International Accounting, 6/e Frederick D.S. Choi Gary K.

Meek

Chapter 9: International Financial Statement Analysis

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Learning Objectives

What is a logical approach to analyzing foreign financial statements? Why is it difficult to undertake an international business strategy analysis? What are some steps to examining foreign accounting practices? How do cross-country variations in accounting measurements, disclosure practices, and auditing standards impact ones analysis of foreign financial statements? How can you cope with differences in national accounting measurement practices? What does international prospective analysis entail and why is it difficult to perform in an international setting? What are some pitfalls to avoid when conducting cross-country ratio analysis?
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What is a Logical Approach to Analyzing Foreign Financial Statements?

Undertake a business strategy analysis. Conduct an analysis of a firms financial reporting practices. Conduct a financial analysis using ratio and cash flow data. Do a prospective analysis.

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International Business Strategy Analysis

Strategy analysis = getting to know a company and its competition in relation to its economic environment. Information gathering includes recourse to Annual reports Company staff, financial analysts, and other financial professionals World Wide Web Trade groups Competitors Reporters Lobbyists Regulators Financial press
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International Business Strategy Analysis (contin)

Difficulties in undertaking an IB business strategy analysis

Profit drivers and business risks may be country specific. National business and legal environments differ. Environmental risks such as changing process and FX risk need to be evaluated. Information sources may be limited or unreliable.

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Steps in Examining Foreign Accounting Practices

Identify key accounting policies. Assess a firms accounting flexibility. Evaluate the firms accounting strategy. Evaluate the quality of its financial disclosures. Identify reporting outliers. Adjust for accounting measurements that distort the underlying economics of a firms transactions.
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How Does Diversity in International Accounting Impact Financial Statement Analysis?

Measurement differences within and between countries make performance comparisons difficult.

Measurement differences may relate to measurement options permitted by GAAP. Measurement differences may be due to differences in management discretion. Measurement difference may be due to differences in financial statement orientation; i.e., creditor vs. shareholder. Measurement differences may relate to the objectives of financial statements; i.e., oriented toward more macro decisions vs. micro decisions.
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How Does Diversity in International Accounting Impact Financial Statement Analysis? (contin)

Differences in corporate transparency make it difficult:

to comprehend what measurement rules are being followed to estimate future performance metrics to value forecasted numbers because of large variances of these subjective probability distributions Auditing differences affect the credibility of reported numbers owing to differences in: the information content of the auditors report the source of auditing standards the enforcement of auditing standards auditor liability to third parties auditor qualifications auditor certification procedures auditor independence

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Coping Mechanisms

For measurement differences:

Adopt a mutual fund (passive) approach to investing. Restate foreign GAAP to domestic GAAP. Restate foreign GAAP to IFRS. Rely on non-accounting data using a dividend discount model or cash flow data. Immerse yourself in the language, currency and GAAP of the country you are investing in; i.e., develop a multiple-principles capability.
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Coping Mechanisms (contin)

For disclosure differences:

Undertake company visitations. Attend company road shows. Alter investment classifications from speculative grade (poor disclosure) to investment grade (good disclosure). Alter investment strategies from active investing (good disclosure) to passive or non-investing (poor disclosure).
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Coping Mechanisms (contin)

For audit differences:

Research the auditing environment in the country being analyzed. Institutional investors ask for a second audit opinion or engage a recognized audit firm when confidence in the integrity of the attest function is in doubt. Assess a higher risk premium for audit risk.

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Prospective Analysis

Prospective analysis: forecasting a firms prospects based on an assessment of a firms business strategy, accounting policy, and its financial analysis, and arriving at an estimate of the firms value. Complicating factors: Fluctuating exchange rates make it difficult to forecast a firms future costs and revenues when sales/purchases are invoiced in foreign currencies. National variations in measurement, disclosure, and auditing practices including national enforcement regimes add to the difficulty of achieving forecast accuracy. National variations in pricing risk make it difficult to select an appropriate discount rate for valuation purposes. Valuation multiples such as P/E ratios also vary from country to country complicating appropriate corporate valuations.
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Pitfalls in Conducting International Ratio Analysis

All of the difficulties mentioned previously in conducting business strategy, accounting, and financial analysis. A lack of understanding of the political, legal and business environment that affects the analysis of financial ratios generated in that environment.

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Pitfalls in Conducting International Ratio Analysis (contin)

Examples of environmental differences:

Government systems

UK and U.S. governments are more laissez-faire; i.e., ensure free markets. Self-regulation is encouraged. German and Japanese governments are more active in orchestrating growth. Government has a major role in market regulation. UK and U.S. governments are common law countries where standard-setting is delegated to professional bodies and standards oriented toward investor decisions. Germany and Japan are code law countries. Government active in standard setting with pronouncements oriented toward societal rights.

Legal systems

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Pitfalls in Conducting International Ratio Analysis (contin)

Fiscal systems UK and U.S. make a distinction between financial reporting and tax reporting. Emphasis on consolidated reporting. Germany and Japan exhibit a degree of tax-book conformity. Parent company financial statements are important. Capital markets UK and U.S. markets oriented more toward equity investors. Theyre more equity-oriented with significant individual ownership. Earnings tend to have an optimistic bias. German and Japanese markets traditionally oriented toward creditors. Earnings tend to have a more conservative bias with more smoothing opportunities.
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Chapter Exhibits

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Chapter Exhibits (contin)

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Chapter Exhibits (contin)

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Chapter Exhibits (contin)

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Exhibit 9-4 (contin)

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Exhibit 9-4 (contin)

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Chapter Exhibits (contin)

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Chapter Exhibits (contin)

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Chapter Exhibits (contin)

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Exhibit 9-11 (contin)

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Chapter Exhibits (contin)

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Exhibit 9-12 (contin)

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