Chapter 9
International Financial Statement Analysis
Discussion Questions
1.
a. Business strategy analysis
Difficulties in cross-border business strategy analysis: Identifying key profit drivers and
business risk in two or more countries can be daunting. Business and legal environments
b. Accounting analysis
Difficulties in accounting analysis: Two issues are important here. The first is cross-
country variation in accounting measurement quality, disclosure quality, and audit
quality. National characteristics that cause this variation include required and generally
c. Financial analysis (ratio analysis and cash flow analysis)
Difficulties in financial analysis: Extensive evidence reveals substantial cross-country
differences in profitability, leverage, and other financial statement ratios and amounts
d. Prospective analysis (forecasting and valuation)
Difficulties in prospective analysis: Exchange rate fluctuations, accounting differences,
different business practices and customs, capital market differences, and many other
factors have major effects on international forecasting and valuation. Application of price
multiples in a cross-border setting requires that the determinants of each multiple, and
reasons why multiples vary across firms, be thoroughly understood. National differences
in accounting principles are one source of cross-country variations in these ratios.
Finally, all four stages of business analysis may be affected by:
2. Timeliness of information
4. Differences in financial statement formats
2. Information accessibility is a major condition for an efficient capital market, that is,
information must be rapidly analyzed and made available to investors capable of acting on it.
3. Investment analysis almost always involves paired comparisons, even if the benchmark
alternative is to do nothing. In evaluating the risk and return characteristics of a nondomestic
4. One way of coping with GAAP differences is to restate foreign accounting measures to an
internationally recognized set of principles or the reporting framework of the investor’s home
country. An alternative tack is to develop a detailed understanding of accounting practices in
the investee’s country.
Students will definitely disagree on this one. Eventually some will offer a compromise: use
the former coping mechanism if the investee company is being compared with a firm in the
5. Prospective analysis involves forecasting a firm’s future cash flows and then valuing those
cash flows. As future cash flow estimates are based on accounting measurements, differences
in measurement rules between countries complicate this effort. The range of accounting
6. Translation of foreign financial statements for the convenience of domestic readers is
fundamentally distinct from the translation of branch or subsidiary accounts for purposes of
7. Important recommendations include the following:
a. Be aware that national differences in accounting measurement rules can add “noise” to
reported performance comparisons. The reader should be prepared to unwind accounting
differences where necessary.
b. Use a structured approach, such as the one presented in this chapter, to ensure that all
relevant factors are considered.
c. Cash flow–related measures are less affected by accounting principle differences than are
8. The following list describes in general fashion what probable effect the Dutch translation
practice would have on selected financial ratios in comparison with the temporal method. The
analysis assumes that the original financial statements of the two companies are identical in
all respects save for the currency translation method used. Inventories are assumed to be
carried at cost.
_______________________________ ______________________
____________________________ Devaluation ____ Revaluation ____
Current ratio (liquidity) decrease increase
Debt ratio (solvency) increase decrease
9. The attest function is what gives credibility to the financial statements. If this function is
10. Internal control is an activity performed by a firm’s internal auditors that helps to assure that
management’s policies and procedures are being carried out effectively, that financial
transactions are being properly reported both internally and externally and that the assets of
Exercises
1. The trend of dividends from a U.S. dollar perspective can be ascertained by translating the
peso dividend stream using the $/P exchange rate prevailing at the beginning of the time
series or the end. Use of the ending exchange rate provides the following trend data:
_____________ ______________________
2009__________ 2010 __________ 2011_______
Net income (P) 8,500 10,800 15,900
2. How the statement of cash flows appearing in Exhibit 9.5 was derived:
Beg. Bal. DR. CR. End. Bal.
Cash 3,120 5.190
New fixed assets 11,050 (3) 3,150 (2) 720 13,840
Sources Uses
of of
Funds Funds
Sources:
Net income (1) 324
Depreciation (2) 720
3. Consolidated Funds Statement
(figures appearing in parentheses denote changes due primarily to translation effects)
Sources:
Net income 324
Depreciation 720
Increase in LT debt 2,064 (2,064)
Translation adjustment 2,070 (2,070)
Less intercompany payable 180
Uses of funds:
Increase in fixed assets 3,510 (3,510)
Net increase in cash 2,070 (1,206)
The $1,206 translation effect is that part of the $2,472 gain on the translation of net worth which is
related to the translation of cash. It is derived as follows.
a. Opening cash of 24,000 kroner translated at .13 =$3,120
4. Yes, Infosys added value for its shareholders as its EVA was a positive RPE 1,540. Operating
income more than covered the company’s cost of debt and equity. EVA is an attempt to
5. Debit: Cost of goods sold ¥250,000,000
6. a.
2009 2010 2011
b. Percentage change 2010/2009 2011/2010
Pounds 21.9% 15.7%
c. This problem can be minimized by translating the time series using the 2009 exchange
7. Assessing reasons for P/E ratio trends and cross-country comparisons is difficult. The text
discusses two studies that have analyzed differences in P/E ratios between Japan and the
8. Student answers will naturally vary. However, they should recognize that audit practices are
9. Student opinions are likely to vary on this one as well. Some will argue for opinions coined
by private professional bodies. Others, in light of Enron, et al., will opt for more legal
10. Reasonable criteria for judging the merits of a database for company research include (but are
not limited to):
a. Coverage (number of companies, countries, years of data)
b. Amount of information for each company (number of financial, market-based measures
per company)
Case 9-1 Sandvik
1.
a. There are several advantages that accrue to Swedish firms employing the system of
special reserves. First, political dividends accrue to firms that align their goals with those
2. The government benefits from the reserving system in that it has an ally in maintaining full
3. The use of reserves makes it difficult for statement readers who are unfamiliar with Swedish
reporting practices to assess the risk and return attributes of the firm. For example, it will not
5. The entries used to increase the reserves can be determined by examining the change in
Untaxed Reserves in the balance sheet as well as examining the relevant notes to the financial
statements. The entries were:
Excess depreciation reserve 2,429
Income 2,429
6. With reserves Without reserves
ROS 8,314/20,682 8,314 – 3,063(1-.082)/20,682
ROA 8,314 + 745 +1,165 8,314 +7451 + 1,165 – 3,063
Case 9-2 Continental A.G.
Students will first gravitate to the notes to the financial statements dealing with Special Reserves and
Provisions. Their instincts are correct. The problem facing an external analyst is that it is difficult to
determine which of the reserve and provision items are legitimate and which are not.
It turns out that two important keys to this case are to be found in footnotes 21 and 22. Focusing on the
consolidated figures, we see that Continental is using entries under Other operating income and Other
operating expenses to smooth reported earnings. The following analysis backs out 1) Credit to income from
the reversal of provisions, 2) Credit to income from the reduction of the general bad debt reserve, and 3)
Credit to income from the reversal of special reserves appearing in note 21 and Allocation to special reserves
under note 22.
Adjustments:
19X9
Operating income DM68,029
Provisions DM33,559
20X0
Operating income DM57,237
Provisions DM17,312
To determine the net overstatement on an after-tax basis, the students should attempt to approximate
Continental’s effective tax rate. Information to do this are contained in footnote 24 and Continental’s
income statement.
Effective Taxes: 19X9 20X0
Income tax 141,476 59,884
Reduction in taxes:
66,751 X .39 57,069 X .39