1. McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter Ten Analysis of Foreign Financial Statements Copyright © 2012 The McGraw-Hill Companies, All Rights Reserved

2. 10-2 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.

3. 10-3 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).

4. 10-4 Overview of Financial Statement Analysis 1. Accounting analysis—reflection of economic reality (e.g. inconsistent standards, estimation errors and intentional manipulation) 2. Financial analysis (cash flow, profitability and risk analysis) 3. Prospective analysis—using accounting analysis and financial analysis, along with business environment analysis and company strategy, to forecast future cash flow and income

5. 10-5 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

6. 10-6 International mergers and acquisitions The frequency and size of international corporate mergers has increased in recent years. Examples include Ambev/Anheuser-Busch; BP/Amoco; and acquisitions by Ford Motor such as Volvo (of Sweden), who, in 2010, reached a deal to sell Volvo to China’s Zhejiang Geely Holding Group. The purchaser of an international company needs to analyze the target company ’ s financial statements to determine the acquisition price. Learning Objective 1

7. 10-7 Other reasons Extending credit for foreign customers. Evaluating foreign vendors. Comparisons to international competitors. Learning Objective 1

8. 10-8 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. 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. 10-9 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

10. 10-10 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

11. 10-11 Terminology 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

12. 10-12 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

13. 10-13 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

14. 10-14 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

15. 10-15 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

16. 10-16 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 IFRS becomes more widespread, many of these problems will abate. Learning Objectives 2 and 3

17. 10-17 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

18. 10-18 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 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

19. 10-19 Form 20-F Foreign companies that file non-U.S. GAAP financial statements with the SEC are required to complete a Form 20- F, with the exception of those that use IFRS. 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

20. 10-20 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

21. 10-21 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

22. 10-22 Restatement overview – Step two of 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

23. 10-23 Step one mechanics – Reformatting 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

24. 10-24 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, while others affect both. Each entry reflects the adjustment needed to reconcile to U.S. GAAP from local GAAP. Learning Objective 4

25. 10-25 Partial example -- restated financial statements 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: Sales2,000Cash 500 Cost of sales1,100Inventory 600 SG&A expense 200Deferred liability 50 Other income 100Pension liability 800 Retained earnings (beg) 500Retained earnings (end) 1,300 Learning Objective 4

26. 10-26 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 local GAAP. Learning Objective 4

27. 10-27 Partial example -- Income statement Local 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

28. 10-28 Partial example – Retained earnings statement Local 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

29. 10-29 Partial example – Balance sheet Local 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