II. There are several problems an analyst might encounter in analyzing foreign financial statements, including:
III. Some of the potential problems can be removed by companies through their preparation of convenience translations in which language, currency, and perhaps even accounting principles have been restated for the convenience of foreign readers.
IV. A significant number of investors find that differences in accounting practices across countries hinder their financial analysis and affect their investment decisions. Some analysts cope with this problem by restating foreign financial statements to a familiar basis, such as U.S. GAAP.
A. Another coping mechanism is to base analysis on a measure of performance from which many accounting issues have been removed, such as EBITDA.
V. Analysts should exercise care in interpreting ratios calculated for foreign companies. What is considered to be a good or bad value for a ratio in one country may not be in another country.
A. Financial ratios can differ across countries as a result of differences in accounting principles.
B. Financial ratios also can differ across countries as a result of differences in business and economic environments. Optimally, an analyst will develop an understanding of the accounting and business environments of the countries whose companies they wish to analyze.
VI. To facilitate cross-country comparisons of financial information, foreign company financial statements can be restated in terms of a preferred format and preferred GAAP through a two-step process.
A. First, financial statements are reformatted. Adjustments are made for differences in terminology, presentation, and classification.
B. Reformatted financial statements then are restated to a preferred GAAP. This takes care of comparability problems caused by differences in accounting principles. GAAP restatement can be carried out through the use of reconciling accounting entries posted to a restatement worksheet.
1. Investors can diversify their risk by including shares of foreign companies in their investment portfolio. Correlations in the returns (increases and decreases in stock prices) earned across stock markets are relatively low. The high degree of independence across capital markets affords investors diversification opportunities.
2. Ford might want to include the following companies in a benchmarking study:
U.S. – General Motors
Japan – Honda, Toyota, Subaru
Germany – Daimler-Chrysler, BMW, Volkswagen, Audi
Korea – Hyundai, Kia
Note: Due to the consolidation in the automobile industry, several companies are now divisions of other companies. For example, Ford owns Mazda (Japan), Volvo (Sweden), and Jaguar (U.K.). BMW owns Land Rover (U.K.), and Renault owns Nissan (Japan). Of course the largest consolidation occurred when Daimler-Benz (Germany) acquired Chrysler (U.S.).
3. Commercial databases tend not to include notes to financial statements, which are an important source of information about a company. They also tend to force different country formats for financial statements into a common format and thereby run the risk of misclassification and loss of information. Data entry errors are also a potential problem.
4. The first (easiest) place to look for the most recent annual report is on the company’s internet website. Several internet resources can help in locating a company’s financial statements including Hoover’s, EDGAR, and CAROL.
5. Much financial statement analysis is conducted using ratios or percentage changes (comparing one year with another). Ratios and percentages are not expressed in currency amounts. In fact, in analyzing year-to-year percentage changes, analysts must be careful in translating from a foreign currency to their own currency as changes in exchange rates can distort underlying relationships.
6. If an analyst is unable to read a company’s annual report, they will be less likely to feel that they have sufficient information to make an informed investment decision. This would be analogous to making an internet purchase of an electronic product manufactured by a company with which you are unfamiliar and the only description of the product is in a language you do not read.
7. Unless one is familiar with German accounting, it is possible only to make an educated guess as to what the item “revenue reserves” represents. Because it is a positive amount reported in stockholders’ equity, it is likely to be an appropriation of retained earnings.
8. Disclosures in the notes to financial statements can provide additional detail related to specific line items that allows the analyst to reformat the financial statements to a format preferred by the analyst (e.g., that can be compared with other companies). Disclosures related to items such as provisions can allow analysts to assess the impact that these have on income.
9. The time lag between fiscal year end and when financial statements are made available to the public can differ substantially across countries. This time lag is influenced by the stock market regulator in many countries. For example, the SEC requires U.S. companies to file financial statements within 90 days of the fiscal year end, whereas publicly traded British companies are allowed six months to file their reports. Substantial differences in the timeliness of earnings announcements also exist across countries.
Timeliness is also a function of how often companies must prepare financial statements. Whereas the U.S., Canada, and the U.K. require publication of quarterly reports, the European Union requires only semi-annual reporting, and annual reporting only is the norm in many countries.
13. Conservatism implies “overstating” expenses and liabilities, and “understating” revenues and assets. Overstating expenses and/or understating revenues results in an “understatement” of net income and retained earnings.
Profit margin -- If net income is understated because of an overstatement of expenses (or understatement of revenues), profit margins (net income/sales) will be smaller (understated).
Debt to equity ratio -- Overstatement of liabilities and understatement of retained earnings results in an inflated debt-to-equity ratio (total liabilities/total stockholders’ equity).
Return on equity -- The impact of conservatism on return on equity (net income/average stockholders’ equity) is not as clearcut because both the numerator and denominator in the ratio are understated.
Assume income would be 100 and beginning stockholders’ equity 1,000 absent any overstatement of expenses (base case). If expenses are overstated 10 each year, income is understated by 10 each year and the extent to which retained earnings are understated increases by 10 each year. As the table below illustrates, return on equity will be smaller each year as a result of the understated net income.
Effect of conservatism on Return on Equity: