When Financial Statement Analysis Becomes More of an Art than a Science

Part of a global equity analyst’s job is to deconstruct the financial statements of companies from around the world. This can be a harrowing task, especially when one considers the multitude of differing accounting standards practiced in countries outside the U.S.

American companies and foreign companies listed on domestic exchanges must report financial data using U.S. Generally Accepted Accounting Principles (GAAP), simplifying the drudgery of financial statement analysis.

However, companies that are listed on domestic exchanges, or ones that only trade over-the-counter in the U.S. market, are not required to translate their fundamental data into U.S. GAAP format.

What makes matters worse is that the accounting principles used by many other countries such as Japan, China, and Germany, are vastly different than U.S. GAAP. This makes international comparisons excruciatingly difficult in the best case, and completely irrelevant in the worst case. It takes an informed and astute analyst to understand the differences in accounting practices and be able to reconcile the statements to make them comparable.

Cultural differences in the financial environment of various countries explain the differences in accounting practices. The Anglo-Saxon model (the U.S. and U.K fall into this category) is generally designed to cater to shareholders and investors. The Asian and Germanic model, meanwhile, is geared to tax authorities.

For example, the Price to Earnings ratio (P/E) is simply the price of a stock divided by its earnings per share. However, a company’s earnings per share can vary widely depending on what it wants to reveal or conceal from the tax authorities of the country in which it is domiciled. American firms can amortize the goodwill that arises through acquisition over time, but companies in Hong Kong must write it off immediately. Generally speaking, German firms depress earnings through accelerated depreciation and the use of hidden reserve accounts. Japanese companies, not faced with the requirement to consolidate total subsidiary earnings, have lower reported earnings compared to American companies with similar corporate structures.

And earnings manipulation is just the tip of the iceberg. Various countries ‘ GAAP also outline different ways to treat the revaluation of assets to reflect inflation, the remeasurement of foreign currency revenues, the accounting for pensions and other entitlements, allowance of LIFO versus FIFO inventory accounting, etc.

When one introduces emerging markets into the equation, financial statement analysis becomes more of an art than a science.

While full disclosure and transparency can usually be counted on in developed markets, some Latin American markets would better be described as “translucent” or “opaque”. Indeed, some banking sector companies in Southeast Asian countries have accounting practices so dissimilar to U.S. GAAP, taking them at face value is simply a leap of faith.

The point here is that one must be aware of the reporting differences and accounting slight-of-hand that is used to arrive at the bottom line. Remember to look at the numbers within the context of the local tax environment in which the reporting firm is domiciled. And, remember that corporate accountants can make the numbers conform not to what economic reality is, but to how management wants the market to perceive them.