Accounting Principles Tests

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					                 Chapter 5
International Financial Statement
                          Analysis
International Accounting Differences
and Financial Statement Analysis
   The key question
       How do differences in accounting affect earnings
        and cash flow assessments – are the differences
        material in the decision process
   These assessments are important to
       Investors
       Corporations concerned with foreign direct
        investment
   Growing number of companies are listing on
    international exchanges (London, New York)

         International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gray, Black
Stock Market Comparisons




   International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gray, Black
International Accounting Differences
and Financial Statement Analysis

   A tendency exists to looks at earnings from a
    home country perspective – that may or may
    not place a high value on accounting.
       This tendency may ignore accounting differences
   A 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, Gray, Black
Major Differences in Accounting
Principles Around the World
   Inventory measurement                                      Construction contracts
       Generally based on                                          Wide usage of
        “lower of cost or                                            percentage-of-
        market” with market                                          completion method – is
        defined as either                                            this better / more
           Net realizable value                                     accurate?
           Replacement cost                                        Completed contract
       LIFO is permitted for                                        method – Switzerland,
        tax purposes in U.S.                                         China, Japan
        and Japan, but not in
        the EU

            International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gray, Black
Major Differences in Accounting
Principles Around the World
   Measurement basis                                        Depreciation
    used                                                      accounting
       Historical cost is used in                                Useful economic life
        the U.S., Brazil,                                          concept – U.S. and EU
        Switzerland, China, and                                   Accelerated methods –
        Japan.                                                     France, Germany,
       More flexible approach                                     Switzerland, Japan
        with some restatements
        to market value or
        replacement cost – U.K.,
        Holland


          International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gray, Black
Major Differences in Accounting
Principles Around the World
   R&D costs                                                Retirement benefits
       Expensed immediately in                                   Generally accounted for
        Anglo-American and                                         on the basis of accrued
        Germanic countries                                         and/or projected benefits
       Brazil has a more flexible                                 payable to employees
        approach                                                  Pay-as-you-go approach
       Some countries allow                                       in Brazil and China
        capitalizing the borrowed
        cost of assets




          International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gray, Black
Major Differences in Accounting
Principles Around the World
   Taxation                                                 Business Combinations
       Accounting income                                         Varies with allowance of
        strongly influenced by                                     pooling-of-interests
        the tax system in France,                                 Purchase method is
        Germany, Brazil,                                           generally required
        Switzerland                                               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, Gray, Black
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, Gray, Black
The Impact of U.S.-U.K. Accounting
Differences- A Quantitative Look
Index of conservatism (Gray, 1980)
   1 – [RA – RD / l RA l]

   Where RA = adjusted earnings (or returns) (i.e. earnings converted to
     an alternate accounting system)
          RD = disclosed earnings (firm earnings reported on the home
     countries accounting system).

   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” or more
        optimistic/aggressive
   If index value < 1, U.K. GAAP earnings are more “conservative”


        International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gray, Black
The Impact of U.S.-U.K.
Accounting Differences
Example 1                                              Example 2

U.K. earnings                                          U.K. earnings
£110 million                                           £90 million


U.S. earnings                                          U.S. earnings
£100 million                                           £100 million


Index
                                                       Index
1 – [100-100]/100 = 1.1
                                                       1 – [100-90]/100 = 0.9


        International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gray, Black
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 – to assess the accounting policy you
 wish to examine.

 Partial index of “conservatism” - first adjust to overall
   comparison accounting method
 Then: analyze the accounting issue in question

 1 – [partial adjustment (accounting policy in question) / l U.S.
    GAAP Earnings l ]

      International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gray, Black
The Impact of U.S.-U.K.
Accounting Differences
Example
                                                                         Millions of Pounds

  U.K. GAAP earnings                                                     120
  Adjustments for U.S. GAAP:
  Deferred taxation                                                      (15)
  Goodwill amortization (less of issue now)                              (5)
  Adjusted earnings per U.S. GAAP                                        (100)
  Overall index of „conservatism‟                                        1.2

  Partial index for deferred taxation                                    1 – [-15/100] = 1.15

  Partial index for goodwill                                             1 – [-5/100] = 1.05


       International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gray, Black
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, Gray, Black
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, Gray, Black
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, cross-
        holdings, 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, Gray, Black
Factors Influencing
Measurement Differences
   U.S. and U.K.
       Stock market is the dominant influence
           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, Gray, Black
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, Gray, Black
Factors Influencing
Measurement Differences
   Continental Europe and Japan
       Users of financial information may be more
        concerned with balance sheet information
         Black and White (2003) findings
            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, Gray, Black
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 nonlisted companies
        adopt?
   Will the U.S. accept IFRS?

          International Accounting & Multinational Enterprises - Chapter 5 - Radebaugh, Gray, Black

				
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