9-1

Analysis of Foreign Financial Statements

Reasons for analyzing foreign financial statements. Problems encountered in analyzing foreign financial

statements. Possible solutions to problems encountered in analyzing

foreign financial statements.

9-2

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

9-3

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

9-4

Reasons to Analyze Foreign Financial Statements

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

Learning Objective 1

9-5

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

9-6

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

9-7

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

9-8

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

9-9

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 not to provide cost of good sold. This prevents an analyst from determining gross margin

percentage and inventory turnover.

Learning Objectives 2 and 3

9-10

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

9-11

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

9-12

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

9-13

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.

Some investors attempt to reframe foreign financial statements to a more familiar GAAP.

Learning Objectives 2 and 3

9-14

Restating Foreign GAAP Net Income to US GAAP Net income

Microsoft Corporation

Consolidated Statement of Earnings

Year Ended June 30, 1999

Australian Canadian UK French

NIAT Foreign GAAP $10,658 $10,794 $10,529 $7,783

Preferred stock dividends -28

Acquired in-process 99

Tax benefits of stk options -2,873 -3,107 -2,743

Other adjustments 29 3

NIAT US GAAP $7,786 $7,786 $7,786 $7,786

NIBT $11,891 $11,793 $11,892 $11,888

9-15

Foreign Financial Statement Analysis – Problems and Solutions

Differences in accounting principles 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 Statementsto 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 GAAP Net Income to US GAAP Net income

You are employed by a US-based multinational, Exxon Mobil. You have been asked to compare Exxon’s profitability (net income) for 2006 with the profitability (net income) for 2006 of the following foreign-based multinationals:

• BP• Royal Dutch Shell• Total• Petrobras

All of the information necessary for these comparisons can be found on the company websites.

9-20

Restating Foreign GAAP Net Income to US GAAP Net income

Company

Country/LocalGAAP

Local GAAP US GAAP

DifferenceUS Dollars(millions)

Net Income (Loss)(millions)

Net Income (Loss)(millions)

LocalCurrency

US Dollars Local

CurrencyUS

Dollars

Exxon Mobil

USA $39,500

BP UK

IFRS

$22,000 $21,114 ($886)

Royal DutchShell

UK

IFRS

$25,442 $24,797 ($645)

Total France

IFRS

€11,768 $14,828 €11,400 $14,364 ($464)

Petrobras Brazil

IFRS

$10,344 $10,344 0