Class #22 International Financial Analysis 15.535 - Class #22 1Next Steps for Projects • Analyst Project Presentations – In Class on May 12 and 14 – Same Format as previous presentations (should be no longer than 8 minutes!) – Due Diligence Presentations – (4-5 minutes in length) – Presentation Schedule is Posted in Announcements • Due diligence on other team reports – All teams must send their completed reports (Parts 1 and 2) to their opposing due diligence teams. – Due Diligence Teams should only evaluate PART 2 of the analysis (ie the valuation using DCF and relative multiples comparions. 15.535 - Class #22 2International Financial Analysis and Valuation • Differences in Accounting Across Countries – Outsider versus Insider Economies • Legal Tradition and Law Enforcement – Observed Differences in Accounting Across Countries • Differences in Opacity and Cost of Capital Across Countries 15.535 - Class #22 3Framework for Analyzing Accounting Across Countries • Financial reports for firms from different countries are often very different from each other. WHY? • See attached tables describing properties of accounting earnings across countries – From Leuz, Nanda and Wysocki (2001) 15.535 - Class #22 415.535 - Class #22Austria 28.3South Korea 26.8Italy 24.8Taiwan 22.5Switzerland 22.0Singapore 21.6Germany 21.5Japan 20.5Hong Kong 19.5India 19.1Spain 18.6Indonesia 18.3Thailand 18.3Pakistan 17.8Malaysia 14.8France 13.5Finland 12.0U.K. 7.0 Sweden 6.8 Canada 5.3 Australia 4.8 U.S. 2.0 Earnings Management Around the World (Leuz, Nanda, Wysocki, 2003) 5Accounting in Insider (Code-Law) Countries • Insider Economies (Codified System) – Legal system/accounting rules typically codified by government ministries – Close interplay between government & “major” constituents (large firms, banks, labor unions) • Capital supplied by large banks and other big investors. – Governing boards of firms include banks, labor unions and major suppliers/customers. – Transactions rely less on public information in financial reports. 15.535 - Class #22 6Accounting in Insider Countries • Insider Economies (Codified System) – Continental European Origin • Belgium, Denmark, France, Germany, Italy, Norway, Spain, and Sweden. – Japan: German commercial code & French accounting code adopted in (1800’s) •Result: – Public disclosure has smaller role in accounting reports and rules. • Dominance of private communication • Fewer publicly-traded companies in these countries / Fewer small outside investors 15.535 - Class #22 7Accounting in Outsider (Common- Law) Countries • Common Law System (Anglo-American) – Evolves from bottom up (vs top down) • Dispersed parties involved in “arms-length” transactions – Final arbiter is often the court system: – Financial reports try to present a “True & Fair” picture of firm performance. – Financial disclosures are more detailed. – Generally former UK colonies • UK, United States, Canada, Australia, New Zealand. – Because of trend toward greater litigation in the U.S., the financial reports of U.S. companies have become far more conservative. 15.535 - Class #22 8Implications of Poor Disclosure and “Opaque” Financial Reports • What happens if outside investors cannot decipher a company’s financial report? – Who bears the costs? What are the costs? – PriceWaterhouse Coopers Survey of Corporate Opacity: • The O-Factor • Oi =average of (corruption, judicial and legal rights, economic opacity, accounting and governance opacity, regulatory opacity) 15.535 - Class #22 9Some Differences in Accounting Across Countries • Accounting Rules in many countries allow for “Hidden Reserves” – DEFINITION: An amount by which a firm has understated Shareholders’ Equity in a given year. The understatement arises from an undervaluation of assets or an overvaluation of liabilities. By undervaluing the net assets on this year’s balance sheet, the firm can overstate net income in the future by disposing of the asset. – Why is this allowed in some countries? – What is this entry called under U.S. GAAP and law? 15.535 - Class #22 10Big Differences in Accounting Even in “Similar” Countries USA United Kingdom Asset Revaluations Since 1934, cannot revalue assets upwards (writedowns allowed) Revaluations allowed. Professional appraisers assess value of assets Accounting for Goodwill Purchased goodwill not amortized (check for impairment) Purchased goodwill either immediately write off or amortize LIFO for Inventories Allowed (must be same for IRS report) Not allowed Intangible Assets Only purchased intangibles recognized All intangibles valued – Use DCF or royalty method (appraisers) 15.535 - Class #22 11Differences in Accounting: Solutions • Investors & analysts need information that is consistent across companies – COMPARISON • Diversity of accounting rules makes it difficult to compare companies across countries • Potential Solutions: – Convenience Report: use local GAAP but print the report in language of users – Create 2 sets of reports under different standards (20-F reconciliation) – Use International Standards or adopt U.S. GAAP 15.535 - Class #22 12Differences in Accounting: Solutions • American Depository Receipts: – An American Depositary Share ("ADS") is a U.S. dollar denominated form of equity ownership in a non-U.S. company. – Represents the foreign shares of the company held on deposit by a custodian bank in the company's home country and carries the corporate and economic rights of the foreign shares, subject to the terms specified on the ADR certificate. – An American Depositary Receipt ("ADR") is a physical certificate evidencing ownership in one or several ADSs. The terms ADR and ADS are often used interchangeably. – Each ADR is backed by a specific # or fraction of shares in the non-U.S. company. The relationship between the # of ADRs and the # for foreign shares is called the ADR ratio. 15.535 - Class #22 13Types of ADRs Expand Existing Raising Capital with ADRs Shareholder Base Level I Level II Level III public offer Private placement GDR (global) Description Unlisted in Listed on Shares Placement Global the U.S. US offered & with offering exchange listed in US Institutions Trading OTC Amex, Amex, Private U.S. and NYSE, NYSE, Placement non-U.S.