additional financial information is provided in the notes to the
financial statements.

Learning Objectives 2 and 3

9-13

Foreign Financial Statement

Analysis
Problems and
Extent of disclosure
Solutions
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

9-14

Foreign Financial Statement

Analysis
Problems and
Timeliness
Solutions
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

9-15

Foreign Financial Statement

Analysis
Problems and
Differences in accounting principles
Solutions
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

9-16

Foreign Financial Statement

Analysis
Problems and
Differences in accounting principles
Solutions
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 IFRS becomes more widespread, many
of these problems will abate.

Learning Objectives 2 and 3

9-17

Foreign Financial Statement

Analysis
Problems and
Business environment differences
Solutions
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

9-18

Foreign Financial Statement

Analysis
Problems and
Business environment differences
Solutions
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.
Learning Objectives 2 and 3

9-19

Restating Foreign Financial

Statements
Form 20-F
to U.S.
GAAP
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

9-20

Restating Foreign Financial

Statements
Form 20-F
U.S. GAAP
Some ratios, such as return onto
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

9-21

Restating Foreign Financial

Statements
Restatement overview Step one of two
to U.S.
GAAP
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

9-22

Restating Foreign Financial

Statements
Restatement overview Step two of two
to U.S.
GAAP
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

9-23

Restating Foreign Financial

Statements
Step one mechanics Reformatting
to U.S.
GAAP
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.

Learning Objective 4

9-24

Restating Foreign Financial

Statements
Step two mechanics Reformatting
todebit
U.S.
GAAP
The work in this step affects the
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.

Learning Objective 4

9-25

Restating Foreign Financial

Statements
Partial example -- restated financial statements
to U.S.
GAAP
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
Cost of sales
SG&A expense
Other income
Retained earnings (beg)
Learning Objective 4

Cash
1,100
200
100
500

500
Inventory
Deferred liability
Pension liability
Retained earnings (end)

600
50
800
1,300

9-26

Restating Foreign Financial

Statements
Partial example -- restated financial statements
to U.S.
GAAP
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.

Learning Objective 4

9-27

Restating Foreign Financial

Statements
Partial example -- Income statement
to U.S. GAAPU.S.
Local
U.S. Format
Sales
Cost of sales
Gross profit
S,G,&A expense
Other income
Net Income

Learning Objective 4

GAAP
2,000
1,100
900
200
100
800

Dr.

Cr.

40
20

GAAP
2,000
1,100
900
240
80
740

9-28

Restating Foreign Financial

Statements
Partial example Retained earnings statement
to U.S. GAAPU.S.
Local
U.S. Format
R/E, beginning
Net income
R/E, ending

Learning Objective 4

GAAP
500
800
1,300

Dr.
100

Cr.

GAAP
400
740
1,140

9-29

Restating Foreign Financial

Statements
Partial example Balance sheet
to U.S. GAAPU.S.
Local
U.S. Format
Cash
Inventory

Deferred liability
Pension liability

GAAP
500
600

50
800

Retained Earnings

1,300

Learning Objective 4

Dr.

Cr.

GAAP
500
600

20
100
40

70
940
...
1,140
9-30