IMChap 010

Chapter 10 - Analysis of Foreign Financial Statements
CHAPTER 10
ANALYSIS OF FOREIGN FINANCIAL STATEMENTS
Chapter Outline
I.
Reasons to analyze financial statements of foreign companies include:

making foreign portfolio investment decisions,
making foreign merger and acquisition decisions,
making credit decisions about foreign customers,
evaluating foreign suppliers, and
benchmarking against foreign competitors.
II.
There are several problems an analyst might encounter in analyzing foreign financial
statements, including:
finding and obtaining financial information about a foreign company,
understanding the language in which the financial statements are presented,
the currency used in presenting monetary amounts,
terminology differences that result in uncertainty as to the information provided,
differences in format that lead to confusion and missing information,
lack of adequate disclosures,
financial statements are not made available on a timely basis,
accounting differences that hinder cross-country comparisons, and
differences in business environments that might make ratio comparisons meaningless
even if accounting differences are eliminated.
III.
Some of the potential problems can be removed by companies through their preparation of
convenience translations in which language, currency, and perhaps even accounting
principles have been restated for the convenience of foreign readers.
IV.
A significant number of investors find that differences in accounting practices across

countries hinder their financial analysis and affect their investment decisions. Some
analysts cope with this problem by restating foreign financial statements to a familiar
basis, such as U.S. GAAP.
A. Another coping mechanism is to base analysis on a measure of performance from
which many accounting issues have been removed, such as EBITDA.
10-1
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Education.
V.
Analysts should exercise care in interpreting ratios calculated for foreign companies.
What is considered to be a good or bad value for a ratio in one country may not be in
another country.
A. Financial ratios can differ across countries as a result of differences in accounting
principles.
B. Financial ratios also can differ across countries as a result of differences in business
and economic environments. Optimally, an analyst will develop an understanding of
the accounting and business environments of the countries whose companies they
wish to analyze.
VI.
To facilitate cross-country comparisons of financial information, foreign company financial

statements can be restated in terms of a preferred GAAP through the use of a
reconciliation worksheet in which debit/credit entries summarizing the differences in GAAP
are used to adjust the original reported amounts.
A. All income differences also affect stockholders equity through retained earnings.
B. In addition to adjustments resulting from differences in GAAP, an adjustment also will
be needed for the deferred tax effect of the aggregate difference in pre-tax income.
10-2
Education.
Answers to Questions
1. Investors can diversify their risk by including shares of foreign companies in their investment
portfolio. Correlations in the returns (increases and decreases in stock prices) earned
across stock markets are relatively low. The high degree of independence across capital
markets affords investors diversification opportunities.
2. Ford might want to include the following companies in a benchmarking study:
U.S. General Motors, Chrysler
Japan Honda, Toyota, Nissan, Subaru
Germany Daimler, BMW, Volkswagen, Audi
Korea Hyundai, Kia
France Renault, Peugeot
3. Commercial databases tend not to include notes to financial statements, which are an
important source of information about a company. They also tend to force different country
formats for financial statements into a common format and thereby run the risk of
misclassification and loss of information. Data entry errors are also a potential problem.
4. The first (easiest) place to look for the most recent annual report is on the companys
internet website. Several internet resources can help in locating a companys financial
statements including Hoovers and EDGAR.
5. Much financial statement analysis is conducted using ratios or percentage changes
(comparing one year with another). Ratios and percentages are not expressed in currency
amounts. In fact, in analyzing year-to-year percentage changes, analysts must be careful in
translating from a foreign currency to their own currency as changes in exchange rates can
distort underlying relationships.
6. If an analyst is unable to read a companys annual report, they will be less likely to feel that
they have sufficient information to make an informed investment decision. This would be
analogous to making an internet purchase of an electronic product manufactured by a
company with which you are unfamiliar and the only description of the product is in a
language you do not read.
7. Disclosures in the notes to financial statements can provide additional detail related to
specific line items that allows the analyst to reformat the financial statements to a format
preferred by the analyst (e.g., that can be compared with other companies). Disclosures
related to items such as provisions can allow analysts to assess the impact that these have
on income.
10-3
Education.
8. The time lag between fiscal year end and when financial statements are made available to
the public can differ substantially across countries. This time lag is influenced by the stock
market regulator in many countries. For example, the SEC requires U.S. companies to file
financial statements within 90 days of the fiscal year end, whereas publicly traded British
companies are allowed six months to file their reports. Substantial differences in the
timeliness of earnings announcements also exist across countries.
Timeliness is also a function of how often companies must prepare financial statements.
Whereas the U.S., Canada, and the U.K. require publication of quarterly reports, the
European Union requires only semi-annual reporting, and annual reporting only is the norm
in many countries.
9. The advantage of using a measure such as EBITDA to compare profitability of companies
across countries is that differences in accounting for interest (I), taxes (T), depreciation (D),
and amortization (A) across countries do not affect the profitability measure. The
disadvantage is that these expenses might be important in evaluating profitability and in
determining the value of the firm.
10. The different features that might be translated in a convenience translation are:
Language,
Currency, and
GAAP.
The most common type of convenience translation is a language translation only. Exhibits
10-3, 10-4, and 10-5 are examples of this type of convenience translation.
11. Analysts should be careful in comparing ratios across companies in different countries
because of differences in business environments that might affect those ratios. For
example, in countries in which accounting income is the basis for taxation, it is logical that
companies will attempt to report as little accounting income as possible. It might be
misleading to therefore assume that these companies are not as profitable as companies in
countries in which accounting income is not used for tax purposes.
12. Conservatism implies accelerating the recognition of expenses and liabilities, and deferring
the recognition of revenues and assets. Conservative accounting can result in a smaller
amount of net income, retained earnings, and assets, and a larger amount of liabilities.
Profit margin a smaller amount of net income has a negative impact (reduction) on profit
margins (net income/sales).
Debt-to-equity ratio a larger amount of liabilities and a smaller amount of retained earnings
has a positive (increasing) effect on the debt-to-equity ratio (total liabilities/total stockholders
equity).
Return on equity the impact of conservatism on return on equity (net income/average
stockholders equity) is not clearcut because both the numerator and denominator in the
ratio are likely to be smaller.
10-4
Education.
13. Companies with predominantly debt financing (rather than equity financing) will have a
larger amount of liabilities (and a smaller amount of stockholders equity), and a larger
amount of interest expense and therefore smaller net income. Profit margins (net
income/sales) will be smaller, and debt-to-equity ratios (total liabilities/total stockholders
equity) will be larger. Debt financing will reduce both the numerator and the denominator in
the calculation of return on equity. The net effect on return on equity (net income/average
stockholders equity) depends upon the relation between before tax return on assets and the
interest rate on borrowing. As the table below demonstrates, if the before tax return on
assets is greater than the interest rate on debt, return on equity increases; if the before tax
return on assets is less than the interest rate on debt, return on equity decreases.
Note: Before tax return on assets is 20% (400/2,000).
Effect of Debt on Return on Equity:
No debt
Debt 10%
Debt 20%
Debt 25%
Assets
2,000
2,000
2,000
2,000
Liabilities
Stock equity
0
2,000
1,000
1,000
1,000
1,000
1,000
1,000
2,000
2,000
2,000
2,000
EBIT
Interest
400
0
400
100 10%
400
200 20%
400
250 25%
EBT
Tax
400
140
300
105
200
70
150
53
260
195
130
98
Net income
Avg Stock Eq
260
2,130
195
1,098
130
1,065
98
1,049
ROE
12.2%
17.8%
12.2%
9.3%
Net income
35%
14. Interest can be either capitalized as part of the cost of a depreciable asset or expensed
immediately. Adjustments to capitalize interest that was previously expensed must be made
to:
Increase depreciable assets;
Reduce interest expense; and
Increase beginning retained earnings for the reversal of interest expense that was
improperly recognized in previous years.
10-5
Education.
Solutions to Exercises and Problems

1. Arcot Company (Calculating ratios from Local GAAP and U.S. GAAP statements)
Ratio
Formula
Current ratio
CA
CL
Total asset turnover
Debt/equity ratio
Times interest earned
Profit margin
Return on equity
Operating profit margin
Oper income as % of
avg total stock equity
Local
GAAP
9,778
2,980 3.281
Sales
TA
9,148
23,326
TL
TSE
9,148
14,178
EBIT
Int Exp
3,664
156
Net income
Sales
2,456
9,148
Net income
Avg TSE
2,456
13,145
Op inc
Sales
Op Inc
Avg TSE
a.1.
3,532
9,148
3,532
13,145
U.S.
GAAP
a.2
b. % Diff.
9,966
2,702
3.688
12.4%
0.392
9,148
23,288
0.393
0.2%
0.645
8,875
14,413
0.616
-4.6%
23.49
3,763
156
24.12
2.7%
0.268
2,526
9,148
0.276
2.9%
0.187
2,456
13,150
0.92
2.8%
0.386
3,804
9,148
0.416
7.7%
0.269
3,804
13,150
0.289
7.7%
a. The profitability ratios using operating income and the current ratio are the ratios most
affected by differences in the two sets of accounting principles. There also is a relatively
large decrease in the Debt-to-Equity Ratio due to a larger amount of liabilities and smaller
amount of equity under U.S. GAAP. Total asset turnover is virtually unaffected by the
accounting differences. This is due to the fact that there are no differences affecting
revenues and the positive and negative adjustments to total assets tend to offset one
another.
Note that total asset turnover was based on total assets at the end of 2006, not the average for
the year. This is due the fact that total assets on a U.S. GAAP basis is not available for 2005.
10-6
Education.
2. China Petroleum & Chemical Corporation (Sinopec) (Comparison of ROE under

different accounting rules)
Profit, 2006
Total equity, 12/31/06
Total equity, 12/31/05
Average total equity, 2006
Accounting Rules
PRC
IFRS
U.S. GAAP
50,664
55,408
54,862
254,875
262,297
262,297
215,623
222,803
222,803
235,249
242,550
242,550
a. % difference in profit
% difference in average equity
IFRS/PRC
9.4%
3.1%
U.S./PRC
8.3%
3.1%
U.S./IFRS
-1.0%
0%
b. Return on average total equity
21.54%
22.84%
22.62%
IFRS/PRC
c. % difference in ROE
6.1%
U.S./PRC
5.0%
U.S./IFRS
-1.0%
The answers to a., b., and c. show that there is a larger difference between PRC profit
(average equity) (return on equity) and both IFRS and U.S. GAAP profit (average equity)
(return on equity), than between IFRS and U.S. GAAP profit (average equity) (return on
equity).
d. There is no correct answer to this question. Students might mention that IFRS and U.S.
GAAP are designed specifically to provide information useful to investors. Interestingly,
there is no difference in stockholders equity between IFRS and U.S. GAAP in either
2005 or 2006 and only a relatively small difference in profit. As a result, whether the
company used IFRS or U.S. GAAP made almost no difference on ROE in 2006. These
relationships may or may not be generalizable to other years.
10-7
Education.
3. SAB Miller PLC (Stockholders equity terminology)

SAB Miller Terminology
Share capital
Share premium
Merger relief reserve*
Other reserves
U.S. Terminology
Common stock
Paid in capital in excess of par value
No apparent equivalent in U.S.
Accumulated other comprehensive
income
Same as in U.S.
Same as in U.S.
Same as in U.S.
Same as in U.S.
Retained earnings
Total shareholders equity
Minority interests in equity
Total equity
A footnote to the Consolidated Statement of Changes in Equity provides the following

information about the Merger relief reserve.
Merger relief reserve
In accordance with section 131 of The Companies Act, 1985, the group recorded the
US$3,395 million excess of value attributed to the shares issued as consideration for
Miller Brewing Company over the nominal value of those shares as a merger relief
reserve in the year ended 31 March 2003.
The US$1,191 million increase in the merger relief reserve in the year ended 31 March
2010 relates to the merger relief arising on the issue of SABMiller plc ordinary shares for
the buyout of minority interests in the groups Polish business.
Thus, merger relief reserve appears to be additional paid-in capital in excess of par value
resulting from the issuance of shares to effect a business combination.
10-8
Education.
4. Babcock International (Reformatting of balance sheet)

Babcock International
Balance Sheet
As at 31 March 2010
Assets
Cash
Receivables
m
48.9
527.
6
576.5
359.1
0.3
935.9
Total current assets

Investments in subsidiaries
Property, plant and equipment
Total assets
Liabilities and stockholders' equity
Current liabilities
Long-tem liabilities
Total liabilities
104.0
355.0
459.0
Common stock
Paid in capital in excess of par value
Capital redemption reserve
Retained earnings
137.7
148.2
30.6
160.4
Total stockholders equity

Total liabilities and stockholders' equity
476.9
935.9
Note: It might be appropriate to combine the Capital redemption reserve and Profit
and loss account and report Retained Earnings of 191.0. One would need to know
more about the Capital Redemption Reserve account. For example, if this is an
appropriation of retained earnings, combining the two might make sense.
10-9
Education.
5. China Eastern Airlines (Useful life)

a. Adjustment (1) relates to Item (a). Item (a) indicates that flight equipment is depreciated
over 20 years under IFRS and amortized over only 5 years under PRC rules. The larger
amount of amortization expense recognized under PRC rules must be added back to
PRC profit to obtain IFR profit.
Item (b) represents the difference in gain on disposal of depreciable assets due to
different useful lives. Assets are depreciated more quickly under PRC rules, resulting in
smaller book values than under IFRS. Subtracting the smaller book value from
proceeds received upon disposal results in a larger gain on disposal under PRC rules.
Adjustment (2) subtracts the difference in the larger gain recognized under PRC rules
and the smaller gain recognized under IFRS, which causes IFRS profit to be smaller
than PRC profit.
b. Both adjustments affect retained earnings. Item (a) will require an adjustment in the
reconciliation of net assets that increases stockholders equity and item (b) will require
an adjustment that decreases stockholders equity.
6. China Eastern Airlines (Revaluation of fixed assets)
a. Under IFRS, the company has revalued its fixed assets, which resulted in a revaluation
surplus (increase in stockholders equity). Under U.S. GAAP, revaluation is not allowed.
Therefore, IFRS-based stockholders equity is greater than what would be reported
under U.S. GAAP. Depreciation is based on the revalued amount of fixed assets, which
results in a larger amount of depreciation expense and smaller net income under IFRS.
In addition, when revalued assets are sold, they have a higher cost under IFRS and
therefore a smaller gain (or larger loss) is recognized upon disposal of the assets.
(1) In 2003, the depreciation related to the revaluation amount must have been
US$7,720, causing IFRS-based income to be less than U.S. GAAP income. This
amount is added back to IFRS-based income to reconcile to U.S. GAAP.
(2) Fixed assets have been revalued by US$109,811. The journal entry to effect the
revaluation was:
Dr. Fixed Assets (+Assets) US$109,811
Cr. Revaluation Surplus (+ Owners equity).
US$109,811
Revaluation causes IFRS-based owners equity to be greater than owners equity under
U.S. GAAP by US$109,811. This amount is subtracted from IFRS-based owners equity
to reconcile to U.S. GAAP.
10-10
Education.
6. (continued)
The revaluation of fixed assets must have taken place several years ago. Each year
since revaluation, depreciation expense on the revaluation amount has been taken
under IFRS, with a corresponding reduction in retained earnings. In addition, some of
the revalued fixed assets have been disposed of at a loss. This loss is greater under
IFRSs than it would have been under U.S. GAAP, resulting in a smaller amount of IFRSbased retained earnings. The accumulated depreciation (including 2003 depreciation
expense) on the revaluation amount plus the additional amount of loss calculated under
IFRS sums to US$83,516. IFRS-based owners equity is less than U.S. GAAP owners
equity by this amount. This amount is added back to IFRS-based owners equity to
reconcile to U.S. GAAP. The shareholders equity account affected is retained earnings.
In summary, the net effect on owners equity from (1) reversing the revaluation surplus
[US$109,811] and (2) reversing the accumulated depreciation on the revaluation surplus
and the additional loss [US$83,516] is US$26,295. IFRS-based owners equity exceeds
U.S. GAAP owners equity by this amount.
b. The revaluation of fixed assets causes noncurrent assets (and therefore total assets)
and owners equity to be larger and income to be smaller under IFRS than under U.S.
GAAP.
Ratio (under IFRS instead of U.S. GAAP)
Current ratio (CA/CL) /
Total asset turnover (sales/average TA) /
Profit margin (NI/sales) /
Return on assets (NI/average TA) /
Return on equity (NI/average SE) /
Debt to equity ratio (TL/TSE) /
Under IFRS
No effect
Smaller
Smaller
Smaller
Smaller
Smaller
where: = no effect, = decrease, = increase
10-11
Education.
7. Novartis Group (Share-based compensation)

a. The amount of expense related to share-based compensation under IFRS was USD 5
million less than would have been recognized under U.S. GAAP. The entry to adjust to
a U.S. GAAP basis would be as follows:
Dr. Expense (+ Exp - NI, - SE)
Cr. Paid-in capital (+ SE)
$5 million
$5 million
In addition, USD 186 million that was recognized as equity under IFRS would have been
recognized as a liability under U.S. GAAP. The entry to adjust to U.S. GAAP would have
been:
Dr. Paid-in capital (- SE)
Cr. Long-tem liabilities (+ L)
$186 million
$186 million
The company does not provide information whether this adjustment affects current
liabilities, long-term liabilities, or some combination of the two. This solution assumes
that it affects long-term liabilities only.
The difference in accounting for share-based compensation causes income and equity
to be smaller and liabilities to larger under U.S. GAAP. There is no effect on assets.
b. Ratio (under U.S. GAAP rather than IFRS)
Current ratio (CA/CL) /
Debt to equity ratio (TL/TSE) /
Total asset turnover (sales/average TA) /
Profit margin (NI/sales) /
Return on equity (NI/average SE) /
Under U.S. GAAP

No effect*
Higher
No effect
Smaller
Larger**
where: = no effect, = decrease, = increase

* The company does not provide sufficient information to determine whether the
adjustment to U.S. GAAP affects current liabilities, long-term liabilities, or both.
Assuming only long-term liabilities are affected, there would be no effect on the current
ratio.
** Both net income and average stockholders equity are smaller under U.S. GAAP. But
the decrease in stockholders equity is much larger than the decrease in equity: USD
181 million vs. USD 5 million. As a result, return on equity is larger under U.S. GAAP.
10-12
Education.
8. Gamma Holdings NV (Provisions)

a. Percentage change in income (loss) before tax (group result before taxation):
33.9% [(45.8) - (34.2)/(34.2)].
The before tax loss increased 33.9% from 2008 to 2009.
b. Provisions are estimated, accrued liabilities; recognition of a provision increases
liabilities and expenses. Increasing a provision causes a decrease in net income.
c. Provisions are increased at the time that (a) an accrued liability is recognized (increase
provision, increase expense). (Note: Some companies will intentionally overstate a
provision to create hidden reserves of income that can then be reported in a later year.)
Provisions are decreased when (b) the liability provided for is paid (decrease provision,
decrease cash), or (c) the accrued liability is determined to have been overstated and
the provision is reversed (decrease provision, increase revenue). Reversing the
previously recognized provision (releasing hidden reserves to income) is a method
used in income smoothing, sometimes known as cookie jar accounting. The ending
balance in provisions increases when (a) > (b) + (c), and decreases when (a) < (b) + (c).
d.
Calculation of change in other provisions
Ending balance in other provisions
Change in other provisions
2009
16.3
- 14.5
Calculation of income (loss) before tax with no change in other

provisions
Group result before taxation (as reported)
Change in other provisions
Group result before taxation with no change in other provisions
2008
30.8
+ 12.9
2007
17.9
2009
2008
(34
.1)
12.9
(21.2)
(45.8)
(14.5)
(60.3)
Percentage change in income (loss) before tax (group result before taxation) would have
been: 184.4% [(60.3) - (21.2)/(21.2)].
The before tax loss would have increased 184.4% from 2008 to 2009 if there had been
no changes in other provisions.
e. Gamma provides a significant amount of detail about what causes the change in other
provisions over time. Analysts would like to know whether the decrease in provisions
results (a) from incurring the cost that had been accrued as a liability or (b) from
reversing the accrued liability because subsequently it is determined to have been
overstated. To the extent that income is recognized as a result of reversing (releasing)
previously recognized provisions, the quality of income is questionable. Note 19
provides adequate disclosure to determine what caused the net decrease in other
provisions in 2009 of 14.5 million. Only 0.4 million of the decrease in Other
provisions was a Release credited to the income statement.
10-13
Education.
9. Gamma Holding NV (Estimation of gross profit)

a. Because the change in finished products (FP) and work in progress (WIP) is subtracted
in calculating total operating income, the balance in FP and WIP inventory must have
decreased during the year. This can be demonstrated by considering the following
example of the calculation of cost of goods sold.
Beginning inventory
Plus: purchases
Goods available for sale
Less: ending inventory
Equals: cost of goods sold
3,000
5,000
8,000
2,000
6,000
Cost of goods sold (6,000) is equal to the cost of purchases (5,000) plus the decrease in
inventory (1,000 = 3,000 beginning inventory 2,000 ending inventory).
In Gamma Holdings income statement, the amount spent on purchases is reflected in
the line items cost of raw materials and consumables, personnel costs, and so on.
The change in FP and WIP also is subtracted to accurately reflect the cost of the goods
sold for the year.
b. To calculate cost of goods sold for the year, an analyst would need to know the amount
of each operating expense related to manufacturing activities. For example, the amount
of depreciation of property, plant and equipment related to factory assets would be
needed.
c.
Operating expenses
Raw materials and consumables
Contracted work and other external costs
Personnel costs
Depreciation of property, plant and equipment
Impairment of property, plant and equipment
Amortisation of intangible assets
Impairment of intangible assets
Other operating expense
Total
212.9
42.7
236.9
29.4
7.4
4.2
18.5
100.2
652.2
Change in finished products and WIP

Estimated cost of goods sold
Sales (net turnover)
Estimated cost of goods sold
Estimated gross profit
d. Estimated gross profit margin
90%
100%
50%
75%
75%
80%
80%
10%
Manufacturing
191.6
42.7
118.5
22.1
5.6
3.4
14.8
10.0
408.7
14.3
423.0
658.5
423.0
235.5
= 35.8% [235.5/658.5]
10-14
Education.
10. Neopost SA (Development costs)

a. Calculation of average expected useful life of development costs
Development costs
Beginning gross value
Charges (amortization expense)
Estimated useful life (years)
2009
73.5
7.9
9.3
2008
64.5
7.1
9.0
b. Calculation of income before tax and net income assuming development costs
were not capitalized
The capitalization of development costs must be subtracted from income before tax
The charges (amortization expense) related to capitalized development costs must
be added back to income before tax
The effective tax rate is determined based on actual reported amounts
2009
2008
Income before tax
204.9
214.8
Development costs capitalized
(10.2)
(9.0)
Charges (amortization expense)
7.9
7.1
Adjusted income before tax
202.6
212.9
Income taxes (based on effective tax rate)
56.4
57.4
Adjusted net income
146.2
155.5
Calculation of effective tax rate
Income taxes
Income before tax
Effective tax rate
2009
2008
57.0
204.9
27.8%
57.9
214.8
27.0%
c. Determination of net profit margin

Calculation of proft margin
Reported amounts
Net income
Sales
Net profit margin
2009
2008
147.9
913.1
16.2%
156.9
918.1
17.1%
Adjusted amounts
Adjusted net income
Sales
Net profit margin
146.2
913.1
16.0%
155.5
918.1
16.9%
Capitalization of development costs results in a slightly higher profit margin in both 2008
and 2009.
10-15
Education.
11. Vale S.A. (Statement of Added Value)

a. The external parties who might be most interested in Vales Statement of Added Value
are those to whom the value added is distributed (Employees, Government, Creditors,
Stockholders, Minority shareholders) and the public at large.
b. Personnel; Taxes, rates and contribution less Taxes paid recover; and Remuneration on
third partys capital have not been subtracted in calculating Total Added Value to be
Distributed. These represent expenses (i.e., salaries and wages, taxes, and interest)
that would be subtracted in measuring net income.
c. Perhaps the most important story being told is the manner in which added value (AV) is
being distributed and how this has changed from 2008 to 2009. In 2008, 44% of AV was
reinvested in the company
10-16
Education.
12. Babcock International Group PLC (Determine Gross Profit and Estimate Sustainable
Income)
a. Determine gross profit and gross profit margin
Note 4, Operating expenses, indicates that Cost of sales in 2009 was 1,685.1. Gross
profit and gross profit margin are calculated as follows:
Revenue
2009
1,901.9
Cost of sales
Gross profit
Gross profit margin
1,685.1
216.8
11.4%
b. Estimate sustainable income

Babcock reports profit for the year 2009 of 74.3, but this includes several items that are
non-recurring (and therefore not part of sustainable income) and are given special
presentation in the income statement.
First, the loss for the year from discontinued operations (13.3) is reported separately
from profit for the year from continuing operations. By definition, this loss is not going
to recur and would be excluded from the estimate of sustainable income.
Second, amortization of acquired intangibles and exceptional items are reported in a
separate column of the income statement. To determine whether these special items
are non-recurring and therefore should be excluded from the estimation of sustainable
income, it is useful to read the relevant note, Note 6. Operating exceptional items and
acquired intangible amortisation.
Note 6 indicates that: In 2009 there were no operating exceptional items (2008: nil).
Thus, the entire 14.2, before tax, is attributable to acquired intangible amortization.
The note indicates that 4.8 of this amount is attributable to the acquisition of Strachan &
Henshaw (S&H), which could mean that this is goodwill impairment loss. It is
reasonable to assume that this is a non-recurring item.
Based on the presentation of the income statement and the information provided in Note
6, the following would be a reasonable estimate of sustainable income for 2009:
Profit for the year, net of tax
Add: Loss for the year from discontinued operations, net of tax
Profit for the year from continuing operations, net of tax
Add: Amortization related to acquisition of S&H, net of tax
Estimate of sustainable income, net of tax
*
74.3
13.3
87.6
3.9 *
91.5
Effective tax rate: 17.9% (19.1/106.7)

Amortization, net of tax [4.8 x (1-.179) =3.9]
10-17
Education.
13. Vale S.A. (EBITDA)

a. EBITDA is a measure of the amount of income a company generates before subtracting
depreciation of fixed assets, amortization of intangible assets, impairment of fixed and
intangible assets, interest expense, and income tax expense.
b. One explanation for why Vale included Note 11 in its 2009 annual report is that the
company truly believes that EBITDA is a more meaningful measure (than net income or
cash flows) for evaluating annual operating performance. Managements use of EBITDA
as a measure of performance provides insight into what management believes is
important for the company to be successful.
c. EBITDA can be useful in comparing the performance of companies located in different
countries where difference exist in (a) methods of accounting for depreciation,
amortization, interest, and/or taxes, (b) differences exist in how business is financed
(e.g., more debt financing leads to higher interest expense), and/or (c) differences exist
in national tax regimes.
d. The obvious limitation in using EBITDA to evaluate a companys performance is that by
doing so, management is not being held responsible for controlling those costs that are
not subtracted in its calculation especially the cost of acquiring the use of assets
(depreciation and amortization), and the cost of financing (interest). Moreover, EBITDA
is not distributable to stockholders as dividends and as such is not useful in evaluating a
companys ability to generate a return for its stockholders in the current period.
10-18
Education.
14. Arcot Company (Restatement of financial statements Year 1)

Reconciling Entries
[1]
[2]
[3]
[4]
[6]
[8]
Inventory indirect costs

Dr. Inventories
Cr. Cost of goods sold
60
60
Revaluation of property, plant, and equipment

Dr. Revaluation reserve
200
Cr. Property, plant, and equipment
Capitalized interest
Dr. Property, plant, and equipment
Cr. Interest expense
200
15
15
Deferred charges
Dr. Operating expenses (preop/startup costs) 24
Cr. Deferred charges
24
Government grants
Dr. Revenue
Cr. Property, plant and equipment
Operating expenses (depreciation)
27
3
Derivative financial instruments

Dr. Unrealized gain (loss)
Cr. Other income (expense), net
30
38
38
[11] Deferred tax effect of U.S. GAAP adjustments

Dr. Provision for income taxes
19
Cr. Deferred income taxes
19
10-19
Education.
14. (continued)
Worksheet for Restatement of Income and Retained Earnings to U.S. GAAP
For the year ended December 31, Year 1
(1)
(2)
(3)
(4)
Reconciling
Adjustments
(millions of Crowns)
Sales
Cost of goods sold
Local GAAP
Debit
7,952
30
Credit
U.S. GAAP
[6]
(4,415)
7,922
60
[1]
(4,355)
Gross profit
3,537
Operating expenses
(421)
Operating income
3,116
Interest expense
(186)
15
[3]
(171)
Other income (expense), net
(12)
38
[8]
26
Income before income taxes
2,918
Provision for income taxes
(875)
Net income
2,043
2,086
Retained earnings, January 1

Dividends
Retained earnings, December 31
Ratio
Current ratio
Debt/equity ratio
Net profit margin
3,567
24
[4]
[6]
(442)
3,125
2,980
19
[11]
(894)
2,043
2,086
Local GAAP
U.S. GAAP
2.63
2.65
0.43
0.43
0.85
0.87
14.69
16.43
25.7%
26.3%
39.2%
39.4%
10-20
Education.
14. (continued)
Worksheet for Restatement of Balance Sheet to U.S. GAAP for the year ended
December 31, Year 1
(1)
(2)
(3)
(4)
Reconciling Adjustments
Local GAAP
Cash
1,272
Accounts receivable
2,064
Inventories
4,240

Property, plant, and equipment,
net
7,576
Long-term investments
Deferred charges
Total assets
9,524
Debit
Credit
U.S. GAAP
1,272
2,064
6
0
[1]
4,300
7,636
1
5
[3]
2
7
20
0
[6]
9,312
[2]
1,113
1,113
2
4
345
[4]
321
18,558
18,382
507
507
Accrued expenses
1,262
1,262
Short-term debt
1,000
1,000
Accounts payable
Dividends payable
Other current liabilities
115
115
Total current liabilities
2,884
2,884
Long-term debt
5,000
Deferred income taxes

Other long-term liabilities
5,000
1
9
56
[11]
75
612
612
8,552
8,571
150
150
Capital surplus
7,575
7,575
Retained earnings
2,043
Total liabilities
Capital
Revaluation reserve
Unrealized gains (losses)
Treasury stock
Total stockholders' equity
Total liabilities and stockholders'
equity
200
38
2,086
20
0
3
8
[2]
[8]
10,006
9,811
18,558
18,382
10-21
Education.
15. Arcot Company (Restatement of financial statements Year 2)

Reconciling Entries
[1]
[2]
[3]
[4]
[6]
[8]
[9]
Inventory indirect costs

Dr. Cost of goods sold
Inventories
Cr. Retained earnings, 1/1/Y2
41
19
60
Revaluation of property, plant, and equipment

Dr. Revaluation reserve
200
Cr. Property, plant, and equipment
Capitalized interest
Dr. Property, plant, and equipment
Cr. Interest expense
Retained earnings, 1/1/Y2
160
40
24
3
12
15
Deferred charges
Dr. Operating expenses (preop/startup costs) 18
24
Cr. Deferred charges
Operating expenses (amort. of def chg)
34
8
Government grants
Dr. Retained earnings, 1/1/Y2
Cr. Property, plant and equipment
24
3
Derivative financial instruments

Dr. Other income (expense), net
Cr. Unrealized gain (loss)
27
108
70
38
Employee Share Trust Agreements

Dr. Treasury stock
Cr. Long-term investments
62
62
[11] Deferred tax effect of U.S. GAAP adjustments

Dr. Deferred income taxes
13
19
Cr. Provision for income taxes
32
10-22
Education.
15. (continued)
Worksheet for Restatement of Income and Retained Earnings to U.S. GAAP
For the year ended December 31, Year 2
(1)
(2)
(3)
(4)
Sales
Cost of goods sold
Local GAAP
8,348
(4,610
)
Gross profit
3,738
Operating expenses
(448)
Operating income
3,290
Interest expense
(128)
Other income (expense), net
28
Income before income taxes
3,190
Provision for income taxes
(957)
Net income
2,233
Retained earnings, January 1
2,043
Dividends
Retained earnings, December 31
Ratio
Current ratio
Debt/equity ratio
Net profit margin
Debit
Credit
4
1
U.S. GAAP
8,348
(4,651
)
[1]
3,697
3
[3]
40
[2]
18
[4]
[4]
[6]
(418)
3,279
12
108
[3]
(116)
[8]
(80)
3,083
32
[11]
(925)
2,158
24
[4]
60
[1]
27
[6]
15
[3]
19
[11]
38
[8]
2,086
4,276
4,244
Local GAAP
U.S. GAAP
2.70
2.71
0.40
0.40
0.74
0.75
25.9
27.6
26.7%
25.9%
39.4%
39.3%
10-23
Education.
15. (continued)
Worksheet for Restatement of Balance Sheet to U.S. GAAP
for the year ended December 31, Year 2
(1)
(2)
(3)
(4)
Local GAAP
Debit
Credit
U.S. GAAP
Cash
1,298
1,298
Accounts receivable
2,381
2,381
Inventories
4,683
8,362
Property, plant, and equipment, net

Long-term investments
Deferred charges
Total assets
11,104
19
[1]
4,702
8,381
24
[3]
160
[2]
10,944
24
[6]
1,188
62
[9]
1,126
436
34
[4]
402
21,090
20,853
654
654
Accrued expenses
1,256
1,256
Short-term debt
1,000
1,000
182
182
3,092
3,092
Long-term debt
5,000
5,000
Accounts payable
Dividends payable
Deferred income taxes

Total liabilities
Capital
98
13
[11]
85
789
789
8,979
8,966
150
150
Capital surplus
7,575
7,575
Retained earnings
4,276
4,244
Revaluation reserve
Unrealized gains (losses)
200
(90
)
200
62
Treasury stock
[2]
7
0
(20
)
[8]
[9]
(62)
Total stockholders' equity
12,111
11,887
Total liabilities and stockholders' equity
21,090
20,853
10-24
Education.
Case 10-1 Swisscom AG

a. Property, plant and equipment

Depreciation and amortization
Interest expense
Retained earnings
b. Property, plant and equipment
Restructuring charges
Debit
54
5
13
46
107
98
205
c. Depreciation and amortization

d. Other noncurrent assets
Goods and services purchased
Retained earnings
5
5
475
188
370
293
e. Investments
Equity in net loss of affiliate
Total
Credit
50
50
982
982
10-25
Education.
Worksheet for Restating Swisscoms Financial Statements from IFRSs to U.S. GAAP
(1)
IFRSs
Consolidated Statement of
Operations
Net revenues
Capitalized cost and changes in
inventories
Total
Goods and services purchased
Personnel expenses
Other operating expenses
Restructuring charges
Total operating expenses
Operating income
Interest expense
Financial income
Income (loss) before income taxes
and equity in net loss of affiliated
companies
Income tax expense
(2)
(3)
Reconciling
Adjustments
Debit
Credit
(4)
Note U.S. GAAP
9,842
9,842
277
10,119
1,666
2,584
2,090
1,739
277
10,119
1,296
2,584
2,090
1,937
1,726
9,805
314
(428)
25
370
205
a
c
d
b
13
5
5
188
1,521
9,428
691
(415)
25
(89)
1
301
1
Income (loss) before equity in net

loss of affiliated companies
Equity in net loss of affiliated companies
Net income (loss)
(90)
(325)
(415)
300
(275)
25
Consolidated Ret Earnings Statement

Retained earnings, 1/1/97
(151)
Net loss
Profit distribution declared
Conversion of loan payable to equity
Retained earnings, 12/31/97
(415)
(1,282)
3,200
1,352
50
46
293
a
d
188
25
(1,282)
3,200
2,131
10-26
Education.
(1)
IFRSs
Consolidated Balance Sheet
Assets
Current assets
Cash and cash equivalents
Securities available for sale
Trade accounts receivable
Inventories
Other current assets
Non-current assets
(2)
(3)
Reconciling
Adjustments
Debit
Credit
Note U.S. GAAP
256
51
2,052
169
34
2,562
11,453
256
51
2,052
169
34
2,562
54
107
5
Investments
Other non-current assets
Total non-current assets
Total assets
Liabilities and shareholders' equity
Current liabilities
Short-term debt
Trade accounts payable
Accrued pension cost
Long-term liabilities
Long-term debt
Finance lease obligation
Accrued pension cost
Accrued liabilities
Total long-term liabilities
Total liabilities
(4)
1,238
220
12,911
15,473
50
475
a
b
c
e
d
11,609
1,288
695
13,592
16,154
1,178
889
789
2,213
5,069
1,178
889
789
2,213
5,069
6,200
439
1,488
709
338
9,174
14,243
6,200
439
1,488
709
240
9,076
14,145
98
10-27
Education.
Shareholders' equity
Retained earnings
Unrealized market value adjustment on
securities available for sale
Cumulative translation adjustment
Total shareholders' equity
Total liabilities and shareholders'
equity
1,352
R/E
2,131
39
(161)
1,230
15,473
39
(161)
2,009
794
794
16,154
Ratios
IFRSs U.S. GAAP Difference*
1. Net income/Net revenues
-4.22%
0.25%
-106.02%
2. Operating income/Net revenues
3.19%
7.02%
120.06%
3. Operating income/Total assets
2.03%
4.28%
110.79%
-33.74%
1.24%
-103.69%
25.53%
34.40%
34.73%
0.51
0.51
0.00%
11.58
7.04
-39.20%
4. Net income/Total shareholders equity

5. Operating income/Total shareholders equity
6. Current assets/Current liabilities
7. Total liabilities/Total shareholders equity
* Difference = (U.S. GAAP IFRSs) / IFRSs
It is difficult to interpret the size of the difference in ratios involving Net income, because net
income is negative under IFRSs but positive under U.S. GAAP.
Operating income/Net revenues is the ratio most affected by the accounting standards used,
followed by Operating income/Total assets. This is attributable to the fact that Operating income
is more than twice as large under U.S. GAAP as under IFRSs.
The current ratio is unaffected by the accounting standards used.
10-28
Education.

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Chapter 10 - Analysis of Foreign Financial Statements

Reasons to analyze financial statements of foreign companies include:

A significant number of investors find that differences in accounting practices across

Chapter 10 - Analysis of Foreign Financial Statements

To facilitate cross-country comparisons of financial information, foreign company financial

Chapter 10 - Analysis of Foreign Financial Statements

Chapter 10 - Analysis of Foreign Financial Statements

Chapter 10 - Analysis of Foreign Financial Statements

Chapter 10 - Analysis of Foreign Financial Statements

Solutions to Exercises and Problems

Total asset turnover

Times interest earned

Operating profit margin

Chapter 10 - Analysis of Foreign Financial Statements

2. China Petroleum & Chemical Corporation (Sinopec) (Comparison of ROE under

b. Return on average total equity

Chapter 10 - Analysis of Foreign Financial Statements

3. SAB Miller PLC (Stockholders equity terminology)

A footnote to the Consolidated Statement of Changes in Equity provides the following

Chapter 10 - Analysis of Foreign Financial Statements

4. Babcock International (Reformatting of balance sheet)

Total current assets

Total stockholders equity

Chapter 10 - Analysis of Foreign Financial Statements

5. China Eastern Airlines (Useful life)

Chapter 10 - Analysis of Foreign Financial Statements

where: = no effect, = decrease, = increase

Chapter 10 - Analysis of Foreign Financial Statements

7. Novartis Group (Share-based compensation)

Under U.S. GAAP

where: = no effect, = decrease, = increase

Chapter 10 - Analysis of Foreign Financial Statements

8. Gamma Holdings NV (Provisions)

Calculation of income (loss) before tax with no change in other

Chapter 10 - Analysis of Foreign Financial Statements

9. Gamma Holding NV (Estimation of gross profit)

Change in finished products and WIP

Chapter 10 - Analysis of Foreign Financial Statements

10. Neopost SA (Development costs)

c. Determination of net profit margin

Chapter 10 - Analysis of Foreign Financial Statements

11. Vale S.A. (Statement of Added Value)

Chapter 10 - Analysis of Foreign Financial Statements

b. Estimate sustainable income

Effective tax rate: 17.9% (19.1/106.7)

Chapter 10 - Analysis of Foreign Financial Statements

13. Vale S.A. (EBITDA)

Chapter 10 - Analysis of Foreign Financial Statements

14. Arcot Company (Restatement of financial statements Year 1)

Inventory indirect costs

Revaluation of property, plant, and equipment

Derivative financial instruments

[11] Deferred tax effect of U.S. GAAP adjustments

Chapter 10 - Analysis of Foreign Financial Statements

Other income (expense), net

Income before income taxes

Provision for income taxes

Retained earnings, January 1

Chapter 10 - Analysis of Foreign Financial Statements

Total current assets

Total current liabilities

Deferred income taxes

Chapter 10 - Analysis of Foreign Financial Statements