Chapter 5

International Financial Statement

Analysis

FASB, IASB, and IAAER

Project on Financial Reporting
Questions

addressed in this project include

Should the performance (income) statement be

the primary focus of financial reporting?
How should the performance statement
complement the other financial statements?
How should the cash flow statement be used?
What information should be presented in the
performance statement?
Is one approach applicable to all countries?

International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gra

International Accounting Differences

and Financial Statement Analysis
The

key question

How do differences in accounting affect earnings

and cash flow assessments?

These

assessments are important to

Investors
Corporations concerned with foreign direct
investment

Many

companies are listing on international

exchanges (London, New York)

International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gra

Stock Market Comparisons

International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gra

Accounting Diversity and

Economic Environments

International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gra

International Accounting Differences

and Financial Statement Analysis
A

tendency exists to looks at earnings from a

home country perspective

This tendency may ignore accounting differences

need exists to better understand foreign

accounting principles in the context in which
they are derived
International comparability is important in
considering alternative investments
International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gra

Major Differences in Accounting

Principles Around the World

Inventory measurement

Generally based on
lower of cost or
market with market
defined as either

Net realizable value

Replacement cost

Construction contracts

Wide usage of
percentage-ofcompletion method
Completed contract
method Switzerland,
China, Japan

LIFO is permitted for

tax purposes in U.S.
and Japan, but not in
the EU

International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gra

Major Differences in Accounting

Principles Around the World

Measurement basis
used

Historical cost is used in

the U.S., Brazil,
Switzerland, China, and
Japan.
More flexible approach
with some restatements
to market value or
replacement cost U.K.,
Holland

Depreciation
accounting

Useful economic life

concept U.S. and EU
Accelerated methods
France, Germany,
Switzerland, Japan

International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gra

Major Differences in Accounting

Principles Around the World

R&D costs

Expensed immediately in
Anglo-American and
Germanic countries
Brazil has a more flexible
approach
Some countries allow
capitalizing the borrowed
cost of assets

Retirement benefits

Generally accounted for

on the basis of accrued
and/or projected benefits
payable to employees
Pay-as-you-go approach
in Brazil and China

International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gra

Major Differences in Accounting

Principles Around the World

Taxation

Accounting income
strongly influenced by
the tax system in France,
Germany, Brazil,
Switzerland

Business Combinations

Varies with allowance of

pooling-of-interests
Purchase method is
generally required
Goodwill is amortized in
Brazil, China, and Japan
Goodwill impairment
tests are used in U.S.,
U.K.

International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gra

Major Differences in Accounting

Principles Around the World
Intangibles

Generally are capitalized and subject to

amortization or impairment tests
Exception Switzerland

Foreign

Currency Translation

Choice between average or closing rate

Generally flexible; actual or average rate allowed

Big

Question: Do these differences matter?

International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gra

The Impact of U.S.-U.K.

Accounting Differences
Index of conservatism (Gray, 1980)
1 [RA RD / l RA l]
Where RA = adjusted earnings (or returns)
RD = disclosed earnings
Therefore,
1 [U.S. GAAP Earnings U.K. GAAP Earnings /
l U.S. GAAP Earnings l]
If index value > 1, U.K. GAAP earnings are less conservative
If index value < 1, U.K. GAAP earnings are more conservative
International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gra

The Impact of U.S.-U.K.

Accounting Differences
Example 1

Example 2

U.K. earnings
110 million

U.K. earnings
90 million

U.S. earnings
100 million

U.S. earnings
100 million

Index
1 [100-100]/100 = 1.1

Index
1 [100-90]/100 = 0.9

International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gra

The Impact of U.S.-U.K.

Accounting Differences
It is possible to establish the relative effect of
individual adjustments with partial indices of
adjustment
Partial index of conservatism
1 [partial adjustment / l U.S. GAAP Earnings l ]

International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gra

The Impact of U.S.-U.K.

Accounting Differences
Example
Millions of Pounds
U.K. GAAP earnings
Adjustments for U.S. GAAP:
Deferred taxation
Goodwill amortization
Adjusted earnings per U.S. GAAP
Overall index of conservatism

120

Partial index for deferred taxation

1 [-15/100] = 1.15

Partial index for goodwill

1 [-5/100] = 1.05

(15)
(5)
(100)
1.2

International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gra

The Impact of U.S.-U.K.

Accounting Differences
Differences

between methods are illustrated

in the Form 20-F report
Form 20-F can be used to test how
conservative U.S. and U.K. GAAP are in
comparison with each other
Form 20-F is reliable because it is provided
by the company itself
Research findings show U.K. GAAP to be
less conservative
International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gra

A Global Perspective on
Earnings Management

How do Anglo-American earnings compare with

continental Europe and Japan?
Continental Europe

Gray (1980) compared French and German companies to

British companies
Insert Exhibit 5.8, 5.9
French and German earnings are more conservative than
British earnings
Weetman and Gray (1991) found that
Netherlands was less conservative that Sweden, U.K.
Swedish methods were more conservative than U.S. GAAP

International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gra

A Global Perspective on
Earnings Management

Japan

Earnings are relatively understated compared to the U.S.

(33.9%, according to Aron (1991)
Historically high PE ratios were deflated by adjustments for
reserves, consolidation practices, depreciation, crossholdings, and differences in capitalization (Morgan Stanley)
Higher levels of gearing (leverage) and short-term
payables are tolerated because of long-term relationships
with bankers and suppliers
Emphasis tends to be on long-term growth rather than
instant profitability

International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gra

Factors Influencing
Measurement Differences
U.S.

Stock market is the dominant influence

and U.K.

Information needs of investors encourage a more

optimistic view of earnings and higher share prices

Accounting principles are flexible

Accounting profession is independent
Tax rules have a limited influence
Cultural values motivate a less conservative
approach to measurement

International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gra

Factors Influencing
Measurement Differences
Continental

Europe and Japan

Taxation and sources of finance are influential

Tradition of commercial codes and accounting
plans
Tendency to report lower earnings for tax
purposes

International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gra

Factors Influencing
Measurement Differences
Continental

Users of financial information may be more

concerned with balance sheet information
Black and White (2003) findings

Europe and Japan

Balance sheet info is more informative in Germany, Japan

Income statement is more relative in the U.S.

Professional influence is low due to legal

requirements related to accounting
Cultural values motivate a more conservative
approach

International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gra

Global Accounting
Convergence

IASB sets IFRS

Goal is to develop comparable international standards with

low cost to MNEs
Provides a model for developing countries
More uniform standards have been developed to aid in
capital raisings and stock exchange listings
Core standards program with IOSCO was completed in
1998
May 2000 IOSCO endorsed IFRS
EU will adopt IFRS in 2005

Will the U.S. accept IFRS?

International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gra