Problems in Comparing Financial Performance Across
International Boundaries: A Case Study Approach
Mark Whittington
Warwick Business School, Coventry, UK
Key Words:International accounting practices; Financial reporting issues; Dual listed companies
Abstract:In increasingly global markets for finance, goods, and services, a variety of decision makers need to assess companies from numerous countries on a common basis. Differences between national and international accounting principles and practices make such a task difficult, if not impossible.
This article considers the contribution of previous research to resolving this problem. Much of the earlier work in this area has used metrics based on a broad database of companies from many different industries and worked out conservatism indices based on a comparison of profit levels of companies reporting in two generally agreed accounting principles and practices (GAAPs). While useful, this does not address the problems of conversion for any one industry or company. In order to examine the implications of GAAP differences for international comparisons, a case study approach is adopted, considering two of the major players in the European steel industry. Accounting information is produced for both companies under their domestic GAAPs and under United States (US) GAAP, thus allowing for an analysis based on a common, US, GAAP. As a part of this analysis, a time series approach is taken.
The article concludes that there are additional factors that may affect the evaluation of relative conservatism and the financial comparison of individual companies even when carried out on a common GAAP basis.
The use of financial analysis, based on published accounts, is both commonplace and fraught with difficulties. Even within one country, company directors may choose accounting policies that differ from those of their competitors making the validity of any comparison questionable. The level of difficulty is increased if the analysis requires comparison of companies from different countries as the set of available policy choices may be different for each one. The existence of differing GAAPs (generally agreed accounting principles and practices), the reasons for this and the problems caused, has given rise to an extensive literature that has attempted to
The International Journal of Accounting, Vol. 35, No. 3, pp. 399±413 ISSN: 0020-7063. All rights of reproduction in any form reserved. Copyright#2000 University of Illinois Direct all correspondence to: Mark Whittington, Warwick Business School, Coventry CV4 7AL UK; E-mail: m.whittington@warwick.ac.uk.
catalogue and describe differences and develop taxonomies; for example, Nobes and Parker (1998).
In parallel with this literature has been one that has considered the effects on reported performance of alternative GAAPs. A number of adjustment indices, that measure the relative conservatism in the level of published profit, have been developed and these provide a conversion multiplier metric for translation from one GAAP to another (for example, Gray, 1980; Simonds and Azieres, 1989; French and Poterba, 1991; Economist, 1992; Weetman et al., 1998). It is worth noting that all these studies have examined the effect of GAAP conversion on profit rather than that on other measures such as return on equity.
Companies that produce more than one set of accounts, each governed by different GAAPs, have provided one means of comparing the out-turn effect of one set of accounting principles with another. However, these results can only be indicative, as the available companies for such studies are limited in number and unlikely to be an unbiased sample of companies from an accounting regime. Analysis of such companies shows that the degree of disparity in GAAP translation from company to another can be large and impossible to predict from a linear conversion metric. For example, Pareira et al. (1994) calculate that on converting RTZ's net income from UK to United States (US) GAAP, the metric falls by 59 percent in 1993, but the same adjustment to Midland Bank's figures produces an increase of 20 percent. Hence, while conservatism studies are of interest, they would have to be used with caution when applying a conversion ratio to a particular company.
To a great extent, the cause of differences, and any understanding of real underlying performance, is hidden to the external user. Samuels et al. (1995) examined the possibility of translating the accounts from six different European countries as an outsider. They concluded that not enough information was available to the external analyst to make the necessary adjustment (p. 371). Hawkins (1990) is more pragmatic in setting out the Merrill Lynch method of translation, but observes that the method lacked accuracy despite being the best that could be done. The process of mapping raw accounting data to each GAAP that might be published takes place inside the company and is confidential with only the legally required information being made public. This process is shown in Figure 1, taken from Whittington and Steele (1998).
While recognizing this problem of the ``black box,'' the article investigates whether a comparison between two competitor companies, which are based in different countries, might be said to be more meaningful when based on a common GAAP than when carried out based on the companies' domestic GAAPs. In addressing this issue, it also considers the relative stability of translation for one company.
THE NEED FOR COMPANY APPRAISAL
Many companies and individuals need to make economic choices and decisions based on the information available to them. An important subset of decisions faced by companies and individuals require analysis of individual companies and, in many cases, the comparative analysis of competitor companies. For example, an investor concerned to spread risk will attempt to diversify a portfolio over a number of industry sectors. The question that arises is which company in a sector should be chosen and which rejected. Also, companies that trade with others need to assess whether they have chosen the most appropriate trading partner. Figure 2 shows three competing supply chains and the arrows indicate the companies that ``competitor 2'' would need to analyze. In order to decide whether they have the best trading partners, customers, and suppliers, the company needs to analyze each of the available alternatives and to assess its own performance, comparison with competitors is required.
Some of the pieces of the decision jigsaw will be formed from analysis of the accounts of the companies concerned. Indeed, comparative ratio analysis of compa-nies in one industry sector reduces some of the problems inherent in analyzing a company without having considered the context and the particular features of the industry. A company from an industry where cash payment for sales is the norm, for example, may well have a current ratio considerably lower than a second company in another sector whose customers generally pay after six weeks. Such a comparison would not, in itself, reveal whether either company had a liquidity problem.
when the companies concerned are based in different countries with dissimilar culture, relationship between tax (see Lamb et al., 1998) and financial reporting, legal system, and GAAP. Some textbooks, for example Ellis and Williams (1993), advocate a selection process, as in Figure 3, where companies with incompatible accounting policies are weeded out and excluded from analysis. The desire for such a process is understandable, but will not stop senior managers requesting and needing comparison with key competitors, who may be few in number and based in different countries.
This article seeks to provide insight to these issues by adopting a case study approach, considering two key players in the European steel industry.
THE CASE STUDY: BACKGROUND
Competition in the European steel industry is international, but, mostly, still within the continent; the concept of the global steel company is still in the future, but perhaps the near future. Table 1 shows the world's leading steel companies and their sales in million of tons for 1995. It can be seen that, by this definition of size, British Steel and Usinor were the two leading European companies at the time. Both companies produce a wide range of steel products and are alternative suppliers for companies in a variety of industries including construction and vehicles. This implies that a meaningful comparison of their relative performance and financial strength will be important to investors, suppliers, customers, and other steel companies as well as to each other.
financial numbers in line with US GAAP. It might be assumed that such restatement to one common GAAP would improve the quality of analysis that can be undertaken and the quality of any decisions based on the results of such analysis. A time series analysis questions whether using different GAAPs produces systematic differences in the results of the analysis.
Three of the conservatism studies mentioned earlier (Gray, 1980; Simonds and Azieres, 1989; Economist, 1992) provide adjustment metrics for conversion between UK and French GAAP, our interest here. The relevant restated portion of their findings is shown in Table 2. Each of the three statistics implies that French GAAP is more conservative than UK GAAP, but differs in the degree of relative conservatism. A US comparison is also shown because both British Steel and Usinor restate their results for their US investors in accordance with US GAAP. The result shown in the table implies little difference between US and UK GAAP. Other research that has compared US and UK GAAP has concluded that US GAAP is generally more conservative (see Weetman and Gray, 1990, 1991; Weetman et al., 1998).
DATA SOURCES
The information required for the analysis is taken from the public domain. British Steel shares are traded on the International Stock Exchange in London and American Depository Receipts, equivalent to 10 shares, are traded on the New York Stock Exchange. This dual listing requires the company to produce a UK set of annual report and accounts and also a document for the Securities and Exchange Commission, form 20-F. Dual listing Table 1. Largest Steelmakers
Note: Million tons of steel sales in calendar year. Source: International Iron and Steel Institute.
Table 2. Accounting Adjustment Indices
Country Smithers et al. (1992) Simonds and Azieres (1989) Gray (1980)
USA 97 NA NA
UK 100 100 100
in the US has become an increasingly common practice for UK companies with some 90 companies likely to have to file a 20-F for the accounting period covering the end of 1997. The latter contains a wealth of information, including the adjustments required to convert British Steel's profit for shareholders from UK to US GAAP. The changes to convert shareholder's equity from one GAAP to the other are also included. Both the UK and US documents are independently audited.
The data for Usinor is taken from the company's annual report and accounts. Usinor is quoted on the Paris exchange, but unlike British Steel, it does not have a full listing in the US. Investment is possible in the US, however, through private placements. This method does not usually require the filing of a 20-F document, but Usinor provides information on French and US GAAP differences for both profit and shareholders' equity as a note to the English language version of their annual accounts. The company produces its main set of accounts in accordance with both International Accounting Standards (IAS) and French GAAP. The auditor comments that there is a material transaction that is not in accordance with French GAAP (or IAS) in 1993 and 1994. Each year until 1997, the auditor also comments on the translation to US GAAP as being shown ``on a consistent basis,'' but does not state whether the revised figures also conform to US GAAP. This phrase was not Table 3. Adjustments Stated as Required in the Conversion to US GAAP
British Steel (US$) Usinor (US$)
Profit adjustments
Profit attributable to shareholders: domestic GAAP 372 351
Amortization of goodwill ÿ23 ÿ1
Interest costs capitalized (net of depreciation) 31 9
Investment write-down 0 15
Pension costs ÿ30 0
Stock-based employee compensation awards ÿ10 0
Treasury stock 0 1
Rationalization costs 23 0
Deferred taxation 15 ÿ12
Accounting change 0 ÿ23
Profit attributable to shareholders' US GAAP 379 340
Shareholders' equity adjustments
Shareholders' equity: domestic GAAP 7,779 4,478
Goodwill 348 355
Interest costs capitalized (net of depreciation) 231 47
Pension costs 173 0
Stock-based employee compensation awards ÿ19 0
QUEST shares held in trust ÿ30 0
Treasury stock 0 ÿ49
Rationalization costs/ Restructuring provisions 24 16
Deferred taxation ÿ835 121
Investments in equity securities 52 0
Proposed dividend 231 0
Minority interests 0 0
Accounting change 0 61
Investments 0 48
used by the auditors of any of the other French companies filing 20-Fs. For the year ending December 1998 the comment is more straight forward, stating that ``a complete reconciliation. . .is set forth in note 26'' (page F2 in the 20-F for that year).
Table 3 shows the adjustments required for translation of domestic GAAP to US GAAP for both British Steel and Usinor for the years ending March 1998 and December 1997. Note the number of adjustments and that some counter each other out. Hence, there is a greater degree of underlying disharmony between the GAAPs than the net movement in profit or equity suggests.
The two companies do not have the same financial year-ends. British Steel has a financial year-end of March 31 and Usinor, December 31. Despite the 3-month difference, it was decided not to adjust the results, but to compare, for example British Steel's year ending on March 31st 1996 with Usinor's ending on December 31st 1995. Two reasons for this were, firstly, to limit the impact of one-off adjustments to one time period and, secondly, a realization that the UK and French economies did not have identical growth paths. Given a longer time series of data for both companies, the second point might be addressed by considering relative performance at similar stages of each company's domestic economic cycle. The importance of the economic cycle cannot be overstated for companies such as these (Financial Times, 1996).
CONSERVATISM INDICES
British Steel has had a quote in New York and produced a 20-F since privatization in 1988. The prospectus also included a previous year, so there are 11 data points available for the translation. Weetman et al. (1998) examine the trend in GAAP translation for UK companies with US listings from 1988 to 1994. Using the conservatism index first introduced by Gray (1980), they examine whether UK GAAP has moved closer to US GAAP over the period. They find that the distance between the two accounting approaches has widened rather than diminished as the number of companies with a material increase in reported profit when converting from UK to US GAAP has increased. Profit is a residual arising from the gap between revenue and cost, hence materiality of difference is dependent on the size of the gap. Basing materiality on a percentage of turnover would be an alternative, but, as in the case study here, assuming a materiality level of perhaps 3 percent of turnover could easily lead to the disappearance or doubling of profit that would be deemed immaterial.
increase on translation, three of no significant change, and one material fall. The only noticeable trend is that of the last 3 years, two are not significant, and the other is a fall. Hence, for the way in which GAAP translation affects British Steel at least, UK GAAP has become relatively less conservative over the last 3 years than before.
As Usinor was privatized by the French government rather later than British Steel in the UK, there are less years of translation available. All three of the adjustment indices in Table 2 would lead to the expectation that the US GAAP profit reported would be higher than the French one. Table 5 shows that of the 5 years of conservatism indices, two show a material fall on translation from French to US GAAP, two no significant change, and one material rise. When rejecting the loss making 1993, there remains only one significant fall.
The variability in index is high year by year and this might be caused by a number of factors. Changing GAAPs due to introduction of new standards will mean that each year's translation is not necessarily comparable for the one before or the one after. Changing activities of the companies concerned may give rise to more significant positive or negative factors on conversion than before. For example, the movement in the index for British Steel from 1990 to 1991 could be said to be due to the Table 4. British Steel Conservatism Index
Year Index value Ignoring years with losses
1988 0.949 0.949
Year Index value Ignoring years with losses
acquisition and goodwill write-off that British Steel carried out in that year. Indeed, if it had been accounted for in the US manner in the UK accounts, then the conservatism index for 1991 would have been lower than 1990 rather than higher. Both companies have a high level of volatility in their profit levels over the periods under examination and this might also cause a distortion on the translation.
RATIO ANALYSIS
The conservatism index addressed the question of change in profit level on GAAP translation. Investors, and indeed others concerned for assessing company success, are interested in comparing profit to the level of investment made in order to generate the return. This assessment requires the use of ratios such as return on capital employed, return on net assets or return on equity.
The relative conservatism of profit calculation may be undermined by the relative conservatism of the equity stake. As not all changes in reserves are effected through the profit and loss account under some GAAPs, the likely relative change is not clear. However, it is also possible to analyze the effect of GAAP translation on some balance sheet and return based measures as well as profit because the 20-F requires a restating of the equity stake on conversion as well as the profit for the year. A breakdown of the material reasons for difference in both these figures is given by most companies, the alternative being the preparation of complete financial statements to US norms. The key measure analyzed is return on equity, this compares the profit available for shareholders to the level of shareholder investment. The ratio, and movement of it, may be taken to give an indication of relative success or failure.
Table 6. British Steel
Net income 105 51 736 539 1,290 1,318 491 675 384 367
Equity 5,551 5,660 6,641 6,682 7,882 7,972 8,362 8,653 8,370 8,575
Return on
GAAP France US France US France US France US France US
Net income ÿ1,199 ÿ1,559 410 397 1,109 1,258 339 223 372 339
Equity 3,377 3,577 4,136 4,493 5,902 6,297 5,727 6,067 4,691 5,315
Return on equity (%)
RETURN ON EQUITY
Table 6 gives the key figures for both British Steel and Usinor for the last 5 years. The accounting information has been translated into US dollars in order for direct comparison, using average rates for profit and loss account items and closing rates for balance sheet figures.
The relative movement of the domestic and US GAAP lines in Figure 4 indicates that over this limited period there is no linear pattern of adjustment in translating either company's profits from their domestic to US GAAP; this concurs with the conservatism index findings in Tables 4 and 5. Both the UK and US GAAP British Steel figures are higher than Usinor's in every year except 1997/1998, when the French GAAP profit for Usinor is greater than the US profit for British Steel despite still being below the UK GAAP profit. Figure 4 also highlights the similar trend behind each company's result showing how both companies are subject to similar competitive and economic pressures.
Figure 5 shows the size of the equity stake in each company under both domestic and US GAAP. There is a small, but repeated increase in equity when restating both companies' domestic GAAP figures to US GAAP. This appears particularly stable for Usinor. The level of British Steel's equity investment is considerably larger than that of Usinor, hence it is not clear whether the higher profit level of the UK company will translate into a higher return on equity.
privatization to equate the balance sheet size with the value of the issued shares. In effect there is no duty of care due to any stakeholder for this sum as the funds represented by it were not provided by the current shareholders. For the purpose of comparison, however, it needs to be included as it does represent investment made at an earlier stage in the company's life. British Steel's equity stake is also likely to higher than Usinor's due to adopting a different, longer, view of likely asset life. This policy of slower depreciation should lead to higher profits, as seen above, and higher equity stake as long as both companies keep investing in fixed assets.
The return on equity figures, from Table 6, are plotted on Figure 6. Usinor's return for 1993 is not shown as the large negative percentage distorts the y axis range unduly. Again, Figure 6 shows the two companies moving in tandem and that the industry is a volatile one. There is no obvious pattern behind the relative performance of one company against the other or, indeed, between either basis for reporting. It would seem that British Steel outperformed on both a domestic and common GAAP basis in 1993/1994, but that Usinor did the same in 1995/1996 and 1997/1998. The results for 1994/1995 and 1996/1997 are more confused. In 1994/ 1995, British Steel outperforms on a domestic comparison and Usinor does so under US GAAP. In 1996/1997, British Steel outperforms on the US GAAP figures, but Usinor does so on the domestic ones. Without considering the remaining differences in accounting policy choice and application, the figures suggest that since 1993/1994 performance has been fairly similar and certainly that neither company is consistently outperforming the other.
Figure 6. Return of Equity (US$ million).
Figure 7 shows the percentage difference in translating the return on equity from domestic to US GAAP. There appears no common pattern of adjustment here, the particularly large swings in 1996/1997 occurred when return on equity was low. Hence, a difference of 2.2 percent represents a swing of some 60 percent.
CONCLUSION
The degree in improvement in the quality of analysis of using a common GAAP is difficult to quantify. If one of the companies is outperforming the other consistently, then the consistent GAAP analysis does no more to reveal this than the domestic comparison. The seeming lack of predictability, at least from past conversion factors, of the overall effect of conversion to US GAAP, especially for British Steel, as shown in both Table 4 and Figure 7, potentially undermines any attempt to address the problem of future trends and likely relative success of each company. However, some progress towards predicting converted profit or return may be possible because component parts of the conversion could be forecast with some accuracy.
The high level of cyclical variation in the industry may distort consistent differences that might have been found if performance were more stable. The cyclical impact on profit and return for both companies is clearly seen whichever GAAP is adopted.
An analyst is interested in investigating both static and dynamic performance using a variety of analytical techniques and should be concerned about how differences in accounting might potentially undermine any conclusions that might otherwise be reached. Year-on-year changes in relative performance might be caused by a combina-tion of four factors:
a. change in company performance,
b. change in performance of key markets and economies; c. change in corporate accounting policy choice; and d. change in either domestic or US GAAP.
The assessment of underlying corporate performance would be the objective of customer, supplier or competitor appraisal, the other three factors are likely to distort the interpretation of financial results in such an analysis. The differing relative importance of individual markets to each company would need to be understood. In this instance, the French domestic steel market is of greater importance to Usinor and the UK market similarly to British Steel. Both are players in each, but the effect of boom or slump in either will not cause equal joy or pain.
materially affected by the nature of pension funds in the US and how US companies are instructed to account for pension and post-retirement liabilities. Any time series analysis would be affected by the related changes in US GAAP over the last few years.
GAAPs only remain ``generally accepted'' within a short time frame, and in many years, one could argue that introduction of new standards implies a discontinuity from previous results for the same company.
The need to produce comparative company analysis spanning international boundaries is likely to increase rather than diminish as many markets continue their trend to globalization. Analysis of published accounts is not the only tool available; use of stock market data, undercover investigations, conversations with mutual trading partners, for example, are also useful. It would be anticipated, at least by non-accountants, that ratio analysis could play a part in building up a complete picture. Hence, the quality of such analyses remains a serious issue. A line-by-line approach to accounting statement adjustment can be attempted, reworking each company to a common base, but lack of information will force the analyst to rely on their own judgment as well as published information. The additional US GAAP data may assist in this lengthy process. The individual undertaking the task needs to be well informed regarding all relevant GAAPs.
Further Research
The examination of other pairings of companies that report in multiple GAAPs would shed further light on the advantages of common GAAP assessment; choosing an industrial sector with a more stable environment might enable the benefits of using a common GAAP to appear more obvious. Further longitudinal studies of companies to seek out any common adjustment factor for a single firm may also be of interest. The volatility in the conservatism index over time for one company suggests that there may be further work to be done in this area focusing on the underlying causes of the measurement disparity between GAAPs. This article has highlighted the need to assess the effect of GAAP selection on the balance sheet as well as the profit and loss account. There is further work here, too, assessing GAAP impact on issues such as leverage and provisions.
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