Case 9-2 Continental A.G. Write a report of approximately 750 words that addresses the following points: Examine Continental?s financial statements for unusual accounting practices that may have a distorting effect on the company?s reported performance. Recommend adjustments for any disparities you find. Cite international accounting policies and standards in your response. Attached is the full chapter with the Case 9-2 Continental A.G. at the end of the chapter

CHAPTER 9 International Financial Statement Analysis INTRODUCTION Trends in global trade, investment, and external finance, documented in Chapter 1, imply that financial managers, vendors, investors, equity research analysts, bankers, and other financial statement users have a growing need to read and analyze nondomestic financial statements. Cross-border financial comparisons are vital when assessing the financial promise and soundness of a foreign direct or portfolio investment. There has been tremendous growth in international capital issuance and trading in recent years due to privatizations, economic growth, relaxation of capital controls, and continued advances in information technology. The need to use, and therefore understand, nondomestic financial statements has also increased as merger and acquisition activities have become more international. The value of cross-border mergers grew steadily during the 1990s, and this growth shows no signs of abatement. Finally, as business becomes more global, financial statements become more important than ever as a basis for competitive analysis, credit decisions, business negotiations, and corporate control. Continued reduction in national trade barriers, the emergence of Europe as a unified market, convergence of consumer tastes and preferences, and a growing sophistication of business firms in penetrating nondomestic markets have significantly intensified multinational business competition. All this creates a further need for international financial statement analysis and valuation. This chapter synthesizes information presented in Chapters 1 through 8. It examines opportunities and challenges encountered in analyzing foreign financial statements, and provides suggestions for the analyst. CHALLENGES AND OPPORTUNITIES IN CROSS-BORDER ANALYSIS Cross-border financial analysis involves multiple jurisdictions. An analyst, for example, may have occasion to study a company outside her home country or to compare companies from two or more countries. Unique challenges face those doing international analysis. 281 282 Chapter 9 International Financial Statement Analysis Nations vary dramatically in their accounting and auditing practices, disclosure quality, legal and regulatory systems, nature and extent of business risk, and modes of conducting business. This variation means that analytical tools that are effective in one jurisdiction may be less so in another. The analyst often faces daunting challenges in obtaining credible information. In many emerging market economies, financial analyses often have limited reliability. International financial analysis and valuation are characterized by many contradictions. On the one hand, the rapid pace of harmonization of accounting standards is leading to enhanced comparability of financial information worldwide. However, vast differences in financial reporting practices remain. An examination of international financial reporting standards (IFRS's) issued by the IASB to date suggest that definitions of corporate transparency are not necessarily consistent with the notion of transparency that analysts are accustomed to. To wit, IASB/IFRSB pronouncements focus on the extent of discloure as opposed to disclosures that help reveal the economics of underlying transactions. Restatement of prior year financial statements for first-time adopters of IFRS's are limited to one year thereby complicating trend analysis. And, some standards continue to permit reporting options. As one example, in adjusting their accounts for changing prices, reporting entities are allowed the option of accounting for general price level changes or specific price changes. As Chapter 7 illustrates, the information content of both measurement options are very different. Some analysts question the extent to which greater uniformity in accounting standards will actually result in the provision of comparable information by leading companies in an industry.1 As discussed in Chapter 5, companies around the world are disclosing more information voluntarily, and more credible information. At the national level, many countries are striving to improve the availability and quality of information about public companies. Empirical research has validated the benefits of doing so. Specifically, the strength of a country's disclosure system, including discloure requirements, monitoring, and enforcement, is positively associated with market development.2 Moreover, access to freely available information relevant for financial analysis is growing dramatically with dissemination of company information on the Internet. However, in many countries there continues to be a great gulf between expectations based on these advances and reality. Financial analysts are often frustrated in their attempts to gather information. Also, many governments continue to publish highly suspect information. Despite the foregoing contradictions, the environment of international financial analysis and valuation are improving, and the overall outlook for the analyst is positive. Globalization of capital markets, advances in information technology, and increasing competition among national governments, stock exchanges, and companies for investors and trading activity continue. Together these forces are creating incentives for companies to voluntarily improve their external financial reporting practices. 1 For example, see Hope, Ole-Kristan, \"Variations in the Financial Reporting Environment and Earnings Forecasting,\" Journal of International Financial Management and Accounting 15, no. 1 (2004): 22. 2 Carol Ann Frost, Elizabeth A. Gordon, and Andrew F. Hayes, \"Stock Exchange Disclosure and Market Development: An Analysis of 50 International Exchanges,\" Journal of Accounting Research, Vol. 44, no. 3 (2006): 437-483. Chapter 9 International Financial Statement Analysis With the implementation of the euro, together with continued advances in European corporate disclosure practices, distinctions between cross-border and withinborder financial analysis are blurring. Portfolio diversification strategies in Europe are increasingly based on industry sectors rather than countries. Rather than balancing stock picks among strong and weak currency countries, portfolio managers are increasingly focusing on picking the best companies in an industry regardless of country of origin. Globalization also means that strictly domestic analyses are becoming less relevant. Interdependencies are growing and no company is insulated from events happening worldwide. BUSINESS ANALYSIS FRAMEWORK Palepu, Bernard, and Healy provide a useful framework for business analysis and valuation using financial statement data.3 The framework's four stages of analysis (discussed in more detail in the following pages) are: (1) business strategy analysis, (2) accounting analysis, (3) financial analysis (ratio analysis and cash flow analysis), and (4) prospective analysis (forecasting and valuation). The relative importance of each stage depends on the purpose of the analysis. The business analysis framework can be applied to many decision contexts including securities analysis, credit analysis, and merger and acquisition analysis. INTERNATIONAL BUSINESS STRATEGY ANALYSIS Business strategy analysis is an important first step in financial statement analysis. It provides a qualitative understanding of a company and its competitors in relation to its economic environment. This ensures that quantitative analysis is performed using a holistic perspective. By identifying key profit drivers and business risks, business strategy analysis helps the analyst make realistic forecasts.4 Standard procedures for gathering information for business strategy analysis include examining annual reports and other company publications, and speaking with company staff, analysts, and other financial professionals. The use of additional information sources, such as the World Wide Web, trade groups, competitors, customers, reporters, lobbyists, regulators, and the trade press is becoming more common. The accuracy, reliability, and relevance of each type of information gathered also needs to be evaluated.5 Business strategy analysis is often complex and difficult in an international setting. As noted previously, key profit drivers and types of business risk vary among countries. Understanding them can be daunting. Business and legal environments and corporate objectives vary around the world. Many risks (such as regulatory risk, foreign exchange risk, and credit risk, among others) need to be evaluated and brought together coherently. In some countries, sources of information are limited and may not be accurate. 3 Krishna G. Palepu, Victor L. Bernard, and Paul M. Healy, Business Analysis and Valuation Using Financial Statements, Cincinnati, Ohio: South-Western College Publishing, 1996. 4 Profit drivers are principal financial and operating elements that affect a firm's profitability. 5 Financial analysts are increasingly using techniques developed in the fast-growing business discipline of competitive intelligence (CI). 283 284 Chapter 9 International Financial Statement Analysis Information Availability Business strategy analysis is especially difficult in some countries due to lack of reliable information about macroeconomic developments. Governments in developed countries are sometimes accused of publishing faulty or misleading economic statistics. The situation is much worse in many emerging economies. For example, one reason the 1994/95 Mexican currency crisis was a surprise was that the government concealed information about its shrinking foreign reserves and exploding money supply. Some countries delay publishing statistics when the numbers are unfavorable, or even falsify their economic figures. Obtaining industry information is also difficult in many countries and the quantity and quality of company information varies greatly. The availability of company-specific information has been strikingly low in many developing economies.6 Recently, many large companies that list and raise capital in overseas markets have been expanding their disclosures and have voluntarily switched to globally recognized accounting principles such as International Financial Reporting Standards. EXHIBIT 9-1 Country Information Freely Available on the Internet Organization Web Site Address Description Canada Department of Foreign Affairs and International Trade http://www.dfait-maeci. gc.ca/english/menu.htm Market information China's Official Gateway to News and Information CRUISE www.china.org.cn Country information on a variety of fronts. www.cranfield.ac.uk/cils/ Library/subjects/country.htm Country reports including economic and market data. CIA-The World Factbook www.cia.gov/cia/publications/ Factbook/geos/fm.html Information on government, economy, communications, and transnational issues. Financial Times http://ft.com Political and Economic Risk Consultancy, Ltd. (PERC) UNCTAD http://www.asiarisk.com/ www.unctad.org U.S. Federal Reserve U.S. State Department World Bank World Tourism Organization www.federalreserve.gov http://travel.state.gov/ www.dev.data.worldbank.org http://www.world-tourism.org Country reports (also industry reports, company news, and financial information) Country outlooks; connection to other WWW sites Data for analysis of international trade, foreign direct investment commodities and development Foreign exchange rates Travel warnings Country development data Newsletters, press releases 6 See Chapter 5 for further discussion. Also see S. M. Saudagaran, and J. G. Diga, \"Financial Reporting in Emerging Capital Markets: Characteristics and Policy Issues,\" Accounting Horizons (June 1997): 41-64. Chapter 9 International Financial Statement Analysis Recommendations for Analysis Data constraints make it difficult to perform business strategy analyses using traditional research methods. Very often, travel is necessary to learn about local business climates and how industries and companies actually operate, especially in emerging market countries. The World Wide Web also offers quick access to information that recently was unavailable or difficult to obtain. Exhibit 9-1 presents a sampling of freely available Web resources that can be used to learn about country risks and travel conditions. Country information can also be found in \"international briefings\" publications distributed by large accounting firms, banks, and brokerages.7 The International Federation of Stock Exchanges (FIBV, http:/ /www.fibv.com) and the Federation of European Stock Exchanges (FESE, http:/ /www.fese.be) publish highly informative international newsletters and Accountancy, the Economist, Financial Analysts Journal, Euromoney articles highly relevant for international financial analysis. Enormous risks may follow an inadequate business strategy analysis. Consider the Parmalat affair, representing the largest fraud in European financial history. In this case, at least $13 billion in missing assets of Italy's fastest growing dairy group could not be accounted for, resulting in huge losses for the company's investors and creditors alike. Commentators attribute this financial debacle to several causes. Foreign investors reportedly invested in a company that did not provide complete or credible disclosures. They did not know much about the business environment in which they were investing and participated in a market in which financial reporting rules were not strictly enforced.8 ACCOUNTING ANALYSIS The purpose of accounting analysis is to assess the extent to which a firm's reported results reflect economic reality. The analyst needs to evaluate the firm's accounting policies and estimates, and assess the nature and extent of a firm's accounting flexibility. The latter refers to management's discretion in choosing which accounting policies and estimates to apply to a particular accounting event. To reach reliable conclusions, the analyst must adjust reported accounting amounts to remove distortions caused by the use of accounting methods the analyst deems inappropriate. Examples might include marking trading assets to market and not recording the gains or losses in income but in an allowance account, prematurely recognizing revenues, or reversing estimated liability accruals to smooth earnings. Corporate managers are allowed to make many accounting-related judgments because they know the most about their firm's operations and financial condition. Flexibility in financial reporting is important because it allows managers to use accounting measurements that best reflect the company's particular operating circumstances. 7 For example, PricewaterhouseCoopers LLC publishes International Briefings every month, which reports on notable business, political, and economic developments worldwide. 8 Gail Edmondson, David Fairlamb, and Nanette Byrnes, \"The Milk Just Keeps on Spilling,\" BusinessWeek (January 26, 2004): 54, 55, 58. 285 286 Chapter 9 International Financial Statement Analysis However, managers have incentives to distort operating reality by using their accounting discretion to distort reported profits. One reason is that reported earnings are often used to evaluate their managerial performance.9 Healy and colleagues suggest the following process for evaluating a firm's accounting quality: Identify key accounting policies Assess accounting flexibility Evaluate accounting strategy Evaluate the quality of disclosure Identify potential red flags (e.g., unusually large asset write-offs, unexplained transactions that boost profits, or an increasing gap between a company's reported income and its cash flow from operations) 6. Adjust for accounting distortions 1. 2. 3. 4. 5. To illustrate this process, consider the accounting quality of WorldCom, a large U.S. company whose accounting policies resulted in a major Wall Street scandal. In formally indicting the company on its faulty accounting practices, the following questions might be asked: (1) How did WorldCom account for its major operating expenditures? (2) What options does U.S. GAAP allow for such expenditures? (3) Did WorldCom adopt an overly aggressive or conservative approach to accounting for these expenditures? (4) Did WorldCom capitalize an expenditure that should have been expensed to manage its earnings? (5) Did WorldCom disclose sufficient information for investors to undo the company's aggressive accounting treatment? (6) Would reversal of WorldCom's selected accounting posture have a significant depressing effect on reported earnings? In this case, WorldCom chose to capitalize what were in effect operating expenses. While this practice is in clear violation of U.S. GAAP, management chose to conceal this information from investors by disguising operating expenses as capital expenditures. The financial statement effects of capitalizing versus expensing its major expenditures had a significant effect on reported earnings as the amounts involved approached $2 billion! Two major issues confront those doing accounting analysis in an international setting. The first is cross-country variation in accounting measurement quality, disclosure quality, and audit quality; the second concerns the difficulty in obtaining information needed to conduct accounting analysis. Cross-country variation in quality of accounting measurement, disclosure, and auditing is dramatic. National characteristics that cause this variation include required and generally accepted practices, monitoring and enforcement, and extent of managerial discretion in financial reporting.10 Chapters 3 and 4 of this text present summaries of significant accounting practices in five European countries and five countries of the 9 Additional influences on corporate managers' accounting decisions include: (1) accounting-based debt covenants; (2) management compensation; (3) corporate control contests; (4) tax considerations; (5) regulatory considerations; (6) capital market considerations; (7) stakeholder considerations; and (8) competitive considerations. Palepu, Bernard, and Healy, op. cit. 10 While faulty application of accounting principles is frequently touted as the leading cause of low accounting quality, some argue that the application of faulty accounting principles is the root cause. See Paul Rosenfield, \"What Drives Earnings Management?\" Journal of Accountancy [October 2000]: 5. Chapter 9 International Financial Statement Analysis Americas and Asia, respectively. These chapters, which summarize only a subset of major accounting topics, show that significant managerial discretion may be used in many countries, including France, Germany, and China. Consider accounting practices in Germany. As discussed in Chapter 3, German financial accounting is closely aligned with tax reporting. Creditor protection is a second goal of financial reporting. As a result, financial reports are prepared with a creditor focus rather than an investor focus. The resulting conservative reporting bias may generate accounting amounts that do not reflect actual operating performance. German managers have great discretion in their use of reserves and in implementing many accounting policies. Even where specific procedures are mandated, monitoring and enforcement of compliance with reporting requirements is far short of what investors can expect in the United States. Disclosure quality and the level of audit assurances must also be closely scrutinized when analyzing the financial statements of a German company. Footnote disclosure of accounting policies is quite limited in some German annual reports. Identifying the components of large financial statement items (such as reserve accounts) can be difficult. Auditing issues are so important that we discuss international auditing in a separate section of this chapter. Financial reporting in China provides a second example of how accounting measurement, disclosure, and audit quality can vary dramatically from accounting practices in Anglo-American countries. Although China is implementing major accounting reform as part of its transition from a planned economy to a controlled market economy, until recently it did not have financial reporting and external auditing in forms that would be familiar to Westerners.11 Private investors and creditors were virtually nonexistent for three decades after the People's Republic was founded in 1948, and The Accounting Law, which sets forth accounting and reporting requirements, was adopted only in 1985. Accounting Standards for Business Enterprises, which specifies that such basic accounting practices as double-entry bookkeeping and the accrual basis should be used, became effective in 1993. The auditing profession is also very new in China. Suggestions for the Analyst Especially when analyzing companies in emerging market countries, the analyst should meet often with management to evaluate their financial reporting incentives and accounting policies. Many companies in emerging market countries are closely held, and managers may not have strong incentives for full and credible disclosure. Accounting policies in some countries may be similar or identical to IAS (or other widely accepted standards), but managers often have great discretion in how those policies are applied. Finally, as noted earlier, new communications technology (including the World Wide Web) is having a great impact on all stages of financial research. Many companies and countries now have Web sites that make it much easier for anyone interested to gather information. Refer to the section entitled \"Information Access\" later in this chapter for a discussion of useful information sources for accounting analysis. 11 For further discussion, see Chapter 4; Ajay Adhikari and Shawn Z.Wang, \"Accounting for China,\" Management Accounting (April 1995): 27-32. 287 288 Chapter 9 International Financial Statement Analysis INTERNATIONAL FINANCIAL ANALYSIS The goal of financial analysis is to evaluate a firm's current and past performance, and to judge whether its performance can be sustained. Ratio analysis and cash flow analysis are important tools in financial analysis. Ratio analysis involves comparison of ratios between the firm and other firms in the same industry, comparison of a firm's ratios across years or other fiscal periods, and/or comparison of ratios to some absolute benchmark. It provides insights into the comparative and relative significance of financial statement items and can help evaluate the effectiveness of managements' operating, investing, financing, and earnings retention policies. A summary of commonly used financial ratios appears in Exhibit 9-2. Cash flow analysis focuses on the cash flow statement, which provides information about a firm's cash inflows and outflows, classified among operating, investing, and financing activities, and disclosures about periodic noncash investing and financing activities. Analysts can use cash flow analysis to address many questions about the firm's performance and management. For example, has the firm generated positive cash flows from operations? How have cash flow components changed across time in relation to changes in income statement components, sales, and cost of sales in particular? What have been the cash flow consequences of management decisions about financial policy, dividend policy, and investment? When used in conjunction with the income statement, cash flow information also informs analysts about the validity of the going concern assumption, a firm's liquidity, and management's use of measurement options to manage earnings. Ratio Analysis Two issues must be addressed in analyzing ratios in an international setting. First, do cross-country differences in accounting principles cause significant variation in financial statement amounts of companies from different countries? Second, how do differences in local culture and economic and competitive conditions affect the interpretation of accounting measures and financial ratios, even if accounting measurements from different countries are restated to achieve \"accounting comparability\"? Extensive evidence reveals substantial cross-country differences in profitability, leverage, and other financial statement ratios and amounts that result from both accounting and nonaccounting factors. (The next section discusses cross-country differences in two valuation ratios, the price-to-earnings and price-to-book ratios.) In one study, sales revenue, net income, and leverage (total debt/shareholders' equity) were compared among firms domiciled in France, Germany, Japan, the United Kingdom, and the United States.12 The five 80-firm country samples were matched according to size (market value of equity), with all firms belonging to the manufacturing industry group (SIC codes 20 through 39). All three financial measures varied substantially among the country samples. For example, median net income was 12 Carol A. Frost, \"Characteristics and Information Value of Corporate Disclosures of Forward-Looking Information in Global Equity Markets,\" Dartmouth College Working Paper, July 2002. Chapter 9 International Financial Statement Analysis EXHIBIT 9-2 Summary of Financial Ratios Ratio Formula for Computation I. Liquidity 1. Current ratio Current assets Current liabilities 2. Quick or acid-test ratio Cash, marketable securities, and receivables Current liabilities 3. Current cash debt ratio Net cash provided by operating activities Average current liabilities II. Efficiency 4. Receivables turnover Net sales Average trade receivables (net) 5. Inventory turnover Cost of goods sold Average inventory 6. Asset turnover Net sales Average total assets III. Profitability 7. Profit margin on sales Net income Net sales 8. Rate of return on assets EBIT1 Average total assets 9. Rate of return on common stock equity Net income minus preferred dividends Average common stockholders' equity 10. Earnings per share Net income minus preferred dividends Weighted common shares outstanding 11. Payout ratio Cash dividents Net income IV. Coverage 12. Debt to total assets ratio Debt Total assets or equities 13. Times interest earned Income before interest charges and taxes Interest charges 14. Cash debt coverage ratio Net cash provided by operating activities Average total liabilities 15. Book value per share Common stockholders' equity Outstanding common shares 1 EBIT = earnings before interest and taxes. Some analysts prefer to use EBITDA, which also includes depreciation and amortization charges in the numerator. 289 290 Chapter 9 International Financial Statement Analysis much greater in the United Kingdom and the United States than in Germany and Japan. Variation in net income was partially explained by accounting principle differences because financial reporting is generally less conservative in the United Kingdom and the United States than in Germany and Japan. Nonaccounting factors also affected reported net income. For example, the creditor focus in France, Germany, and Japan accounted for lower net income than in the United States and the United Kingdom as there is less pressure on managers in those countries to report steadily increasing net income. In the foregoing study, Frost found median leverage in the United Kingdom and the United States to be lower than in Germany and Japan. This is partially attributed to the fact that conservative accounting in Germany and Japan results in lower reported shareholders' equity than in the United Kingdom and the United States. Higher leverage in Germany, Japan, and France is also attributed to higher debt in capital structures, reflecting the heavy dependence on bank financing in those countries. How large are the differences in financial statement items caused by differences among national accounting principles? Although no longer required,13 hundreds of non-U.S. companies listed on U.S. stock exchanges provided footnote reconciliation disclosures that provide evidence on this question, at least in the context of differences between U.S. GAAP-based and non-U.S. GAAP-based accounting amounts. An earlier survey of financial statement reconciliations by foreign registrants prepared by the U.S. SEC is informative.14 Approximately one-half of the 528 non-U.S. registrants surveyed disclosed material differences between net income as reported in their financial statements and U.S. GAAP-based net income. The five types of financial statement differences disclosed by the largest number of registrants were (in descending order): (1) depreciation and amortization, (2) deferred or capitalized costs, (3) deferred taxes, (4) pensions, and (5) foreign currency translation. The study also shows that more than two-thirds of the registrants that disclosed material differences in net income reported that income under U.S. GAAP was lower than under non-U.S. GAAP. Nearly half of them reported income differences greater than 25 percent. Twenty-five of the 87 registrants that reported that income under U.S. GAAP was greater than under non-U.S. GAAP reported differences greater than 25 percent. Similar results were found for reconciliations of shareholders' equity. Overall, the evidence in the SEC study shows that financial statement differences under U.S. versus non-U.S. GAAP are highly material for many companies. Evidence from SEC registrants' reconciliation disclosures therefore indicates that GAAP differences can cause significant variation in financial statement numbers. Even as the world marches toward adoption of IFRS issued by the IASB, measurement options permitted by IFRS, differences in national enforcement policies and differences in flavors of IFRS (see Chapter 8), suggest that measurement and disclosure differences will not disappear. Accordingly, an analyst will often choose to make financial statements more comparable by making accounting principle adjustments to the financial statements being analyzed. Appendix 9-1 illustrates the restatement of an income and balance sheet 13 The U.S. Securities and Exchange Commission relaxed its U.S. GAAP reconciliation requirements for nonU.S. registrants in 2007. 14 U.S. Securities and Exchange Commission, Division of Corporation Finance, Survey of Financial Statement Reconciliations by Foreign Registrants, May 1, 1993. Chapter 9 International Financial Statement Analysis from Japanese GAAP to U.S. GAAP. Even after financial statement amounts are made reasonably comparable (by adjusting for accounting principle differences), interpretation of those amounts must consider cross-country differences in economic, competitive, and other institutional differences. Analysis of Japanese companies provides a good illustration. Brown and Stickney argue that the relation between financial and tax reporting, the importance in Japan of operating through corporate groups (keiretsu), and the tolerance in Japan for heavy use of short-term financial leverage must all be considered when analyzing the profitability and risk of Japanese companies.15 For example, Japanese-reported earnings tend to be lower than earnings reported in Anglo-American countries, even after adjusting for GAAP differences. The close linkage between tax and financial reporting gives Japanese companies an incentive to be conservative in determining their income. Also, because high intercorporate stock holdings reduce the percentage of shares held by outsiders, Japanese companies are under less pressure to report ever-increasing earnings than are companies in the United States and other Anglo-American countries.16 Refer to Appendix 9-2 for further detailed discussion of international ratio analysis. The appendix focuses on comparison of Japanese and U.S. financial ratios and their interpretation. Cash Flow Analysis As discussed earlier, cash flow analysis provides insights into a company's cash flows and management. Highly detailed cash flow statements are required under U.S. GAAP, U.K. GAAP, IFRS, and accounting standards in a growing number of other countries. Cash flow-related measures are especially useful in international analysis because they are less affected by accounting principle differences than are earnings-based measures. When cash flow statements are not presented, it is often difficult to compute cash flows from operations and other cash flow measures by adjusting accrual-based earnings. Many companies simply do not disclose the information needed to make the adjustments. As one example, German balance sheets often contain surprisingly large reserve accounts that reflect many different types of accrual. Few (if any) details are presented that might allow the financial statement user to assess the implications for operating, investment, and financing cash flows. Coping Mechanisms How do financial statement users cope with cross-country accounting principle differences? Several approaches are used. Some analysts restate foreign accounting measures to an internationally recognized set of principles, or to some other common basis. Others develop a detailed understanding of accounting practices in a limited set of countries and restrict their analysis to firms located in those countries. 15 Paul R. Brown and Clyde P. Stickney, \"Instructional Case: Tanaguchi Corporation,\" Issues in Accounting Education 7 (Spring 1992): 57-68. 16 Jill L. McKinnon, \"Application of Anglo-American Principles of Consolidation to Corporate Financial Disclosure in Japan,\" ABACUS 20 (1984): 16-33 provides further detail on corporate groups in Japan versus those in Anglo-American countries. She argues that the Anglo-American consolidation methods adopted by Japan in 1977 may reflect international pressure for accounting conformity more than the inherent desirability of those methods. She implies that as a result, Japanese consolidated financial statements are less useful than they might be. The McKinnon study provides an important illustration that knowing what accounting principles are used is only the first step in interpreting financial statements from different countries. 291 292 Chapter 9 International Financial Statement Analysis Brown, Soybel, and Stickney illustrate the use of a restatement algorithm to enhance cross-border comparisons of financial performance.17 They restate the operating performance of U.S. and Japanese companies to a similar reporting basis. Rather than convert U.S. data to a Japanese financial reporting basis, or Japanese data to a U.S. financial reporting basis, they adjust (as necessary) both U.S. and Japanese data to achieve uniform accounting principles. Appendix 9-1 illustrates another approach, in which the financial statements of a hypothetical Japanese business (Toyoza Enterprises) are restated from a Japanese GAAP basis to a U.S. GAAP basis. The restatement algorithm used in Appendix 9-1 involves a detailed analysis of numerous financial statement items. Relatively simple restatement algorithms can be effective. One approach is to focus on a few of the most material financial statement differences for which enough information is available to make reliable adjustments. For example, Brown and colleagues, mentioned above, summarize many differences between Japan and U.S. GAAP, but their restatement algorithm focuses on only four accounting principle differences: (1) inventory cost assumptions, (2) depreciation method, (3) bonuses to directors and statutory auditors, and (4) deferred taxes and special tax reserves. INTERNATIONAL PROSPECTIVE ANALYSIS Prospective analysis involves two steps: forecasting and valuation. In forecasting, analysts make explicit forecasts of a firm's prospects based on its business strategy, accounting, and financial analysis. It addresses questions such as, How will a company's change in business strategy affect future sales volume and profits? Has the company recently adopted new accounting policies that will make current earnings appear stronger, perhaps at the cost of lower earnings next year? Will financial relationships evidenced in an analyst's ratio analysis continue? In valuation, analysts convert quantitative forecasts into an estimate of a firm's value. Valuation is used implicitly or explicitly in many business decisions. For example, valuation is the basis of equity analysts' investment recommendations. In analyzing a possible merger, the potential acquirer will estimate the value of the target firm. Many different valuation approaches are used in practice, ranging from discounted cash flow analysis to simpler techniques based on price-based multiples.18 Experts in international valuation give this warning to those doing international prospective analysis: \"Any rules you've learned in your home country will fall apart overseas.\" Exchange rate fluctuations, accounting differences, different business practices and customs, capital market differences, and many other factors will have major effects on international forecasting and valuation. For example, discounted cash flow analysis values a business as the present value of its expected cash flows, discounted at a rate that reflects the riskiness of those cash flows. While this valuation principle is no different for developed and 17 See Paul R. Brown, Virginia E. Soybel, and Clyde P. Stickney, \"Achieving Comparability of U.S. and Japanese Price-Earnings Ratios,\" in Frederick D. S., Choi, ed., International Accounting and Finance Handbook, 2nd ed., New York: John Wiley & Sons, 1997, pp. 7.1-7.18. 18 See Aswath Damodaran, Investment Valuation, 2nd ed., New York: John Wiley & Sons, 2000. Chapter 9 International Financial Statement Analysis emerging markets alike, many of the inputs taken for granted in the former may not be as accessible in emerging economies.19 For example, the government bond rate, often used as a surrogate for the risk-free rate, assumes that governments do not default, at least on local borrowing. This is often not the case internationally. Other inputs including risk parameters and premiums are typically more difficult to estimate owing to the paucity of historical data. And earnings forecasts, as a basis for estimating future cash flows, are less reliable. Hope attributes this to several factors.20 One factor is the greater choice that managers have in choosing among accounting methods. Greater choice makes it more difficult to do cross-section analyses and makes it easier for managers to distort economic reality in reporting firm performance. Forecast accuracy is also positively related to the extent to which accrual accounting is prescribed in a country. Accruals provide a better measure of a firm's future cash generating ability than cash receipts and disbursements and irons out discontinuities in reported revenues and expenses. Finally, the accuracy of analysts' earnings forecasts are positively related to the strength of a country's enforcement standards. This is attributed to the notion that enforcement narrows the range of permitted accounting choices. This, in turn, reduces analysts' uncertainty about the degree of firms' reporting discretion.21 Consider next the use of price-based (valuation) multiples in an international setting. Valuation multiples such as price-to-earnings (P /E) and price-to-book (P/B) ratios are often used to estimate a firm's value. One common approach is to calculate the desired multiple for a group of comparable firms (such as other firms in the same industry), and then apply that multiple to the firm being valued to get a reasonable price. For example, if the price-to-earnings ratio of the industry group is 15, and the firm's earnings are forecast to be $1.80/share, then $27.00 per share is a reasonable price for the firm being analyzed. One might use the valuation multiples approach to determine the bid price for an acquisition candidate. If the candidate is a European company, comparable firms might be chosen from selected European countries. Reliance on valuation multiples assumes that market prices reflect future prospects and that pricing of firms with similar operating and financial characteristics (such as firms in the same industry) is applicable to the firm being analyzed because of its similarity to those firms. Application of price multiples in a cross-border setting is challenging because it requires that the determinants of each multiple, and reasons why multiples vary across firms, be thoroughly understood. Exhibit 9-3 displays mean price to earnings ratios for stock indexes in 17 countries at the end of 2007. Exhibit 9-3 shows that P/E ratios vary across countries. At the end of 2007 P/E multiples ranged from 9.5 in South Africa to 41.2 for firms listed on the stock exchange in China. But what accounts for these variations across national boundaries? National differences in accounting principles are one potential source of crosscountry ratio variations. Such differences, for example, cause P/E ratios in Japan to be generally higher than those in the United States (recall that reported earnings in Japan 19 Aswath Damodaran, \"Valuation in Emerging Markets,\" in Frederick D. S. Choi, ed., International Finance and Accounting Handbook, 3rd ed., New York: John Wiley & Sons, 2003, p. 9.3. 20 Hope, op. cit., pp. 21-39. 21 Hope, op. cit., p. 23. 293 294 Chapter 9 International Financial Statement Analysis EXHIBIT 9-3 International Price/Earnings Ratios Country Index Canada China (PRC) France Hong Kong India Italy Japan Mexico Netherlands Russia Singapore South Africa Spain Sweden Switzerland UK US SPTSX SHCOMP CAC HIS SENSEX MIB30 NKY MEXBOL AEX RTSI$ STI TOP40 IBEX OMX SMI UKX SPX P/E 17.8 41.2 16.8 15.74 22.97 15.3 37.7 19.1 11.9 11.1 14.4 9.5 14.8 14.9 15.5 13.6 17.7 Source: \"Global P/E Ratios, Ticker Sense Blogger,\" Birinyi Associates, Inc., July 20-24, 2009. are lower than in the United States for comparable companies with similar financial performance). However, even after adjusting for accounting differences, P/E ratios in Japan are still much higher than in the United States. French and Poterba examined disparities between Japanese and U.S. P/E ratios and the steep increase in Japanese P/E ratios during the late 1980s.22 They made several accounting adjustments to the Japanese data and found that their adjustments reduced but did not eliminate the difference between Japanese and U.S. P/E ratios. French and Poterba concluded that accounting differences explain about half of the long-term differences between U.S. and Japanese P/E ratios. Brown, Soybel, and Stickney also investigated why Japanese P/E ratios are higher than U.S. P/E ratios.23 They found that adjusting for different accounting principles explains only a small part of the difference. A comparison of their study with French and Poterba's shows how different approaches and assumptions can lead to very different conclusions about valuation ratios. The substantial variation in valuation ratios shown in Exhibit 9-3 reflects changes in financial performance and in market prices across time and countries. As discussed 22 Kenneth R., French and James M. Poterba, \"Were Japanese Stock Prices Too High?\" Journal of Financial Economics 29 (1991): 337-362. 23 See Paul R. Brown, Virginia E., Soybel, and Clyde P. Stickney, \"Achieving Comparability of U.S. and Japanese Price-Earnings Ratios,\" op. cit., for a review of comparative analyses of Japanese and U.S. P/E ratios. For further comparative evidence on cross-country differences in P/E and P/B ratios, see Peter Joos and Mark Lang, \"The Effects of Accounting Diversity: Evidence from the European Union,\" Journal of Accounting Research 32 (Suppl., 1994): 141-175. Chapter 9 International Financial Statement Analysis previously, even French and Poterba's rigorous analysis of the changes in P/E ratios in Japan during the late 1980s yielded only partial answers. Thus, accounting offers only a partial explanation for differences among P/E ratios in different countries and over time. An understanding of additional environmental considerations (see Appendix 9-2) is necessary for meaningful analysis and interpretation. FURTHER ISSUES All four stages of business analysis (business strategy, accounting, financial, and prospective analysis) may be affected by the following factors: (1) information access, (2) timeliness of information, (3) language and terminology barriers, (4) foreign currency issues, and (5) differences in types and formats of financial statements. Information Access Information about thousands of companies from around the world has become more widely available in recent years. Countless information sources are appearing on the World Wide Web. Companies around the world now have Web sites, and their annual reports are available free of charge from various Internet and other sources. Refer to Exhibit 9-4 for Web sites that provide information highly relevant for company research. Many companies also respond to written and telephone requests for their annual reports and other financial documents. However, the amount of company information available varies considerably from country to country. Many commercial databases provide access to financial and stock market data for tens of thousands of companies around the world. Companies covered by commercial databases tend to be large companies that are of most interest to financial statement users and investors. It is striking that even in emerging market countries such as China and the Czech Republic, data for many firms are now available. Other valuable information sources include (1) government publications, (2) economic research organizations, (3) international organizations such as the United Nations, and (4) accounting, auditing, and securities market organizations. Web site addresses appear throughout this text and are only a starting point for gathering information. The timeliness of financial statements, annual reports, regulatory filings, and accounting-related press releases varies dramatically by country. Whereas quarterly financial reporting is a generally accepted practice in the United States, this is not always the case elsewhere.24 Financial reporting lags can also be estimated by comparing a company's fiscal year-end with its audit report date. The latter is often considered a reasonable indication of when corporate financial information first becomes publicly available. For Brazil, Canada, Chile, Colombia, Mexico, the Philippines, South Korea, Taiwan, Thailand, and the United States, this reporting lag reportedly averaged between 30-60 days. It averaged 61-90 days in Argentina, Australia, Denmark, Finland, Ireland, Israel, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, South Africa, Spain, Sweden, Switzerland, the United TIMELINESS OF INFORMATION 24 An informal survey of many world-class company Web sites suggests that more and more companies are voluntarily choosing to provide quarterly reports owing to capital market pressures to do so. 295 296 Chapter 9 International Financial Statement Analysis EXHIBIT 9-4 Freely Available Web Sites for Company Research (all Web sites begin with the prefix http://www) Name of Web Site Web Site Address What It Provides Annual Reports Library zpub.com/sf/arl/ Asian Business Watch asianbusinesswatch. com babel.altavista.com Alphabetical listing of U.S. corporations with links to home pages and annual reports that can be downloaded free of charge with Adobe Acrobat Reader. Company and stock market news for Japan and Asia. Translates text files; only does first few pages of long documents. United Kingdom monetary and financial statistics, working papers, and other publications, information on the bank's structure and functions, and much more. South African company and stock market information; check out \"Little Facts.\" Babel Bank of England bank of england.co.uk/ BFA-NET: Bureau of Financial Analysis Network bfanet.com Bloomberg News Service bloomberg.com/ Businessjeeves.com Business Week Online businessjeeves.com businessweek.com CAROL: Company Annual Reports Online Cross Border Capital carolworld.com Daiwa Securities EdgarU.S. Securities & Exchange Commission Emerging Markets Companion EnterWeb: The Enterprise Development Web site EuropagesEuropean Business Directory Financial Times of London liquidity.com/ dir.co.jp/Reception/ research.html sec.gov/edgar.shtml emgmkts.com/ enterweb.org/ welcome.htm europages.com/ ft.com/ Highlights from the Bloomberg news service. Good starting place; many links. Current issue, archives, and an assortment of worthwhile data. Online annual reports for some European companies. Reports on equity, fixed income, and currency markets in over 70 developed and emerging markets. Reports over six months old available for free (with registration). Research reports and forecasts on the Japanese economy. Most SEC filings since 1996. Many useful links and resources on Asia, Latin America, Africa, and Europe. Meta-index to business and finance globalization, and more. \"The focus is on micro, small, and medium-sized enterprise development both in developed and developing countries.\" Lists 500,000 companies in 30 countries; includes some manufacturers' catalogs. Online edition of the Financial Times; current articles, market information, and more. (continued) Chapter 9 International Financial Statement Analysis EXHIBIT 9-4 Freely Available Web Sites for Company Research (all Web sites begin with the prefix http://www) (Continued) Name of Web Site Web Site Address What It Provides FT Interactive Data turboguide.com/ data2/cdprod1/ doc/cdrom frame/ 002/686.pub.FT. Excel.html hksfc.org.hk Good sampling from FT Excel databases; must register. Hong Kong Securities and Futures Commission Hoover's Online INO Global Market ino.com/ International Business (Michigan State University Center for International Business Education and Research) International Monetary Fund Internet Corruption Rankings ciber.bus.msu.edu/ busres.htm Information on Hong Kong securities markets. Some information, such as press releases, is free. Links to company home pages and other information. Includes more than 800 of the most important non-U.S. companies. Information for traders in futures and options markets worldwide. Links to good investment and macro sites. imf.org/ IMF news, publications, and more. gwdg.de/~uwvw/ icr_serv.htm National Corporate Services, Inc. International Investing NIRI Useful Investor Relations Sites Public Register's Annual Report, The companies. Rutgers Accounting Network (RAW) natcorp.com/ Provides the TI-Corruption Perception Index, a comparative assessment of the integrity of many countries, along with many other links and services. Excellent start point; many links to sites providing free information. Links to interesting Web sites. Stewart Mayhew's Directory of Worldwide Securities Exchanges Stock City hoovers.com niri.org prars.com rutgers.edu/ Accounting/ raw.html voltaire.is.tcu.edu/ ~vmihov/ exchanges/xlinks. Htm stockcity.com Annual reports, prospectuses, or 10-Ks on over 32,000 U.S. companies. Excellent starting place. Links to official home pages of stock markets and derivatives exchanges around the world. ADR profiles, organized by sector, region, and country. Profiles require Adobe Acrobat Reader. (continued) 297 298 Chapter 9 International Financial Statement Analysis EXHIBIT 9-4 Freely Available Web Sites for Company Research (all Web sites begin with the prefix http://www) (Continued) Name of Web Site Web Site Address What It Provides Streetlink Investor Information Center United Nations System streetlink.com Financial reports available online; U.S. companies only. Spotty coverage of companies and Accounting information; good information on communications and country background. Comprehensive assortment of news and data. Great for linking to regional sites; excellent starting place, especially good for macro data. Can search alphabetically by country or by industry. Extensive data, news, and stock quotes. USA Today Money unsystem.org VIBES: Virtual International Business and Economic Sources Wright Investor' Service usatoday.com/ money/ mfront.htm uncc.edu/lis/library/ reference/intbus/ vibehome.htm wisi.com Yahoo! Finance finance.yahoo.com Kingdom, and Zimbabwe. In Austria, Belgium, France, Germany, Greece, Hong Kong, India, Italy, Malaysia, Nigeria, and Sri Lanka, information lags averaged 91-120 days. And for Pakistan, the average lag exceeded 120 days.25 Frost documents further international variations in the timeliness of earningsrelated press releases.26 She defined disclosure lags as the average number of days between a company's fiscal year-end and the date of the press release. These lags were 73 days for companies domiciled in France, 82 days for Germany, 46 days for Japan, 72 days for the United Kingdom, and 26 days for the United States. Variability in the timeliness of accounting information places additional burdens on readers of foreign financial statements. This burden is especially pronounced for firms whose operating circumstances are changing over time. Meaningful valuations require constant updates of reported numbers using both conventional and unconventional means. Foreign Currency Considerations Accounts denominated in foreign currency present financial analysts with two types of problems. The first relates to reader convenience, the second to information content. The vast majority of companies around the world denominate their financial accounts in the currency of their national domicile. To a U.S. reader accustomed to 25 See International Accounting and Auditing Trends, 4th ed., Center for International Financial Analysis & Research, Princeton, NJ: CIFAR Publications, Inc., 1995. 26 Carol A. Frost, \"Characteristics and Information Value of Corporate Disclosures of Forward-Looking Information in Global Equity Markets,\" Dartmouth College Working Paper, February 1998. Chapter 9 International Financial Statement Analysis dealing in dollars, analysis of accounts expressed in euros may be discomforting. A normal inclination is to translate foreign currency balances to domestic currency. However, foreign currency reports are, for the most part, troublesome in appearance only. Financial ratios that transform nominal (interval) measurements to percentage relationships are independent of currency. A current ratio computed from a Dutch balance sheet expressed in euros is the same as one computed from the same financial statement translated into dollars. Consider the following year-end balance sheet accounts of a British company. 2009 Current assets Current liabilities 2010 2011 12,500 12,200 12,800 8,333 7,625 8,000 Assuming year-end dollar/pound exchanges rates of $1.70, $1.80, and $1.60 for 2009, 2010, and 2011, respectively, the current ratio will be 1.5 to 1 for 2009, 1.6 to 1 for 2010, and 1.6 to 1 for 2011, whether expressed in British pounds or U.S. dollars. Local currency (e.g., pound) balances are especially appropriate when analyzing financial trends. Readers who prefer a domestic currency framework when analyzing foreign currency accounts may apply a convenience translation using year-end exchange rates. One must be careful, however, when analyzing translated trend data. Use of convenience rates to translate foreign currency accounts can distort underlying financial patterns in local currency. To illustrate, assume the following three-year sales revenue patterns for our British concern. 2009 Sales revenue 2010 2011 23,500 28,650 33,160 Convenience translations using the year-end exchange rates employed earlier (i.e., $1.70 for 2009, $1.80 for 2010, and $1.60 for 2011 ) yield a U.S. dollar sales increase of 7.5 percent [($53,056-$39,950)/$39,950] over the three-year period. The sales gain in pounds, however, is 41 percent [(33,160-23,500)/23,500]. An alternative approach is to translate foreign currency data to domestic currency using a single base year's exchange rate. But which base-year exchange rate should be used? In our example, should the sales figures be translated using the 2009 exchange rate, the 2010 exchange rate, or the 2011 exchange rate? Although we prefer to analyze foreign statements in local currency, we favor the use of the most recent year's exchange rate as a convenience translator for readers who prefer domestic currency statistics. An exception is warranted, however, if the foreign currency financial statements have been adjusted for changes in the general purchasing power of the foreign currency unit (see Chapter 7 for a discussion of this treatment). If foreign currency balances are expressed in base-year purchasing power equivalents, year-end exchange rates associated with the given base year should be employed. In our example, if sales revenues were expressed in pounds of 2009 general purchasing power, the 2009 exchange rate would have been an appropriate translation rate. 299 300 Chapter 9 International Financial Statement Analysis While translated statements give readers the convenience of viewing foreign currency accounts in a familiar currency, they may give a distorted picture. Specifically, exchange rate changes and accounting procedures together often produce domestic currency equivalents that conflict with underlying events. We illustrate this problem using the statement of cash flows as an example. Recall from Chapter 6 that consolidated financial statements allow a multinational company to report the results of its worldwide operations in a single currency. Also recall that a variety of currency translation methods are in use internationally. Regardless of the currency translation method employed, it is not always clear to readers of consolidated funds flow statements, whether reported fund sources or uses reflect the results of an operational decision or simply an exchange rate change. To illustrate, the translated statements of earnings, financial position, and cash flows for the Norwegian affiliate of a U.S.-based multinational company appear in Exhibit 9-5. The parent company employs the current rate method and defines the krone as its functional currency for consolidation purposes. Assume that capital stock is translated at the historical rate. A cursory examination of the translated statement of cash flows shows that major sources of cash were operations (net income plus depreciation), the issuance of longterm debt, and a translation adjustment. In turn, cash was used to increase the company's investment in fixed assets. The pattern of cash flow shown in Exhibit 9-5 differs from that experienced by a purely domestic company due to the presence of an aggregate translation adjustment. However, examination of this component of the translated funds statement reveals that it does not really constitute a source or use of cash. The translation adjustment is calculated by multiplying the beginning foreign currency net asset balance by the change in the current rate during the period and, second, by multiplying the increase or decrease in net assets during the period by the difference between the average exchange rate and end-of-period exchange rate. This procedure, together with the dual nature of the accounting equation, suggests that most components of the translated funds statement are a mix of translation effects and actual cash flows. In our current example, a statement reader needs to figure out whether the increase of long-term debt in the amount of $1,584,000 is an indication of the Norwegian affiliate's financing activities or is largely an accounting adjustment. Similar considerations apply to the purported $2,695,000 investment in fixed assets. Assume that the translated statements appearing in Exhibit 9-5 are based on the Norwegian krone balances appearing in Exhibit 9-6 and that the relevant exchange rate information is as stated. A cash flow comparison between the functional currency (krone) and the reporting currency (dollars) yields some striking contrasts. While the cash flow statement generated from the translated balance sheet and income statement (Exhibit 9-5) shows long-term debt as a source of funds, the krone statement (Exhibit 9-6) suggests that this was not the case. Likewise, what appears to be an investment in fixed assets from a dollar perspective turns out to be a pure translation phenomenon. Closer analysis provides insight into the magnitude of the translation effects. An analysis of the fixed asset account reveals that there was no purchase, sale, or retirement of fixed assets during the year. Thus, the year-end balance should have been the beginning book value, $11,050,000 (NOK85,000,000), less depreciation of $720,000 Chapter 9 International Financial Statement Analysis EXHIBIT 9-5 Translated Financial Statements of Norwegian Subsidiary Translated Balance Sheets as of 12/31/10 and 12/31/11 December 31 2010 Assets (000's) Cash Net fixed assets Total assets Liabilities and owners' equity U.S. $500 payable Long-term franc debt Capital stock Retained earnings Translation adjustment Total liabilities and stockholders' equity 2011 $ 3,120 11,050 $14,170 $ 5,190 13,840 $19,030 $ $ 650 6,240 4,968 2,312 $14,170 Translated Statement of Income for the Year 2011 (000's) Sales Expenses Operating costs $ 864 Depreciation 720 Foreign exchange gain (180) Net income Translated Statement of Cash Flows (000's) Sources Net income Depreciation Increase in long-term debt Translation adjustment Uses Increase in fixed assets Net increase in cash $ 324 720 2,064 2,472 650 8,304 4,968 2,636 2,472 $19,030 $ 1,728 $ 1,404 324 $ 5,580 3,510 $ 2,070 (NOK5,000,000), or $10,330,000. The actual ending balance was $13,840,000, suggesting that the entire increase in fixed assets ($13,840,000 - 10,330,000 ) was due to an exchange rate effect. Similarly, there was no change in Norwegian krone long-term debt during the year. Because this monetary liability was translated by an exchange rate that revalued during the year, the entire increase in long-term debt ($8,304,000 - 6,240,000) also arose from a translation adjustment. Similar transactional analyses account for additional translation effects related to the Norwegian subsidiary's working capital accounts. These effects are summarized in Exhibit 9-7. Note that the sum of all the translation effects appearing in Exhibit 9-6 equals the aggregate translation adjustment appearing in the shareholders' equity section of the translated balance sheet. An informed reader can better determine the influence of exchange rate changes from a firm's financing and investing activities using the foregoing analysis. 301 302 Chapter 9 International Financial Statement Analysis EXHIBIT 9-6 Financial Statements for Wholly-Owned Norwegian Subsidiary Local Currency Balance Sheet as of 12/31/10 and 12/31/11 December 31 2010 2011 Assets Cash Net fixed assets Total assets NOK 24,000 85,000 NOK 109,000 NOK 30,000 80,000 NOK 110,000 Liabilities and owners' equity U.S. $500 payable Long-term krona debt Capital stock Retained earnings Total liabilities and owners' equity NOK 5,000 48,000 46,000 10,000 NOK 109,000 NOK 3,750 48,000 46,000 12,250 NOK 110,000 Statement of Cash Flows Sources Net income Depreciation Less: Krone foreign-exchange gain Uses: None Net increase in cash NOK 2,250 5,000 1,250 NOK 6,000 Relevant Exchange Rates December 31, 2010 Average during 2011 December 31, 2011 NOK1 = $.130 NOK1 = $.144 NOK1 = $.173 EXHIBIT 9-7 Analysis of Exchange Rate Effects Debit Cash Fixed assets Intercompany payable Long-term debt Credit $1,206 3,519 $4,716 Aggregate translation adjustment $4,716 $ 180 2,064 $2,244 2,472 $4,716 Differences in Statement Format Balance sheet and income statement formats vary from country to country. For example, in contrast to the United States, where most companies adopt the balance sheet account format with assets appearing on the left and equity claims on the right, the format is Chapter 9 International Financial Statement Analysis often the reverse in the United Kingdom. As a second example, in contrast to U.S. balance sheets, which display assets in decreasing order of liquidity and liabilities in increasing order of maturity, in many countries the most liquid assets and the shortest term liabilities appear at the foot of the balance sheet. Classification differences also abound internationally. For example, accumulated depreciation is reported as a contra-asset account in the United States. In Germany, depreciable assets are usually reported net of accumulated depreciation, but all current period changes in long-term asset accounts are shown directly in the balance sheet. In most countries, the distinction between a current and noncurrent liability is one year. In Germany it is often four years. Handbooks like Transactional Accounting27 may be c