Financial Reporting and Analysis
Chapter 17 Solutions
Overview of International Financial
Reporting Differences and Inflation
E17-1. Why do financial reporting rules differ?
One important determinant of a country’s reporting standards arises from
regulators’ actions and the demands of external statement users.
In jurisdictions where capital is raised from a broad range of outside
investors–as is the case in the United States and Canada–these users require
detailed and informative disclosures in order to make effective investment
decisions. Their demand for information helps ensure passage of disclosure
laws and the development of reporting standards which provide the necessary
But in countries where much of the capital needed by firms is raised privately–
say, from banks or from related companies in the keiretsu–public disclosure
rules are less important. The primary capital providers have direct contact with
those firms which are raising capital as well as the power to request detailed
information regarding the firms’ financial strengths and prospects. In these
situations, the demand for informative public disclosures is lessened, and
reporting standards are frequently weak.
E17-2. Overcoming reporting diversity
Uniform reporting standards would improve comparability to some extent in
certain circumstances. Two examples will serve to illustrate the point. Capital
lease accounting is not used in Japan. But insofar as long-term, non-
cancelable leases that transfer property rights to the lessee exist in Japan,
then comparisons between United States and Japanese firms would be
hampered. Uniform lease capitalization rules would enhance comparability
here. A second example is The Netherlands where variable costing is allowed
for inventory accounting. Again, comparisons between Dutch firms using
variable costing and other firms in countries which require absorption costing
would be impeded. A uniform standard might help here.
But, uniform international reporting rules cannot overcome all obstacles. U.S.-
type equity method accounting rules when applied to Japanese interlocking
keiretsu investments–as discussed in the text–are an example. The
philosophy underlying reporting rules like equity method accounting–i.e., 20%
or greater ownership conveys some degree of control–do not apply in Japan.
To generalize, other examples of a lack of conformity between the objective of
specific reporting rules and institutional arrangements in certain countries
undoubtedly exist. Uniform rules will not enhance comparability in such
E17-3. Alternative return measures
Spanish GAAP ROA = 112,6083,109,222 = .0362 or 3.62%
U.S. GAAP ROA = 125,069(3,109,222 - 126,552)
= .0419 or 4.19%
There is no “better” ROA. The appropriate ROA measure to use is based on
the following issues: (1) which ROA better reflects the firm’s economic
performance, and (2) which ROA allows users of the financial report to
compare Telefonica de Espana, S.A. to other firms of interest.
As stated in the chapter, some countries’ accounting standards are not
intended to measure and report economic reality. Instead, the accounting
standards are tied to the tax laws or other statutory reporting requirements of
the country. In some cases, countries have not expended the resources
necessary to develop a comprehensive set of accounting standards. For
example, Spanish GAAP does not address the accounting for capital versus
revenue expenditures. Firms reporting in accordance with U.S. GAAP would
be required to capitalize the cost of overhauling machinery if the overhaul
increased the efficiency of the asset, i.e., changed the economic performance
of the assets. Firms reporting in accordance with Spanish GAAP could either
capitalize or expense the cost of the overhaul. The lack of guidance could
result in accounting data that do not reflect underlying economic
It is important to note that Spanish GAAP has less stringent disclosure
requirements than U.S. GAAP. Telefonica, when reporting in accordance with
Spanish GAAP, would not have to disclose financial information that analysts
typically use to adjust earnings and asset figures before calculating a firm’s
ROA, e.g., nonoperating or nonrecurring items.
E17-6. Distinguishing between monetary and nonmonetary items
The nonmonetary items are:
(3) Minority interest (sometimes called noncontrolling interest)
(6) Equity investment in unconsolidated subsidiaries
(7) Obligations under warranties
(8) Accumulated depreciation of equipment
Minority interest is nonmonetary since it is comprised of:
Minority ownership % (Assets - Liabilities).
Since many of the underlying assets and liabilities are nonmonetary,
the net minority interest is nonmonetary.
Equity investment in unconsolidated subsidiaries is nonmonetary for the
same reason minority interest is nonmonetary. It represents an ownership
% times net assets, many of which are nonmonetary.
Obligations under warranties are nonmonetary since these liabilities will be
settled through use of nonmonetary assets and labor services.
Accumulated depreciation of equipment is nonmonetary since the
equipment itself is nonmonetary.
a) favorably than their underlying economic performance warrants.
b) Foreign issuers with excellent prospects won’t “signal” their extraordinary
potential in some way–say, by voluntarily supplying the more stringent U.S.
GAAP data to allow meaningful comparisons and “showcase” their more
On the other hand, consistent with the discussion solution to E17-2, it is not
clear whether a single, uniform set of standards can adequately capture the
subtle institutional and national differences that cause foreign firms’ operating
environments and prospects to diverge from their U.S. competitors. In this
view, since no single set of standards could ever completely reflect these
differences, using different standards for foreign issuers might be no worse
than the noncomparability that arises under the Form 20-F reconciliation.
Financial Reporting and Analysis
Chapter 17 Solutions
Overview of International Financial
Reporting Differences and Inflation
P17-1. Capital sources and disclosure differences
In Equityland, the primary users of the financial reports are the shareholders
who buy and sell stock on the public stock exchanges. In Debtland, the
primary users of the financial reports are the creditors who provide capital to
Both types of users are interested in assessing the profitability of firms.
Shareholders are concerned about profitability because they have dividend
expectations. In addition, shareholders are concerned about a firm’s growth
and growth potential because growth will have an impact on the firm’s market
appreciation. Creditors are concerned about profitability because profitability
is linked to long-term cash flows and creditors want to assess firms’ abilities to
cover interest payments. In addition, creditors are concerned with liquidity. A
firm’s liquidity is useful in assessing its ability to pay back its debts.
EPS Times interest earned
Current ratio Debt-to-equity ratio
The disclosure environments of Equityland and Debtland might be quite
different. Firms in Equityland would be expected to provide more public
disclosures of financial and nonfinancial information simply because individual
investors are not privy to company records. Firms in Equityland may provide
more information about their financial position and operating performance via
footnotes to the financial statements. In addition, Equityland firms may meet
with financial analysts and other intermediaries to disseminate information. A
demand for additional financial information exists in Debtland but firms often
won’t publicly disclose the information. Public disclosures are not essential in
these settings since creditors have the power to examine company records
that shareholders typically cannot access.
P17-2. Overcoming reporting diversity
The footnote states that the reduction in the carrying value of certain assets
represents the write-down of certain planning and development costs. U.S.
GAAP does not allow planning and development costs to be capitalized. They
must be expensed in the period incurred and reported as part of operating
expenses. On the other hand, if the assets were legitimately included in
property, plant, and equipment, the reduction in the carrying value may reflect
an impairment of an asset. According to FASB No. 121, a loss on the
impairment of a long-term asset should be reported as part of income from
continuing operations, generally in the other expenses and losses section.
The loss should not be reported as an extraordinary item.
Summary financial information, e.g., net income, total assets, stockholders’
equity, is a function of the accounting methods a firm employs in preparing its
financial statements. Thus, one must exercise caution in comparing summary
statistics across international firms because firms will be reporting in
accordance with different sets of accounting standards. U.S. GAAP is more
restrictive in its accounting method choices relative to other domestic GAAPs.
However, even within U.S. GAAP, firms have discretion in selecting
accounting methods. Thus, data services that provide only summary financial
information are limited in their usefulness.
Income (loss) as originally reported ($1,282)
Add: Tax reimbursements 8
Estimated expenses associated with
contingent liabilities $111
Costs related to financial
Reduction in carrying value of
certain assets 1,206
Revised continuing income (loss) ($2,997)
In general, there is limited information to determine the proper classification of
the items Euro Disney classified as exceptional items. For example, consider
the gain reported due to payable forgiveness. In accordance with FASB
Statement No. 114, if Euro Disney’s pre-restructure carrying amount of the
debt exceeds the total future cash flows related to the restructured debt, then
Euro Disney would report an extraordinary gain on the debt restructuring.
However, if the total future cash flow after restructuring exceeds the total pre-
restructuring carrying amount of Euro Disney’s debt, no gain would be
reported. Income (loss) from continuing operations is an important calculation
for the users of financial statements. The measure is considered to represent
the firm’s sustainable earnings, i.e., earnings that will persist in the future.
Expected earnings are used to estimate future cash flows, which are relevant
in valuing a firm’s stock. Users of financial statements must realize that
income (loss) from continuing operations reported on the income statement
can vary depending upon the GAAP employed.
P17-5. Overcoming reporting diversity
United Kingdom GAAP ROE = 1,8351,369 = 1.34 or 134%
United States GAAP ROE = 8004,735 = .169 (rounded) or 16.9%
According to U.S. GAAP, the amortization of goodwill is reported as an operating
expense on the income statement. The expense reduces net income that
results in a decrease in earnings per share. The write-off of goodwill at the
time of purchase affects ROE of the current period via the denominator of the
ROE calculation. Stockholders’ equity will be reduced by an amount equal to
the purchase price of the goodwill. Since the denominator is decreasing and
the numerator, net income, is not affected by the goodwill write-off, ROE will
be higher in the period of the write-off. As far as the impact on future periods’
ROE, the difference in stockholders’ equity due to the write-off will ultimately
be eliminated; the amortization expense systematically reduces stockholders’
equity via net income. However, since net income measured in accordance
with U.K. GAAP will be higher relative to U.S. GAAP net income, U.K. GAAP
ROE will also be higher than U.S. GAAP ROE until the point in time that the
goodwill is fully amortized.
One could argue that the U.K. GAAP ROE is a better measure of economic
performance because net income is not garbled with a cost allocation
estimate, i.e., goodwill amortization. However, since stockholders’ equity is
reduced by the goodwill write-offs, the ROE may be overstated. ROE
calculated under U.S. GAAP may not measure “true” economic performance
either. Managers’ have discretion in choosing amortization periods which
influences net income and, consequently, ROE. It isn’t the case that one ROE
better reflects economic performance. Rather, the appropriate ROE should be
based on the comparisons being made; SmithKline Beecham to a U.K. firm
that wrote off goodwill or SmithKline Beecham to a U.S. firm or U.K. firm that
P17-8. GAAP differences
a) Generally, if inventory levels are increasing, Novo Nordisk’s earnings would
be lower under Danish GAAP relative to U.S. GAAP because of the
expensing of direct labor and production overhead costs. This issue is
discussed in Chapter 8. However, if inventory levels decreased, Novo
Nordisk’s Danish GAAP net income would be higher than its net income
measured in accordance with U.S. GAAP.
b) Danish GAAP earnings would be higher than U.S. GAAP earnings since
amortization expense is not recorded on intangible assets.
c) Dividends have no effect on earnings.
d) Danish GAAP earnings would be lower than U.S. GAAP earnings since
construction interest is expensed rather than capitalized.
a) Inventory would have a higher carrying value under U.S. GAAP relative to
Danish GAAP. Thus current assets, total assets, and stockholders’ equity
would all be larger under U.S. GAAP.
b) Since intangible assets are being amortized under U.S. GAAP, U.S. GAAP
would result in a lower carrying value for intangible assets and, in the
aggregate, lower total assets. Because income would be lower,
stockholders’ equity would also be lower.
c) Dividends declared are recorded as a liability in the declaration period
under U.S. GAAP. Thus, Novo’s current liabilities would increase if Novo
prepared a U.S. GAAP balance sheet.
d) Under U.S. GAAP, Novo would have to capitalize construction interest.
This would result in larger fixed asset and stockholders’ equity balances.
P17-9. GAAP differences
One difference is the order of the accounts. In the United States, firms list
assets in descending order of liquidity–most liquid to least liquid. Remy lists
its long-term assets first and its current assets towards the bottom of the
balance sheet. Another difference is in the reporting of prepaid and deferred
charges. Remy reports them as a separate line item in a non-classified
category of assets. In the United States, prepaid assets are usually classified
as current and deferred charges can be either long-term or current. Remy
does not report accounts receivable separately from notes receivable nor
does Remy report them at their net realizable value. There is just one
category for investments. It is not clear if the investments are long-term or
At the time Remy’s balance sheet was prepared, French GAAP did not
require firms to estimate bad debts and set up an allowance for doubtful
accounts. French GAAP was linked to tax reporting which did not allow a
deduction for bad debts unless the firm owing the accounts receivable was in
bankruptcy or receivership. Thus, the asset valuations reported on the
balance sheet were dependent on the tax rules in effect.
In addition to the differences in accounting methods across alternative sets of
GAAP, there can be substantial differences in GAAP disclosure requirements.
Some GAAPs require extensive disclosures to be part of the published
financial report (e.g., U.S. GAAP). Other GAAPs do not require as many
financial disclosures (e.g., German GAAP). Firms can voluntarily provide
financial disclosures to supplement those required by the GAAP employed
and, thus, the variation in disclosure practices across GAAPs generally is less
of a concern than the variations in accounting methods.
In summary, firms can voluntarily improve their financial reporting by
increasing their financial disclosures and/or preparing their financial reports in
accordance with a more stringent set of accounting standards, i.e., standards
that restrict a firm’s choice of accounting methods. Strong firms can “signal”
their strength by choosing more stringent standards.
Intangible fixed assets would include the value of Remy’s brand names. Given
the nature of Remy’s business, brand names are critical to Remy’s economic
U.S. GAAP requires the cost of purchased brand names or trademarks to be
capitalized and amortized over their estimated useful lives. Costs related to
internally generated brand names and trademarks must be expensed in the
period incurred. In adjusting Remy’s statements, reasonable estimates of
amortization expense would need to be calculated and deducted from net
income for the current period. Under U.S. GAAP, the cost of brand names
would be amortized over the brand name’s estimated useful life using the
straight-line method. Accumulated amortization, i.e., the sum of the
amortization expense since the brand names were acquired, would be
subtracted from the carrying value of the intangible fixed assets and from
retained earnings. As a consequence, total assets and stockholders’ equity
would be decreased for the accumulated amortization.