DX194092

THE UNIVERSITY OF READING
Thesis for Doctor of Philosophy Degree
by
Samantha Weaver
Department of Economics
International Financial Statement Analysis:

The Reaction of the UK Investment Community
to International Accounting Differences
15th January 1996

International Financial Statement Analysis:
The Reaction of the UK Investment Community
to International Accounting Differences
Abstract
Globalisation of securities markets has caused many members of the investment
community to use foreign accounting data. This paper examines how this foreign data
is used by London-based participants in the market. Hypotheses are established after
looking at the extensive published research on the use of domestic accounting data and
the small amount of published research in an international context. Seventeen market
participants were interviewed, although four of these were treated as a pilot, so that
most findings were based on 13 interviewees working for five institutions. In addition
a questionnaire was circulated to IIMR members in the UK.
If this sample is representative, the findings suggest that most market
participants are inexpert in accounting; sector experts see international accounting

differences as a hindrance but country experts do not, all participants use foreign
accounting data for analysis but very few adjust it (although fund managers think that
analysts do); there is some avoidance of countries or sectors for accounting reasons;
and there is very little knowledge of international accounting differences.

CONTENTS
Page No.
1. INTRODUCTION, PURPOSE, OVERVIEW OF CONTENTS
1.1 Introduction 1
1.2 Globalisation of fmancial markets 1
1.3 The need for foreign fmancial information 2
1.4 Study overview 4
2. ACCOUNTING THEORY; PERCEPTIONS AND CAPITAL

MARKET EFFECTS
2.1 Domestic accounting choice from a domestic stock market

perspective. 7
2.2 The role of analysts in equity valuation 8

2.3 Theories of market efficiency 11
2.3.1 The Efficient Market Hypothesis 12
2.3.2 The Functional Fixation Hypothesis 16
2.4 Summary 18
3. ACCOUNTING CHOICE AND THE BEHAVIOUR OF THJ

INVESTMENT COMMUNITY
3.1 Introduction 20
3.2 Stock valuation: LIFO v FIFO 20
3.3 Goodwill 28
3.4 Current cost accounting 38
3.5 Further accounting choice examples 41
3.5.1 Extraordinary items 42
3.5.2 Non capitalisation of leased assets 42
3.5.3 Creating profit via asset disposal 42
3.5.4 Non-consolidated subsidiaries 42
II
Page No.
3.6 Summary 43
4. DIFFERENCES IN INTERNATIONAL FINANCIAL
REPORTING
4.1 Introduction 45
4.2 Existing literature 47
4.3 Examples of major differences 50
4.3.1 Purchased goodwill 50
4.3.2 Deferred tax 52
4.3.3 Inventory valuation 53
4.3.4 Long term contracts 56
4.3.5 Fixed asset valuation 57
4.3.6 Intangibles 59
4.3.7 Reserves and provisions 60

4.3.8 Capitalised interest 62
4.3.9 Leasing 64
4.3.10 Foreign currency translation 65
4.4 Summary 66
5. INTERNATIONAL FINANCIAL STATEMENT ANALYSIS

/

5.1 Introduction 67

5.2 Are analysts and investors aware of international accounting 67
differences?

5.3 Is accounting diversity perceived to be a problem? 69

5.4 International comparative financial statement analysis: techniques 72

5.4.1 Reliance on macroeconomic data 72

5.4.2 Trend analysis 73

5.4.3 International financial ratio analysis 73
111
Page No.
5.4.4 Restatement of financial statements to a more familiar GAAP 79
(a) Depreciation of tangible fixed assets 80

(b) Consolidation 81
(c) Tax 81
(d) Inventories 82
(e) Goodwill (Japan) 82
(f) Goodwill (US) 83
(g) Deferred tax 85
(h) Pension costs 85
(i) Dividends 86
(j) Revaluation of fixed assets 86

(k) Business combinations 87
(1) Capitalised interest 87
(m) Revenue recognition 88
(n) Disposal of a subsidiary 88
(o) Depreciation 88
(p) Leasing 89
(q) Foreign currency translation 89
(r) Debt/share issue costs 89

(s) Foreign exchange contracts 89
(t) Amortisation of intangible assets 90
(u) Restructuring provisions 90

5.5 International fmancial statement analysis: translation problems 93
5.6 Approaches adopted where accounting diversity is not perceived to 95
be a problem
5.7 The effect of international accounting differences on stock prices 95
5.8 Summary 97
iv
Page No.
6. METHODOLOGIES PREVIOUSLY USED
6.1 Introduction 98
6.2 Research methods focusing upon individual behaviour 101
6.2.1 Interviewing 101
6.2.2 Questionnaires 106
6.2.3 Structured and unstructured observation 108
6.3 Market-based research methods 109
6.3.1 Statistical measures of dispersion 110

(a) Frequency distribution and the interquartile range 110
(b) The co-efficient of variation 111

(c) The co-efficient of skewness 111
6.3.2 Statistical correlation and regression 112
(a) Least squares method 112
(b) The coefficient of determination 113
(c) Testing for significance 114
(d) The Wilcoxon test 114
(e) Pearson product moment correlation coefficient 115
(f) Spearman rank correlation coefficient 115
6.3.6 Previous research employing market based research techniques 115
6.4 Summary 117
7. PROPOSAL FOR STUDY, HYPOTHESES, METHODOLOGY
7.1 Introduction and purpose of study 119

7.2 Hypotheses 122
7.3 Methodology 127
7.4 The questionnaire 128
7.5 The interview 130
V
Page No.
7.6 Sample selection and size 131
7.7 Summary 133
8. QUESTIONNAIRE SURVEY /
8.1 Introduction 134
8.2 Survey findings 136
8.2.1 Is accounting diversity recognised? 136
8.2.2 Are accounting differences a significant hindrance to the 138
measurement criteria used for assessment of foreign
companies?
8.2.3 Do analysts restrict investment to countries/sectors/companies 140
with more familiar accounting practices?
8.2.4 How do users of non-UK accounts cope with accounting 144
diversity?
8.2.5 How do analysts perceive reported profit levels of different 151
GAAP regimes?
8.2.6 Are analysts aware of specific accounting differences? 152
(a) Goodwill 152
(b) Stock valuation 157
(c) Deferred taxation 162
8.2.7 How do analysts allocate funds between domestic and foreign 163
markets?
8.3 Conclusions and implications 168
9. INTERVIEW SURVEY RESULTS

9.2 Survey fmdings 172
9.2.1 Is accounting diversity recognised and does it affect capital 174
market decisions?
vi
Page No.
9.2.2 Do analysts restrict foreign investment to countries with more

180
familiar accounting practices?
9.2.3 Do analysts restrict foreign investment to more familiar
183
sectors?
9.2.4 Do analysts restrict foreign investment to more familiar 184
companies?
9.2.5 Techniques adopted in international investment: How do 186
analysts cope with international accounting diversity?
(a) Reliance upon information less sensitive to corporate 186
reporting, e.g. macroeconomic data
(b) Reliance upon trend analysis using published financial 190
information
(c) Reliance upon ratio analysis using published financial 191
information
(d) Restatement of fmancial statements to more familiar 193
accounting rules, followed by analysis
(e) Other techniques 196
9.2.6 Are analysts aware of the existence of international 197
accounting differences that effectldistort reported earnings?
9.2.7 Are analysts aware of the international diversity between 200
specific generally accepted practices?

(a) The treatment of goodwill 200
(b) The determination of cost for stocks 212
(c) Deferred taxation 215
(d) Other differences: 224
(i) Accounting for pensions 230
(ii) Leases 231
9.3 Concluding remarks and summary of findings 232
vii
10. CONCLUSIONS AND IMPLICATIONS Page No.
10.2 Summary of objectives 234
10.3 Methodologies 236
10.4 Summary of results 238
10.5 Limitations 245
10.5.1 Limitations of the questionnaire survey 245
10.5.2 Limitations of the interview survey 247
10.6 Conclusions and implications 247
10.7 Suggestions for further research 250

BIBLIOGRAPHY 251
APPENDIX A

A. 1 Questionnaire A.1
APPENDIX B: SUMMARISED NOTES TAKEN FROM I]NTERVIEWS

B.1 Organisation 1 B.1


B.2.1 Far East analystlfund manager B.5

B.2.2 European analyst/fund manager B.7

B.2.3 Japanese analyst B.10

B.2.4 US/Canadian analyst B.11


B.3.1 Capital goods analyst B.15

B.3.2 European chemical sector analyst B.17

B.3.3 Transport and aviation analyst B.20
VII'
Page No.


B.4.1 French analyst B.22

B.4.2 Swiss and Belgian analyst B.25


B.5.1 Continental European fund manager B.27

B.5.2 Asian fund manager B.31


B.6.1 SE Asian fund manager B.33

B.6.2 UK fund manager B.36
ix
CHAPTER 1
INTRODUCTION, PURPOSE AND REVIEW OF CONTENTS
1.1 INTRODUCTION
This thesis is concerned with the awareness in capital markets of the differences in
international corporate fmancial reporting and with the effect that accounting differences have
on capital market decisions. The empirical research that has been undertaken has focused
upon UK professional users of non-UK financial statements, e.g. analysts and fund managers,
in an attempt to establish the following:

• Is accounting diversity recognised by professional users of non-UK financial statements?
• Does international accounting diversity present a problem for such users, and if so is it an
insunnountable one?
• If international accounting diversity is not a problem, why not? If it is a problem, how do
users of this information cope?
This introductory chapter seeks to fulfil three intentions: firstly, to explain the need
for a better awareness of some of the aspects of international accounting, secondly to outline
the purpose of this study and finally to provide an overview of the contents of this study.
1.2 GLOBALISATION OF FINANCIAL MARKETS

Financial markets are progressively becoming globalised, that is to say that "markets
in different parts of the world have become integrated to a sufficient degree to affect price-
setting mechanisms and other conditions under which capital is obtained or invested" (Smith,
199 1, p 2.2). The trend towards globalisation can be traced back to the 1960s with the onset
of the Eurocurrency and Eurobond markets but it was in the period 1981 to 1986 that
international and domestic markets integrated substantially. This is principally attributable to
deregulation and technology. (For in-depth accounts of the trend towards globalisation see
Scott-Quinn, 1991 and Smith, 1991).
However, the trend towards true globalisation is still in its infancy. The early stages
of globalisation only attracted the more sophisticated market participant who was previously
familiar with foreign markets. The present situation in the major stock markets reflects the
conversion of the less sophisticated operatives into global market users. Such operatives
include the majority of fmancial market participants in the world and this will therefore have
an enormous effect upon the world's stock markets once the process of globalisation has
matured. The extent of globalisation over the past decade is illustrated by the fact that
foreign direct investment has increased by 300% since 1980 and foreign holders of US
securities have increased by 200% in the same period. Furthermore, at the end of 1988, 6.7%
of world equity market capitalisation was held by cross-border investments (Choi and Levich,
1991, p2). Further examples are given in Table 1.1.
1.3 THE NEED FOR FOREIGN CORPORATE FiNANCIAL INFORMATION

Globalisation has led concurrently to an increased interest in foreign financial
information and, as the process of globalisation increases, the demand for more
comprehensive international financial information of a higher quality will be required.
Readership of international financial accounts is at an all time high and, as stated, looks set to
be on the increase. Investors now face attractive returns and diversification benefits from
foreign portfolio investments, eased by improved communication, technology and the
deregulation of foreign markets. Furthermore, following the surge of merger and acquisition
activity of foreign finns in the 1980s, interest in appropriate financial data is paramount.
2
Table 1.1 Foreign turnover and the number of foreign companies listed on seven
of the world's major exchanges.'
Global competition has also led to an increased requirement for foreign financial data
as the basis for competitive analysis, pricing policies, credit decisions and other business
decisions:
"Continued reduction in national trade barriers, the emergence of Europe as a unified
market, the convergence of consumer tastes and preferences, as well as growing
sophistication of business firms in penetrating foreign markets, directly or indirectly through

joint ventures, strategic alliances, and other co-operative ventures, has intensfled the
competitive context of multinational business" (Bartlett and Ghoshal, 1989).
1 Derived from J. Cochrane (1994, p13).

It is not sufficient to rely solely on macroeconomic and market data as a basis for
analysis. Problems follow if country allocation is based on GNP weighting, as this can only
be taken as a good indicator of the country as a whole, not of specific sectors or companies.
Hence, a company performing exceptionally well in Greece or Austria, for example, could be
overlooked due to these countries having low GNP weighting assigned to them.
Specific information relating to the potential companies targeted for investment is pre-
eminent. There are however numerous obstacles relating to the use of foreign financial
statements. These include differences in language and terminology, formats and the level of
disclosure, accessibility and timeliness of financial statements and the relative divergencies in
different GAAP regimes. These barriers are not insuperable if the users of the accounts are
aware of and well informed of the heterogeneous nature of international accounting. The
main body of this study is concerned with this issue, focusing upon the international and
comparative aspects of corporate fmancial reporting and how this affects capital market
decisions and the ultimate distribution of wealth.
1.4 STUDY OVERVIEW

There are four distinct parts to this thesis. Attention is initially cast upon the theory of
accounting choice. This highlights the effects of accounting choice i.e. the adoption of one
accounting method rather than another by corporate managers on the stock market in a
domestic context. In order to evaluate the valuation methods employed by analysts and
investors, it is imperative to understand the consequences of the adoption of one accounting

method rather than another. This is important because of the distinction between cosmetic
accounting choices and real accounting choices. A cosmetic accounting choice is a change in
accounting method which alters the results of the company so that they appear in a better
light, usually to increase or smooth profit, although the real position of the company has not
changed i.e. there is no effect on cash flow. This is often referred to as 'window dressing'. A
real accounting choice, on the other hand results in economic consequences for the firm by
4
way of an increase or decrease in cash flow, primarily in the form of increased/decreased
taxation liabilities. Consequently, real accounting choices leading to increased cash flows
usually result in lower reported profits. Examples of cosmetic accounting choices include
depreciation and goodwill in the UK, and a real accounting choice example is LIFO
adoption for stock valuation in the US.
Furthermore, a review of the opposing fmancial theories, the Efficient Market

Hypothesis and the Functional Fixation Hypothesis, together with some related empirical
evidence, detailed in chapter two, helps to shed some light upon the degree to which the
major stock markets of the world can see through accounting choices and classify them into
those which have a real economic consequence and those that do not. In chapter three the
accounting choices highlighted in the previous chapter are further illustrated with a detailed
'case study' style examination of the effects of two major accounting choices, the LIFO v
FIFO experience in the US and accounting for goodwill in the UK.
With this background it is possible to proceed to the second part of the thesis which
examines in detail the differences in accounting practice and procedures between a group of
selected countries (chapter four). In deciding which countries should be used to illustrate the
comparative aspects of international accounting, the list of vital countries highlighted by both
Nobes and Parker (1991b, p 11), and Mason (1978, p 77), was considered and partially
adopted. The resulting countries are the UK, US, Germany, France, the Netherlands and
Japan. Some comparisons are also made in reference to Italy, Belgium, Sweden, Greece and
Spain.
The accounting practices of these countries are examined in order to substantiate the
major differences between the different GAAP regimes. The areas of accounting practice
examined in detail include purchased goodwill, deferred tax, inventory valuation, long term
contracts, fixed asset valuation, intangibles, reserves and provisions, capitalised interest,
leasing and foreign currency translation. These areas were chosen for study following a
review of existing empirical research in this area, for example Sinimonds and Azières (1989)
and Weetman and Gray (1991), which highlighted their relative significance.
The third area of this research is concerned with international financial statement
analysis (chapter five). It is at this stage that existing techniques of international investment
appraisal are examined. The field of inquiry addresses such issues as whether analysts are
aware of accounting diversity and whether accounting diversity is perceived to be a problem.
It is also of paramount importance to ascertain how analysts deal with diversity and what the
capital market effects of international accounting diversity are.

The final section of this study details methodologies previously used within this field
(chapter six), and the proposals for this study, the hypotheses to be tested and the
methodologies available (chapter seven). The resultant methodologies, being a questionnaire
survey and series of interviews directed at professional investors (analysts, brokers and
bankers) and the findings made are addressed in chapters eight and nine respectively. A copy
of the questionnaire survey used is contained within Appendix A. A summary of the joint
results from both surveys together with the limitations and proposals for further research are
detailed in the concluding chapter (ten).
6
CHAPTER 2
ACCOUNTING CHOICE THEORY; PERCEPTIONS AND

CAPITAL MARKET EFFECTS.
2.1 DOMESTIC ACCOUNTING CHOICE FROM A DOMESTIC STOCK

MARKET PERSPECTIVE.
This chapter attempts to highlight the effects of accounting choice on the stock market
in a domestic context. Accounting choice refers to the adoption of one accounting method
rather than another by corporate managers. In endeavouring to explain the behavioural
response of managers to different accounting choices it is imperative that an understanding of
the equity valuation methods employed by analysts and investors are examined. Focus will
therefore, primarily fall upon the role of analysts in valuing companies. A review of previous
research in this field will be examined (Day, 1986; Hand, 1990; Tinic, 1990), evidencing the
overt attention paid to 'the bottom line' and to financial ratios during equity valuation. The
conclusions drawn from the aforementioned studies are central to the issue of
misinterpretation in both national and international financial statement analysis, as it is clear
that focusing upon a few ratios and accounting numbers is insufficient, especially where such
financial indicators are open to manipulation and 'window dressing'. A review of the
opposing financial theories, the Functional Fixation Hypothesis (FFH) and the Efficient
Market Hypothesis (EMH) will follow with empirical evidence endeavouring to shed light
upon the level of efficiency in the major stock markets of the world, i.e. whether the market
can distinguish between accounting choices that have economic consequences and those of a
purely cosmetic nature. Examples of different accounting choices and the associated stock
market effect will follow, taking comprehensive illustrations from the goodwill experience in
the UK and LIFO in the US.
7
2.2 THE ROLE OF ANALYSTS IN EQUITY VALUATION
In an array of attempts to understand how the stock market assimilates information,
many researchers have empirically produced evidence of the information sources commonly
used by analysts in making investment recommendations to their clients. Arnold and Moizer
(1984), Lee and Tweedie (1981), and Day (1986) unanimously found the annual report to be
the most important information source for equity valuation. More recent papers (such as
Pike, Meerjanssen and Chadwick (1993) on UK and German analysts; Gniewosz (1990) on
Australian analysts; and Breton and Taffler (1990), a UK based study) observed direct
company contacts and visits to be of more importance than the company accounts. It has
been argued by Arnold and Moizer (1984) that this may well have been the case but that, at
the time of their research, analysts questioned might have instead been concerned with
allegations about insider information. Thus it would seem that analysts are now more willing
to admit to such meetings. An alternative explanation of the apparent shift away from
dependence upon financial statements could be that companies are now, due to environmental
pressure, more willing to provide better quality information to the capital markets, creating
Investor Relations Departments designed to fulfil this communicative task (Pike et al, 1993,
p20). Other information sources mentioned by analysts questioned in the above studies
include preliminary announcements, interim statements, previous work and market data
already collected, trade journals and newspapers, industry statistics, retail price index, extel
cards, textline, data stream and other analysts.
Due to the significance of published financial statements in equity appraisal it is

therefore of interest to assess the information content of such documents together with their
usefulness. Day (1986) attempted to establish what information is used by analysts and to
what extent. Although her conclusions were in accordance with earlier studies, Day
evidenced financial statements to be important documents for equity valuation, but useful
only as a base from which to work, a reference document not seen as containing price
sensitive information. Furthermore, Lee and Tweedie (1977, p50) found that investors were
seen to make little use of financial statements, possibly because they appear not to understand
them. Analysts are perhaps the best infonned users of fmancial statements although the
proportion of investment analysts who possess any form of accountancy qualification is
exceedingly low (Day, 1986).
The methodology used by Day (1986) to obtain the following data, was to ask a
number of analysts to perform their usual analysis of selected accounts as if they were seeing
them for the first time. In reality analysts track companies and are therefore familiar with
company details, so some scepticism as to the extent that the results reflect actual practice is
warranted. All analysts were extremely interested in the amount of gearing a company had.
One analyst was quoted as saying "above 50% (gearing) the company is working more for
the bank than the shareholders". Dividends and sales, in connection with profits, were also
of much interest. Around half of the analysts interviewed used ratio analysis extensively as
part of a preliminary analysis of the company. There was also a reliance on intuition, general
knowledge and information about the industry, company and general economic background.
Day (1986) quotes an analyst saying "I look through the accounts to see what has changed
since last year and f there is anything out of the ordinary, unusual or unexpected" The
degree of comprehension of individual accounting policies was minimal, with many analysts
confessing a lack of understanding of the accountancy treatment of taxation, how the
accounts dealt with associate companies, and the concept of funds flow. This is congruent
with Lee and Tweedie (1981, pp 3 5-44), whose findings showed that the level of
understanding of accounting information by the institutional investor was not as high as
expected, especially with reference to accounting terminology and financial ratios, for
example, knowledge of the definitions of profit, depreciation, price earnings ratio and
dividend yield were vague (p 43). Analysts were also observed to dislike companies altering
their accounting policies as this made analysis and the following of trends difficult to follow.
The importance of financial ratios as an appraisal technique of investment analysis is

widely recognised. Arnold and Moizer (1984) described the role of analysts as attempting to
arrive at a buy, sell or hold recommendation on the company's shares and found them to do
9
this, broadly speaking, by estimating the future earnings in order to calculate a forecast share
price by using the company's current price/earnings ratio. A comparison of the current share
price and the forecasted future share price will indicate whether the shares are currently over
or under priced, or priced correctly. Thus earnings per share is viewed as an indicator of
growth in future profits. The extent of the use of ratio analysis is well documented, for
example in a recent study paper by Pike, Meerjanssen and Chadwick (1993), examining the
appraisal of ordinary shares by investment analysts in the UK and Germany, conclusions
were drawn from field research that are consistent with this. The price/earnings and
price/cash flow ratios were found to be held by analysts as by far the most useful appraisal
techniques in both the UK and Germany. Lagging behind by a substantial difference in

popularity came the net assets per share ratio for the UK; ranked third by German analysts,
the dividend growth model and discounted cash flow. In the UK technical analysis and Beta
analysis were not deemed to contain a high degree of utility. On the contrary, German
analysts regard technical analysis as the second most important method and the dividend
growth model as being rather insignificant. Explanations for this disparity concerning the
state of development of the stock exchanges of the two countries have been given by the
researchers. London is commonly accepted to be more efficient than the German exchanges
(Beaver, 1989; Goodhart 1985; Darrat, 1987) and therefore permits less scope for the use of
technical analysis.
Citing evidence from the numerous above studies, the following can be stated:
• analysts rely on published fmancial statements as an integral part of equity appraisal;
• the use of financial ratios is paramount to such valuations;
• analysts' level of knowledge and understandability of accounting policies is low.
Consequently it would be expected that the management of companies would attempt

to present their firms in the best possible way, for example improving solvency and profit
indicators (Morris and Breakwell, 1970) through the use of accounting policies. This process
is known as 'window dressing' and although the accounts are drawn up in accordance with
10
GAAP, the directors and auditors fail to show a true and fair view of the company, an
overriding accountancy concept that must be adhered to. Evidently the resulting financial
statements are misleading.
There is widespread belief in the existence of window dressing and creative
accounting (Griffiths, 1986; Jamieson, 1988; Smith, 1992). Academic research has focused
for many decades upon the ability of the stock market to interpret information, observing the
effect such practices have on share price and investor behaviour, i.e. whether investors see
through the manipulation of accounting numbers or if they are accepted at face value due to a
lack of understanding of how the figures are calculated.
The first reported study examining stock prices was by Bachelier (1900) who
discovered that commodity price changes on the Paris Bourse followed a random walk.
Almost a century on, academics are still divided on their views of market efficiency. The two
principal schools of thought lie in the Efficient Market Hypothesis (EMH) and the Functional
Fixation Hypothesis (FFH). A review of these paradigms follows.
2.3 THEORIES OF MARKET EFFICIENCY.
The issue of resource allocation is important in any society, especially in terms of

growth; it is also central to the theory of efficiency in markets. Capital markets such as the
London Stock Exchange are central to resource allocation as they act as intermediaries
between lenders and borrowers, sellers and investors. This role is fulfilled by determining the
price of securities. If this pricing mechanism is poor the allocation of resources becomes
inefficient as speculation occurs on the market resulting in higher borrowing costs as less
funds become available.
Ideally capital markets should be perfect in order to ensure efficiency of allocations.

However, no capital market is perfect due to the existence of factors such as transaction costs,
irrational behaviour by participants, regulation and imposed restrictions, the lack of
11
marketability and divisibility of securities and the absence of perfect competition. it is more
useful, therefore, to determine whether a market is efficient within the bounds of its intended
role i.e. as price setter. This presupposes informational efficiency, in which prices would
fully, instantaneously and in an unbiased manner reflect all available infonnation. If this was
correct security prices would provide accurate signals for resource allocation.
The London Stock Exchange has characteristics that pertain to those of an efficient
market. For example, there are many independent participants within the market who provide
liquidity, competition between dealers and brokers and the monitoring of deals which helps
prevent monopolistic tendencies from any one buyer or seller. Statute law and stock
exchange rules from the Securities Association and the establishment of self regulating
bodies help restrict, although do not prevent, price manipulation and insider trading. Entry
and exit to and from the market is relatively unrestricted and information is widely available
and relatively cheap.
Although the above are necessary conditions for an efficient market they are not
sufficient. An array of empirical work and research has been carried out in attempts to
discover the determinants and implications of efficiency and the degree upheld in the market
place. The majority of these studies have focused on the EMH and/or FFH. EM}I will be
considered first.
2.3.1 The Efficient Market Hypothesis.

The traditional form of the EMil exists as a triple layered hierarchical model,
distinguishing between possible levels of efficiency present in capital markets. The
classification into weak, semi-strong and strong forms of efficiency is attributable to H. V.

Roberts (1967), who developed this structuring as a by product of his research in the area.
The weak form of efficiency suggests that the current share price incorporates all past
information concerning trading volumes and historical prices. Thus no trading rule that relies
12
on these fundamental elements will produce excess returns as share prices change only in
relation to new information, which by definition is unbiased and unpredictable. Changes in
share prices should occur randomly and are thus said to follow the 'random walk' pattern.
Thus, price at time is equal to price at time t1 plus a random variable, e, where e' is
distributed independently of e", e 2 etc.
Le. F' = Pt-i + et
Semi-strong efficiency holds that market prices fully and instantaneously reflect all
past information relating to price and trading volumes and all information which is publicly
available and relevant to the share price. In this sense share prices are said to be 'correct' and
provide accurate signals for resource allocation. Thus changes in reported earnings figures
would cause a change in the market price of the security only if they signal a corresponding
change in the level and/or risk of future cash flows, and that the information was not
previously available in any other form to the investor. Due to the level of sophistication of
the market, participants soon learn to distinguish between those accounting policies that
affect cash flows and those that have no economic consequence.
Strong form efficiency incorporates the pre-requisites of both the weak and semi-
strong forms and further states that all information whether publicly available or not is
embodied in the share price. Thus, insider information is included as having an effect on
share price.
Numerous tests have been carried out to test for all forms of efficiency. The principal
methodologies used to test for weak form efficiency are statistical studies of share price
movement using serial correlation and the examination of various trading mechanisms
devised by traders (Fama and Blume, 1966). With reference to the former, there is
overwhelming evidence to support the notion that weak form efficiency exists in the UK
(Kendall, 1953; Alexander, 1961) in the NYSE (Moore, 1964), in the French Bourse
(Bachelier, 1900) and for other major world stock exchanges (Cooper, 1982).
13
Empirical evidence also finnly supports the presence of information efficiency in the
semi-strong form in most of the world's largest stock markets (Firth, 1976; Jensen, 1968;
Sunder, 1973; Kaplan and Roll, 1972; Scholes, 1972; and others). Such research concentrates
on the ability of the market to anticipate share prices before new information is made publicly
available. Many tests of this form of efficiency rely on the presence of an information release
that is expected to dramatically alter share price. This is necessary because many factors can
influence share price concurrently, such as economic conditions and simultaneous
information releases. For this purpose stock splits are a common data source for residual
analysis.
Testing for strong form efficiency is problematic as it involves examining the effect of
insider information on share price. Insider dealing is an illegal undertaking in many stock
exchanges and therefore finding a suitable database for research is difficult. For this reason
many researchers have redefmed 'an insider' to include professionals who use privileged
access to additional information concerning companies to gain excess returns. This usually
implies an industrial specialist such as a mutual funds manager or an analyst (Sharpe, 1972).
Strong form efficiency is not believed to exist in any stock exchanges of the world, as
insiders in practice have been observed to gain an excess of 5% above the average return for
participants. Thus, empirical evidence would support the presence of semi-strong form of
efficiency in the major markets where the research has been conducted.
Therefore, market prices fully and instantaneously reflect all available information. In
this sense share prices are said to be 'correct' and provide accurate signals for resource
allocation. Thus, changes in reported earnings figures would cause a change in the market
price of the security only if they signal a corresponding change in the level and/or risk of
future cash flows, and that the information was not previously available in any other form to
the investor. Due to the level of sophistication of the market, participants soon learn to
14
distinguish between those accounting policies that affect cash flows and those that have no
economic consequence.
There is some empirical evidence suggesting that different degrees of information
efficiency exist in different sectors of the market. Size has been cited as a key variable:
Foster, Olsen and Shevlin (1984) found large differences in excess returns between the largest
and smallest finns in their analysis. The small finns examined were observed to exhibit
abnormal returns up to five times larger than those experienced by larger companies.
Bhushan (1989) and Richardson (1984) for example suggest that this could be attributable to
the fact that larger companies publish more information in the press and are tracked by a
larger number of analysts. The increase in competition between investment analysts ensures
that all information will be evaluated immediately it becomes available and thus the share
price will be duly altered. Thinly traded shares and markets would therefore not be expected
to exhibit as strong a degree of efficiency as frequently traded securities/markets. For
example, Cooper (1982) found evidence of inefficiency on the Bombay stock market as 25%
of the following day's price can be explained by the previous day's price.
Anecdotal evidence concerning the behaviour of the investment community appears to
be contrary to the general empirical evidence supporting market efficiency (Hines,1982). For
example, one implication of EMH is that it is impossible consistently to earn abnormal profits
for the amount of risk borne, yet many investors and analysts invest resources to discover
mispriced securities. This practice is necessary in order to uphold this level of efficiency, yet
seems irrational as abnormal profits are lost through this competitive action. Further
evidence suggesting disbelief in market efficiency is the practice of the manipulation of
accountancy figures. As stated, an efficient market can distinguish between window dressed
accounting values and the underlying intrinsic value of the firm. For example accounting
choices concerning the treatment of goodwill or depreciation will be recognised as being of a
cosmetic nature and accounting choices that have a real effect on cash flow, such as adopting
LIFO as opposed to FIFO, in an inflationary environment with tax rules that allow the use of
15
LIFO for assessment (e.g. US), will effect share price. A query that therefore needs to be
addressed is, why do managers, and the investment community waste resources in any
attempt to beat the system? The answer probably lies in the actual beliefs of the investment
community as to the degree of efficiency in the market as opposed to the actual degree of
efficiency present.
2.3.2 The Functional Fixation Hypothesis
Also referred to as the naive investor or mechanistic hypothesis (Foster, 1986 p 443),
FFH claims that members of the investment community who are unfamiliar with accounting
policies that produce different accounting outputs, rely on the bottom line, i.e. earnings,
without paying any attention to how this figure has been generated. Foster, 1986 (p 444) also
suggests a myopic hypothesis which states that the capital market has a short-nm focus on the
current year's reported earnings, rather than a focus on a multiyear horizon. Thus, changes
in accounting numbers have an impact on share price, regardless of whether the underlying
fundamentals of the company, the level and/or risk of future cash flow, have altered. As
investors experience difficulty in decoding financial information (Lee and Tweedie, 1977, the
private investor and, 1981, the institutional investor) there exists the potential for investors to
be led astray through window dressing or creative accounting. To ensure any degree of
efficiency in such an environment, Breton and Taffler (1990) recognise the need for analysts
to be able accurately to interpret the accounts and transmit this information to the market.
Both theories rely on the actions of the financial analyst in the process of circulating
information and price setting.
Empirical evidence regarding the FFH is not unanimous, with incongruent

conclusions being drawn as to its validity and belief by the investment community. Jensen
(1968) drew conclusions concurrent with FFH. The research was based upon experiments on
analysts asked to provide decisions based upon information produced from a variety of
accounting policies. Investors exhibited j'unctional fixation' in a similar research programme
16
executed by Ashton (1976) and further evidence supporting FFH can be found in Abdel-
Khalik and Keller (1979).
All of the aforementioned research shared similar research design, questioning the
individual analyst. However it is the market as a whole that is of concern as it is important to

know if stock prices are set by investors who are functionally fixated on accounting figures.
Prices are discovered through competitive actions, where investors have different levels of
knowledge, experience, wealth and risk tolerance, which cannot be simulated by a couple of
investors. Hand (1990) and Harris and Ohison (1990) have attempted to test the FFH in a
more scientific manner using regression analysis on stock market data, with similar research
designs to many of the tests examining EMIT. Hand (1990) tested a middle ground between
FFH and EMIT, whereby both sophisticated and unsophisticated market participants exist.
Hand claims that some stocks at some points in time are determined by unsophisticated
investors, who are fixated on bottom line accounting numbers. Conclusions were stated that
supported the modified version of FFH but were inconsistent with EMH. Harris and Ohlson
(1990) also gave evidence that was inconsistent with both the EMil and FFH in its traditional
form, providing an interesting insight as to how accounting numbers are interpreted and their
effect on share price. However, both these results are only preliminary and more empirical
work needs to be carried out to reinforce evidence of functional fixation.
Tiniç (1990), in criticising Hand (1990) has highlighted possible flaws in the research
design. For the weak form of FFH to exist, there must be limiting conditions that rule out
arbitrage by the sophisticated users. Knowledgeable investors, if unrestricted, would
otherwise exploit the market in taking advantage of the mispricing of securities by those
participants who are functionally fixated. Such restriction could be a lack of wealth or risk
aversion of the sophisticated investor relative to the unsophisticated investor. Thus any
systematic errors made by the fixated investor will not be arbitraged away immediately,
allowing a fraction of error to remain in the share price. Secondly conditions must be
imposed to prevent unsophisticated investors from gaining by the learning process, or at least
17
that the learning period is reasonably long. Market participants who are unwilling to incur
the costs of discovering the effects of different accounting policies, can learn the effects from
the cumulative behaviour of other investors by observing share price. Furthermore if they
recognise their deficiency and rely on other information sources they will not fall prey to the
more knowledgeable investors, losing their wealth and being forced from the market. Weak
form FFH relies on the co-existence of these two types of investor, therefore if
unsophisticated investors become knowledgeable or are forced out of the market due to
diminished wealth there must be conditions whereby they are replaced by more
unsophisticated investors:
"Without such formidable conditions it is virtually impossible to make a compelling a priori
case for the proposal that equilibrium stock prices are determined by functionally fixated
marginal investors." (Tinic, 1990, p 787).
The above review of the opposing stock market efficiency theories is intended to
provide a background for the explanations of how accounting choice theory can influence
share price. A conclusion that is both definitive and pellucid is yet to be reached. However,
both paradigms should be considered in any capital market based research that involves
accounting diversity.
2.4 SUMMARY
This chapter attempted to highlight the effect of accounting choice on stock markets
in a domestic perspective. In order to understand why one accounting policy is chosen over
another it was first necessary to examine how analysts and/or investors evaluate potential and
current investments. Resulting evidence as reviewed here, suggested the following:

• analysts rely on published financial statements as an integral part of equity appraisal;
• the use of trend analysis and fmancial ratio analysis is paramount to such valuation and;
18
• analysts level of knowledge and understanding of accounting policy choices and the direct
effects of such choices on reported profit levels and asset values is low.
With reference to the two leading, and opposing, theories relating to market
efficiency, EMH and FFH, accounting policy choice can be explained to some degree.
Firstly, if EMH held, that is if analysts believed that capital markets were efficient, no
resources would be employed in cosmetic accounting choices, as the market would be able to
see through this and the share price would not be altered. Furthermore, analysts would not
undertake trend analysis as efficient markets would not permit consistent gains above
transaction costs through the use of such a strategy. Secondly, if analysts believed that
markets are not efficient and instead investors driving the share prices were fixated with
certain accounting numbers (FFH) the use of cosmetic accounting would be rife. Thus, if the
market is driven by naive investors, traders would be able to make consistent gains using
fundamental analysis.
These two views on market efficiency are fundamental in trying to understand both
company and market behaviour. Unfortunately, a clear and defmite conclusion has not yet
been reached which favours either theory as the review of conflicting empirical research
suggests. The problems are even greater when viewing accounting policy choices from a
global perspective as little is known as to how international stock markets work and absorb
information. This global perspective is dealt with in the following chapter.
19
CHAPTER 3
ACCOUNTING CHOICE AN]) THE BEHAVIOUR OF ThE

INVESTMENT COMMUNITY
3.1 INTRODUCTION
This chapter is intended to highlight the behavioural response of the investment
community towards accounting choice, building on the conclusions drawn from chapter two.
Endeavouring to examine the level of sophistication of the investment community in
distinguishing between the real and perceived effects of alternative accounting choices, a
comprehensive examination of several accounting choices will be undertaken in a case study
style. An effective method of examining the transparency of accounting choice is to consider
the impact of policy change on stock price. For this purpose there will follow a detailed
examination of the stock market reaction to the change in stock valuation method during the
late seventies in the US : if LIFO is chosen over FIFO, with increasing stock prices, LIFO
leads to a lower profit figure which is acceptable for taxation, therefore increasing cash flow
within the company, i.e. a real accounting choice. A cosmetic accounting choice is also
examined via the effects of goodwill accounting in the UK.
3.2 STOCK VALUATION; LIFO v FIFO

The method of stock valuation chosen by a company can have a real economic
consequence for the distribution of wealth, as prevalent in the US. The adoption of LIFO
(Last in First out) during periods of rising inventory prices can have significant tax benefits,
assuming non decreasing stock levels, when compared to alternative methods such as FIFO
(First in First out). This arises because the most recent purchases are deemed to be disposed
of first, thus attempting to represent something closer to replacement cost for the profit and
loss account. However, the closing stock figure is consequently valued at the purchase price
of the earliest obtained items of stock. The resulting high cost of goods sold figure and
hence lower net income figure reflects the non-realisation of inventory holding gains. In tax
20
regimes, where LIFO is acceptable for the determination of taxable income, the after tax cash
flow is therefore higher using this method. As increasing cash flow is consistent with the
financial objective of the firm to maximise shareholder wealth, this should be interpreted as
beneficial and, ceteris paribus, firms adopting LIFO are more attractive than FIFO firms.
Assuming prices are rising, if the stock market is efficient with regards to accounting
information, this should result in an increase in the stock price of the LIFO firm even though
reported earnings have decreased, along with numerous accounting ratios used for analysis.
Within the UK LIFO has not been widely used, principally because a tax case
prohibits its use for tax purposes and it is not recommended under SSAP 9. In the US
however LIFO is permitted for tax purposes under the Inland Revenue Codes of 1938 and
1939, as long as it is adopted for fmancial reporting purposes. LIFO adoption was not
widespread in the US until the economy experienced periods of high inflation (1 974-5).
Under such conditions the advantages of adopting LIFO can be great. For example, Biddle
(1980) and Morse and Richardson (1983) have documented potential annual tax savings of
several million dollars for each of many firms examined, e.g. Biddle estimated that each of
the 105 FIFO firms in his analysis paid an average amount of $26 million in additional
federal income tax. The surge of companies adopting or extending their use of LIFO in this
period, being more than a fourth of the manufacturing and merchandising firms listed on the
NYSE, has led to a wealth of research examining the effects of accounting change on share
price. This body of research will be examined and discussed, focusing on the issue of
whether this accounting change can be clearly perceived as having an economic consequence.
The way in which this information is conveyed to the market and the implications that
it has regarding share price depends upon the level of efficiency within the market. This can
have far reaching implications concerning the operating and fmancing decisions of the firm
by affecting the terms on which the firm obtains additional financing, and hence altering
management's perceived cost of capital and the nature of the projects undertaken. Economic
consequences also arise for shareholders as the market value of their wealth alters which can
21
have implications concerning their investment/consumption behaviour. All the research to be
examined assumes market efficiency, that is to say: prices act as if every investor knows that
the firm has changed accounting methods, knows what those methods are and what impact
they have on reported earnings, and knows the potential implications for management's
motivation to make such a change (Beaver, 1989, pp 112-115).
If the EMH holds for accounting information, one would expect all firms that are able
to benefit from the increase in after tax cash flow, stemming from the adoption of LIFO, to
use LIFO as the market will duly reward this action through an increase in the current price of
the firm's securities. Empirical evidence suggests that this is not the case, implying that
either the tax benefits are not so large or there are other considerations which outweigh the
benefit.
Ricks (1982) provides evidence that change firms, i.e. those adopting or extending
their use of LIFO, were enjoying a more profitable year than non-change firms in the sample
examined. With respect to the average EPS, change firms experienced a 10% increase on a
LIFO basis, being equivalent to 47% on a FIFO basis, whilst non-change firms exhibited an
average 2% decline (FIFO basis).
Furthermore a high percentage of the non-change firms had large tax loss carry
forwards in 1974 suggesting a lack of incentive to adopt or extend the use of LIFO. Abdel-
Khalik and McKeown (1978) also noted that the market reaction to switch firms was
dependent and consistent with the direction of the change in EPS compared to the previous
years.
However, there may also be inefficiencies: for example, as reported by Abdel-Khalik

and McKeown (1978) and Ricks (1982), the fact that the adoption of LIFO has an inverse
effect on reported earnings. The concern here is whether the market reacts positively to the
increase in the present value of future cash flows or negatively to the decrease in reported
22
profit. However, if this decline in reported income has a detrimental effect upon the share
price of the company, one would assume that the market is not acting efficiently to this
information, as in real terms the present value of future cash flow has been maximised. This
implies that the average market participant does not distinguish between the different
accounting methods.
The empirical evidence is not defmitive as to how the market reacts to the adoption of
LIFO. A positive association between the switch to LIFO and an increase in share prices was
reported by Sunder (1973, 1975) and Biddle & Lindahi (1982). Brown (1980) evidenced no
significant association and a negative association was documented by Ricks (1982) and
Abdel-Khalik and McKeown (1978). The ambiguity of these results could be attributed to
the differences in research design of the various researchers. Many researchers employed the
familiar market model, such as the capital asset pricing model (CAPM), to control for market
wide and risk factors in developing a measure of abnormal or unexplained security returns.
The model asserts that a return on a security Rjt can be broken down into two components, a
systematic component Rmt i.e. relating to the market, and an individual component ejt. The
remaining terms a and 13j,are regression parameters identified with the security in question.
R, =aj +J3JR,fl t +ejg
CAPM predicts a linear relation between risk and return in 'excess return space'.
Some empirical evidence, such as Jensen (1978), has indicated this not to be the case,
suggesting that co-variance is not the best method to measure risk. Research designs
incorporating variations of CAPM in the methodologies used include Sunder (1973), Abdel-
Khalik and McKeown (1978), Brown (1980). It has been suggested that use of the two and
three factor extensions of the basic CAPM could enhance designs (Ball, 1972; Fama and
MacBeth, 1973). Alternative design methodologies include the use of univariate analysis
(Dopuch and Pincus, 1988; Hunt, 1985). Taking Hunt (1985) as an example, statistical tests
were carried out to establish whether LIFO adopting firms were more likely than FIFO
23
adopting firms to have management bonus schemes, debt covenants, and higher degrees of
management ownership of shares.
Multivariate tests were also carried out using the logistic multiple regression model.
The majority of designs that tested for statistical significance used extensive sampling
techniques and pair-wise matching, so as to run the intended regression on a control sample
in addition to the experimental sample.
After allowing for diversity of research design, sample and timing differences, the
majority of research is however, weighted towards results pertaining to the school of thought
that no adverse reaction occurs. The conjectural remarks of Ricks (1982) suggested several
explanations for the negative association results obtained. For example, the market
interpreted the LIFO decision as an indication that the change finns were in dire need of
working capital or that management was expecting lower profits. Alternatively, the negative
performance was due to 'omitted factors totally unrelated to the LIFO decision. Further
explanations, for staying with FIFO, could be that the market expected falling inventory
prices, thus a change to LIFO would be viewed as a decrease in the present value of future
cash flows, or that the LIFO disclosure included several new items of information concerning
the operating environment of the company such as the rate of inflation affecting stock prices
and thus being interpreted as bad news. A further explanation is that analysts overestimated
earnings as the extremity of rising inflation during 1974 was not accurately predicted. The
negative investor reaction was simply in response to the disclosure of earnings that were
lower than expected. Biddle and Ricks (1988) drew this conclusion after a re-examination of
Ricks' earlier research which discovered that the negative response was specific to 1974.
Jennings, Mest and Thompson (1992), in an attempt to enhance previous studies and
to draw a clear inference on the market interpretation of the LIFO decision, improved
previous research designs by carrying out cross-sectional regression analysis, thus
overcoming the problem of inadequate control groups for comparative purposes. However,
24
their concluding remarks were not definitive, stating that the market reaction depends upon
the prior belief of investors with respect to the factors that affect the decision to adopt or
extend LIFO, and the information that is conveyed in the decision concerning other operating
activities of the firm.
A dominant factor that affects the decision to adopt LIFO is the perception of the
manager as to how the market will react to the fall in reported profits. Empirical evidence
suggests a widespread disbelief in the efficiency of the market with respect to accounting
information and hence a willingness by managers to incur costs in order to structure a

transaction in order to have a desired result on reported results.
An interesting aspect of market efficiency and the assimilation of information by the
market is the idea that the release of information can act as a signal to investors. Fellingham
(1988) used a signalling model to rationally explain why managers forgo the tax advantage of
the LIFO adoption and the inverse relationship that has been evidenced between share price
and the use of LIFO. This explanation lacks conviction as there is nothing that singles FIFO
out as being an effective signal, especially in the light of the magnitude of the possible tax
advantages. Hughes and Schwartz (1988) also favour the signalling approach, suggesting that
investors attempt to learn insider information held by the manager by observing the
LIFOIFIFO choice. The resultant signalling model predicted that firms remain with FIFO
only if the cost of forgoing the current and future tax advantages is less than the cost of being
recognised as a low quality firm.
Beaver (1989, p41) refers to the 'contracting perspective' as evidence contrary to
LIFO adoption, arguing that the firm is affected by a number of contracts which are defined
in terms of accounting numbers, for example, compensation plans, debt covenants and tax
laws. Altering the accounting procedures behind these numbers therefore has economic
consequences on the contract. For these purposes higher reported profits and asset values are
preferred.
25
Many firms compensate top management, at least in part, through bonus plans linked
to reported earnings. Personal interest acts to motivate managers to choose accounting
methods that will therefore maximise this figure. This is somewhat disturbing as the
management is directly being compensated for forgoing the tax and cash flow advantage of
LIFO, and ultimately not acting in the best interest of the shareholders (Hunt, 1985; Morse
and Richardson, 1983; Dopuch and Pincus, 1988). Abdel-Khalik (1985) however, found that
the LIFO decision did not have significant effects on executives' compensation, as switching
firms either modified their bonus plans or continued to use the FIFO based earnings to
determine the magnitude of the bonuses.
Corporate lending agreements are designed by bond holders to restrict management
from paying out dividends which can drastically affect the liquidity of the firm. Three
activities commonly controlled by restrictive debt covenants are the payment of dividends,
the creation of additional debt and the maintenance of working capital. Default on a debt
contract can be costly so contracts that define a breach in terms of accounting numbers
provide the management with incentives to choose those procedures that reduce the
possibility of a breach. This principally involves the adoption of procedures that are non
conservative i.e. increasing assets and revenue and decreasing liabilities and expenses. For
example, a stipulation that a minimum amount of working capital must be maintained is less
attainable using LIFO stock valuation as this results in the retention of older prices in the
stock figure (Hunt, 1985; Watts and Zimmerman, 1986; Morse and Richardson, 1983;
Abdel-Khalik, 1985; Lee and Hseish, 1985).
Morse and Richardson (1983) also recognised other factors that could affect the
LIFO/FIFO decision. Firm size was observed to act as a proxy for political costs or antitrust
acts, for example to avoid monopolistic appearance as exemplified by excess profits.

Electing conservative accounting procedures such as LIFO achieves this. Conversely,
smaller listed firms are more likely not to adopt LIFO as the tax benefits to be attained are not
necessarily large enough, if present at all, to entice the company to alter its accounting
26
practice. This is evident after considering the costs involved in computing an individual
index for the company's stock that is based on their own inflation experience. Small
companies simply find this too expensive and cumbersome.
Cushing and LeClere (1992) contribute further evidence that suggests the dominant
reason for adoption of LIFO relates to the tax advantages. However, numerous
considerations are involved in the decision for non-adoption, without a dominant reason.
Factors already mentioned such as debt covenants, bookkeeping costs, declining production
costs and concern about the complexity of using LIFO and the fact that the decision cannot be
easily reversed will have different degrees of dominance within different industries and also
on an individual company basis. A combination of such factors plays an important role in
explaining why many firms forgo potentially large tax savings through non-adoption. It has
also been suggested that the LIFO/FIFO decision is one related to tax planning as opposed to
a pure choice in accounting methods (Hughes and Schwartz, 1988).
This accounting change therefore has real economic consequences for the firm and
thus provides an opportunity to examine whether analysts and investors can recognise this
choice as being something of value to the company. If investors react to the cash flow effect
of the LIFO decision as opposed to the decrease in reported earnings the share price should
rise, ceteris paribus. The empirical evidence examining this issue does however produce a
dichotomy of results, with both positive and negative associations being recorded. The
ambiguity of these results could be attributed to differences in research design. However,
there seems to be a fundamental problematic issue underlying them all: market efficiency is
assumed in all the studies. This is a rational assumption as one cannot simultaneously test
both the efficiency of the market and the reaction of the market to certain information, as to
test the later some prior inference must be made as to how the share price is likely to react to
the information released. Without this prior 'knowledge' neither hypothesis can be tested. An
inference that the adoption of LIFO has 'caused a price change, cannot therefore be made.
The positive association between LIFO adoption and price could be attributable to the fact
27
that firms which made the change saw exceptionally good prospects for themselves and were
therefore not concerned about the adverse effect the decision had on their share price.
Despite the amount of attention this area has received the results are not defmitive.
The fact that some firms fail to adopt LIFO does spread further light on the subject that
managers are dubious as to how the market will perceive the associated fall in earnings,
however many rational explanations have been given for this behaviour. These explanations
are arguable for companies that will not forego substantial tax savings. However, upon
examination of results such as Biddle (1980) who documented potential tax savings of $26
million on average for each company, such factors, even when combined, seem to Jack
conviction. Further research is imperative to clarify the situation.
3.3 GOODWILL
The UK is still working towards an accounting standard that deals effectively with the
treatment of intangible assets. The specific area of accounting for goodwill is highly debated
and controversial. Technically goodwill is the difference between the price one company
pays for another and the net assets of the acquired company stated at fair values. The
treatment preferred for goodwill in SSAP 22 is that purchased goodwill should be eliminated
from the accounts by its immediate write off against reserves. The standard also permits
companies to carry positive goodwill as an asset and to amortise it through the profit and loss
account over its useful economic life. The majority of companies opted for the former,
especially where goodwill is a high percentage of net assets. BP was the only company listed
on the FTSE 100 to write goodwill off through the profit and loss account in 1989 (Pereira et
a! 1992). However, BP's goodwill is equal to only 1% of net assets, whereas the companies
choosing to write the amount of to reserves ranged from, for example, 93% for Grand
Metropolitan, 78% for Rank Hovis McDougall and 48% for Guinness. A further reason why
BP adopts the practice of writing off goodwill could be to reduce the differences between UK
and US GAAP, as BP is listed on NYSE.
28
ED 47 was published by the ASC in February 1990, and proposed to change this
practice, particularly to require that all intangibles be written off through the profit and loss
account over a 20 or 40 year maximum life, thus prohibiting the immediate write off to
reserves and hence reducing the options permitted in an attempt to make the fmancial
statements more credible. This has been received with much scepticism as the amortisation
will lead to declining reported profits and PIE ratios. The sectors protesting about the possible
new treatment for intangibles as per ED 47 are principally service based such as advertising
and employment agencies. Consumer goods companies are also affected as they tend to
generate profit from intangible assets such as brand names.
UITF abstract 3: Treatment of goodwill on disposal of a business, was issued in
December 1991. The major effect this had was to reduce the 'protection' of the profit and
loss account from amortisation charges given by the popular practice of writing goodwill off
to reserves, because upon ultimate disposal or closure of a previously acquired business the
related goodwill must be charged to the profit and loss account.
The goodwill debate is still continuing in the UK. The latest discussion paper on
goodwill issued by the ASB was in December 1993. The current UK practice as per SSAP
22 is viewed as being too flexible and highly inconsistent with international practices,
leading, for example, to UK companies overpaying for acquisitions compared to the US
(Choi and Lee, 1992). The ASB reconsidered accounting for purchased goodwill by
examining the "rationale, related conceptual issues and practical advantages and
disadvantages" of six possible methods. These methods were:
• capitalisation and predetermined life amortisation;

+ capitalisation and annual review;
• a combination of the above where purchased goodwill has a life believed to be greater than
twenty years;
29
• immediate write-off;
• separate write-off reserve.
The ASB expressed some support for two methods: the combination of capitalisation
with predetermined life and annual review and to write goodwill off to a separate reserve.
Ultimately the ASB wish to reduce this choice down to one option before the standard is
revised/replaced.
Capitalisation and predetermined life amortisation has the major practical advantage
of enhancing international comparability. For example, the EC 4th and 7th Directives state
that the life should generally not exceed five years, but allows a longer period where this can
be justified, however, immediate write-off is also permitted. lAS 22, revised for accounting
periods after 1 January 1995, states that the maximum economic life of purchased goodwill
should generally be no longer than five years, but may be up to twenty if a longer period is
justified. Immediate write-off is no longer permitted by the revised lAS 22. The main
international exceptions to this practice are the US and Canada who permit a forty year write-
off period. Therefore if the ASB adopted a twenty year maximum write-off period it would,
to a large extent, enhance international comparability.
If ceiling tests were adopted in the forthcoming FRS, comparability would not be
improved as this is a pioneering step proposed by the ASB. However, it is likely that other
accounting regimes would follow suit.
Throughout the debate on goodwill a problem was highlighted after a number of large
companies decided to capitalise brands in 1988. ED 52 "Accountingfor Intangible Fixed
Assets" was published in May 1990, as the ASC was concerned that companies should not be
able to redefine their 'goodwill' as other forms of intangible assets, thus avoiding the
reduction in profits due to mandatory amortisation charges. Such assets include brands but
might also incorporate publication titles, business names etc. Avoidance of the specific
30
accounting rules relating to goodwill would enable the company to carry these assets in their
balance sheets indefinitely. Examples of this practice can be found in the 1989 accounts of
Cadbury Schweppes plc, Guinness plc and WPP plc.
The following is an extract from Cadbury Schweppes plc. (1989).
"i.. we have included in our Balance Sheet the values of major brands acquired since
1985 at cost. We have decided that no amortisation is necessary as our accounts reflect
signcant expenditure in support of these brands, principally by advertising and sales
promotion.....A signflcant part of the goodwill we acquire is in fact in brand values which,
provided they are supported, tend to increase in value. Revaluation of brands is therefore
more relevant than a reduction in value on an arbitrary time apportionment."
The capitalisation of brands was seen to be the solution to bolstering the balance sheet
aller having to write off goodwill. For example, Guinness initially wrote off £1.39 bn on its
acquisition of Distillers in 1986, only to add back £1.38 bn in 1989 by way of brand
revaluation. The new rules would allow brands to be shown on the balance sheet at valuation
but they will also have to be amortised over a maximum economic life of 20 years.
Little empirical evidence or research has evolved to date relating to the economic
consequences of accounting for brands but comments and opinions are available (Damant,
1989; London Business School, 1989; Arnold and Sherer, 1989 and others.) Mather and
Peasnell (1991) do provide empirical evidence on the share price reaction to the capitalisation
of brands, along with the motivation of managers to indulge in costly cosmetic accounting
procedures. Their conclusions, based on a market price study using two variations of the
capital asset pricing model, were weighted towards support for EMil, given that little
evidence was found that the stock market consistently undervalues companies with large
investments in intangible assets. They confirmed that brand capitalisation markedly reduces
31
gearing ratios and therefore the incentives of management to employ such practices could be
explained through the "debt covenant and shareholder approval hypothesis".
The interesting point stemming from the above is the reluctance of the companies to
alter their accounting practices for goodwill. As Wailer (1990b) explained "to many
observers the debate is of theological interest: after all a change in accounting rules should
have no impact on the way companies run their business or the way investors value those
companies' Thus, the operations of the company are the same regardless of how goodwill is
accounted for and in an efficient market, sufficient sophistication should prevent such a
cosmetic event from altering the fundamental values of shares.
However it is evident from the actions of the investment community and managers
that there is concern about both the fall in reported earnings and the depletion of the balance
sheet where brands are required to be amortised and hence the effect on the capitalisation
value of companies with large amounts ofintangibles. For example, Grand Metropolitan
net assets would have stood at £190m in 1989 if brands had been excluded. This seems
inappropriate considering that the market value of the company was £5 bn at the time, if one
ignores the issue of whether the balance sheet represents a company's value. This concern of
managers relates especially to gearing, and whether this can affect the ability of the company
to raise funds in the market or to make acquisitions. A report by A. Holland (1990) for
Yamaichi, outlines the possible results that the new rules could have. This is shown in Table
3.1 which illustrates the potential impact of goodwill practices upon reported profit levels.
The conclusions drawn by Yamaichi suggested that:

• Net Assets would rise.
• Reported Profits would decrease.
• Gearing Ratios would fall.
• ROCE would fall.
32
BPS would fall and thus PIE would rise. This would make the shares appear
overpriced.
Amortisation period chosen is vital to companies, the longer the better.
The ASC believed that the stock market would be able to see these changes in
accounting policy for what they are. For example, Nobes (1989) a member of the ASC and
of its working party on goodwill, argued that:
"Research on whether visible accounting changes like that (goodwill) affect share prices
has shown that they do not. Financial analysts can easily adjust for goodwill charges, and
analysts find the directors' concerns misguided. ... directors would be well advised not to
indulge in expensive manoeuvres designed to reduce goodwill charges; that would involve
spending real money to reduce accounting charges that are depreciating money already
spent'
R. Thomas (1990), finance director of Fisons, disagrees strongly with Professor
Nobes, saying:
"It is certainly not my experience that financial analysts are willing to recalculate
companies' earnings to adjust for notional charges. In fact, they accept what is reported at
face value and there is no evidence that their assessments take into account inconsistencies in
accounting treatment."
Wailer and Waters (1989) support this view, stating that goodwill charges "..would
have a serious, possibly distorting, influence on the decisions of businessmen and
institutional investors alike."
33

Table 3.1: An example of the potential impact of goodwill practices upon
reported profit levels.
Profit and Assume £125m Assume £62m

Loss Account p.a. depreciation p.a. depreciation
1989 costl cost2
£m £m £m
Sales 9300 9300 9300
Operating costs (8300) (8425) (8362)
Operating profit 1000 875 932
Interest (250) (250) (250)
Pre-tax profit 750 650 682
Tax 3 (225) (225) (225)
Attributable profit 525 400 457
EPS 4 52.5p 4O.Op 45.'7p

PIE (Share price 6SOp) 12.4 16.3 14.2
Holland (1990) also "... take a less sanguine view ... (due to) the considerable impact
on the changes on reported profits, and on P E ratios - the most widely used measure of
share price value.., even [this measure ceases to give an accurate guide to a company share
price, the market is unlikely to change overnight to an alternative primary measure of value,
such as cash flow multiples. We believe that the first reaction of the market will be to mark
down share price of those companies most affected. In the longer term, the changes may lead
to a re-rating of those companies and sectors, and the use of dfferent measures of share
price value." The sentiments are shared by many stockbroking firms in NY, at Bear Sterns,
for example, Patricia McConnell was quoted by Walters (1989) as saying "We are concerned
on the impact on earnings and the price earnings ratio but in itself the accounting rules
'2.5 billion acquired goodwill depreciated over 25 years.

2 2 . 5 billion acquired goodwill depreciated over 40 years.
3 The goodwill depreciation is not allowable for tax purposes thus, the tax charge is the same in all scenarios.
4 EPS calculated on the basis of I billion shares
34
would not sway a decision. It would be a factor ?f the amortisation cancelled out earnings
because we'd be worried that shareholders will question the wisdom of an acquisition that
adds nothing to the bottom line."
The London Business School survey of analysts' and bankers' views on brands
supported the school of thought adopted by the ASC, stating that the relationship between
reported accounting numbers and share returns is not a mechanistic one, i.e. the market does
not take accounting numbers at face value, but uses a broad-based information set in
interpreting their information content. Nevertheless as noted by Damant (1992) '.. there will
be serious results from these accounting changes in the real economy f company
management believes that such changes have an effect on share price valuation."
The array of literature in the financial press at the time of the announcement of the
proposals of the ASC in 1990, is heavily weighted towards the disbelief in the efficiency of
the stock market and the concern of the possible detrimental consequences stemming from
the mandatory adoption of the new rules. Companies are prepared to incur costs to reverse
the 'paper' effects of goodwill. For example, BET, the UK service group whose goodwill
costs are often 80% of acquisition prices paid, has turned to the US market for auction market
preferred stock. By issuing preference shares whose dividends are fixed at regular intervals,
gearing is reduced and capital increased without diluting existing shareholders' equity
interests. Concern over intangibles is so great that eleven leading companies, including
Cadbury Schweppes, Grand Metropolitan, Guinness, Pearson, Rank Hovis McDougall,
SmithKline Beecham, United Biscuits, Thorn EMI, United Newspapers, Reed International
and Reckitt and Coleman, commissioned a report of "the valuation of intangible assets't by
Arthur Andersen. The motive behind this report was to provide further deliberation to the
ongoing ASB debate, as David Nash of Grand Metropolitan said "If valuation methods are
sound companies are failing in their stewardship function by not including intangibles in
their balance sheet".
35
Much concern has also been paid to the consequences relating to take-overs. S. G.
Warburg, the London Investment bank, argued in a letter to the ASC, later leaked to the press
(WaIler, 1989), that lower reported profit figures would lead to lower valuation from the
market, and hence more take-over interest from predators. The short term nature of the City,
which places emphasis on a company's earning power, as opposed to its longer term cash
flow, would lead to lower valuations even though the underlying performance of the company
had not changed at all. Furthermore, the rules will remove an important competitive
advantage when companies make acquisitions overseas, as the practice laid down in SSAP
22 favour UK companies. For example this competitive advantage is recognised as helping
UK companies to purchase Manpower, the employment agency and J. Walter Thompson, the
advertising agency in 1987. In a recent study by Choi and Lee (1992) the merger premia
associated with UK acquirers was found to be consistently higher than for US acquirers. This
higher premia was also highly related to goodwill in the UK example, associated with the
ability of UK companies to write goodwill off to reserves, thus not affecting earnings. The
result of mandatory amortisation of goodwill would therefore appear to be to discourage

acquisition. Pearson believes that its board of directors will be less willing to approve
acquisition involving a high proportional amount of goodwill. This could be viewed as a

good thing if unprofitable acquisitions are curtailed. Behaviour is not expected to change
until more credence is given to equity valuation based on cash flow and less on accounting
earnings and ratios.
Alternatively it can be argued that the position of the company will be stronger due to
the increase in net assets and the maintenance of reserves. The magnitude of reserves is held
by some as important when calculating borrowing powers. For example Hanson hold this
view, however this would depend upon their bankers' recognising goodwill as a credible asset
and ignoring the earnings effect of amortisation.
The aforementioned remarks relating to the possible stock market effects on share
price are conjectural and empirical evidence needs to be presented to confirm or reject the
36
conclusions drawn by managers, investors and journalists. One such example that can be
cited is the effect of the goodwill write off against profits by Blue Arrow in 1990. On
January 29, 1990, Blue Arrow announced a $626m goodwill write-off, resulting in a reported
loss of $686m, compared to a profit of $1.2m for 1988, and some kind of market reaction was
expected. On the contrary the market price was totally unaffected. The reason for this
indifference was explained in relation to cash flow effects, i.e. there were not any. However
alternative explanations could include that the goodwill write off was evident only in the
accounts of the company prepared for the US. With an American shareholding of 65%, Blue
Arrow are compelled to prepare two sets of accounts, one for the UK market and one for the
US. Goodwill was written off to reserves in the UK, whereas in the US the policy had been
to amortise it over 40 years. The staggering write off announced of $626m, however resulted
from a change in the American policy, shortening the amortisation period to 5 years.
The question raised at the time was why the chairman, Mr. Mitchell Fromstein, was
bothering to alter the accounting policy relating to goodwill if the market is sophisticated
enough to see through the accounting numbers? The answer lay in Mr. Fromstein's lack of
belief in the efficiency of the stock market. Goodwill stood at $1.4 bn, which would result in
a reduction of profits of $35m p.a. for forty years. He was quoted by Wailer (1990b);
"Investors'perceptions about the company's tradingfigures would be based on numbers cut

in half because of the amortisation charge. The company would end up at being valued at
half its true value." It would appear therefore that the accelerated write off of this amount
would draw the investors' attention to the superficial nature of such accounting policies, as
the incongruous nature of these figures bear no relation to the underlying cash flows and
fundamental value of the company. Consequently the US figures were ignored by the US
market. This explains the behaviour of managers but still does not shed that much light upon
the stock market reaction. The strongest argument has to be the one stating that the market
was efficient enough to see through the treatment of goodwill prior to the colossal write off.
If the market had taken the accounts at face value and not adjusted for goodwill, would there
not be an expected realignment when the market realised the cosmetic nature of the
37
ainortisation amounts once Mr. Fromstein had announced his plans for an accelerated
amortisation programme? The announcement was not associated with any movement in
share price, therefore a high degree of sophistication can be assumed.
An important consideration examined by Duvall et a! (1992) is the extent to which
current goodwill disclosures in the US, enable the investors to determine the fmancial
statement effects of the current accounting treatment for goodwill. Their research indicated
that investors cannot easily identify the effects of goodwill due to a lack of disclosure of both
net goodwill and goodwill amortised. The level of disclosure is not entirely discretionary,
with regulations set out in APB Opinions Nos. 16 and 17 and the SEC's Regulation S-X, for
publicly traded firms. From a sample of 485 companies listed on either the NYSE or the
American Stock Exchange in 1989, 79% disclosed net goodwill balances, 42% disclosed
balances for accumulated goodwill amortisation, but only 24% disclosed goodwill
amortisation for the year.
Without complete information investors will fmd difficulties In estimating the average
age of a finn's goodwill. Furthermore estimates relating to the periodic amortisation of
goodwill were found to contain material errors. Such errors will impede efficiency in the
price setting process of equity.
3.4 CURRENT COST ACCOUNTING
Due to the inflationary environment in the UK, the Sandilands Committee was
established in September 1975 to discuss alternative accounting bases to historical cost that
accounted for the effect of price increases on historical cost accounts. Following intense
debate and much deliberation current cost accounting was recommended above replacement
cost accounting, present value accounting and current purchasing power. The Committee
advocated that the balance sheet should represent the 'value to the business' of the company's
assets. When SSAP 16 was published in March 1980, inflation had fallen to 19% from a
38
staggering 27% in September 1975. Almost invariably the reported profits shown under
CCA were lower than those reported under historical cost accounting (HCA), as a charge for
the value to the business of assets consumed during the year is made. Four adjustments are
made to HCA, a depreciation adjustment, a gearing adjustment, a cost of sales adjustment and
a monetary working capital adjustment. The later was intended to represent the extra
investment in debtors, creditors and liquid resources required to maintain operations.
SSAP 16 allowed companies to prepare either historical cost accounts as their

principal accounts with supplementary current cost statements, or current cost accounts as the
main statements with either supplementary historical cost accounts or adequate historical cost
information. However at the time of issue, the ASC stated that it was in their intent "to make
no change to SSAP I 6for three years so as to enable producers and users to gain experience
in dealing with practical problems and interpreting information.".
This was interpreted by many as the intention to revise the standard after three years,
thus labelling SSAP 16 as experimental or provisional. Consequently the ICAEW (1984)
initiated a research project into the usefulness of CCA. This project was divided into a
number of studies designed to investigate the costs and benefits and uses made by different
user groups of CCA. The whole project was under the control of Carsberg, as research
director of ICAEW, and its results assisted the ASC with its review of SSAP 16. One survey
commissioned evidenced that the profits for a sample of 52 listed companies examined fell on
average by 50% when using CCA rather than HCA. The provisional nature of SSAP 16
together with the effect on reported profits and the rejection of CCA as a base for the
computation of taxation (Government Green Paper, 1982), led to many companies rejecting
CCA, as they could find no commercial justification for going to the considerable expense of
producing them. Due to extensive lobbying and general rejection of the standard, SSAP 16
was made non-mandatory in June 1985 and later totally rescinded. Few companies in the UK
now produce current cost account, British Gas plc being a principal remaining advocate. As
proposed by Watts and Zimmerman (1978 p 326) "politically sensitive firms may ... be
39
expected to select accounting practices which reduce earnings and the value ofreported
assets". British Gas has two incentives to do this, firstly to avoid excessive regulation
through investigation by the Monopolies and Mergers Commission or the industry regulator,
and secondly to justify price increases for the domestic supply of gas. Griffiths (1986, p1!)
takes a similar example from the electrical industry:
"In 1983/4 it reported profits before interest of£914.4 million (CCA). It is a lot of money but
not so much that the public gets too upset about it...had the electrical industry used the
historical cost principles which are used in the private sector, the story would have been
completely different... £1,852.8 million. More than double the figure which was reported as
the actual result for 1983/4. Suddenly questions might have been asked about prices."
Peasnell and Skerratt (1988) attempted to test whether the reported CCA profit figures
had any impact on share price. The rate of return on investments over a specified period of
time was regressed upon unexpected profit, in order to assess the relationship between share
returns and the accounting variables. This relationship was then examined to observe
whether the selected disclosures could account for the movements in share price. To test for
the impact of current cost accounting over and above those relating to historical cost
accounting, as CCA profit is in effect HCA profit that has been adjusted, the adjustments
were forecasted and then subtracted from the historic cost forecast of expected return. Thus,
the researchers advocate that it is sufficient to examine whether or not an increase (decrease)
in current cost adjustment is accompanied by a decrease (increase) in share price, after
allowing for the unexpected historical cost profit. The results of this research indicated that
the current cost profit figures were not significant in influencing share price, especially after
accounting for the historical cost effect and when longer term views are examined. Assuming
market efficiency these results are consistent with those expected. This is due to the fact that
many investors and analysts believed that SSAP 16 was merely provisional and therefore
current cost accounting stood little chance of effecting the share price.
40
3.5 FURTHER ACCOUNTING CHOICE EXAMPLES.
It can be argued that it is the belief of the investment community as to the degree of
efficiency that is present that is of importance when endeavouring to analyse their behaviour,
not the actual amount of efficiency that is present. O'Keefe and Soloman (1985) examined
beliefs concerning EMH through an examination of letters commenting on the exposure draft
prior to FAS 19 regarding the expenditures of oil and gas exploration. FAS 19 generated
intense lobbying pressure and was ultimately rescinded two months after becoming effective.
The principal incentive behind such powerful lobbying was the dramatic effects
implementation of FAS 19 would have on shareholder equity, estimated at a 22% decrease.
This is strong evidence against belief in EMH, as the accounting treatment of an expense
already occurred does not have any effect on the level or risk of future cash flows.
Furthermore, in an efficient market, a firm expending its exploration expenditure as opposed
to deferring it should not be penalised via share price.
In a paper by Breton and Taffler (1990), analysts were examined to test their
competence in adjusting correctly for a number of window dressed figures. Analysts were
required to compute a number of financial ratios normally calculated for investment
appraisal, based on two sets of accounts, one unaltered and the other containing a differing
degree of window dressed schemes. Conclusions drawn suggest that they do not correctly
adjust for such manipulations. This can be cited in support for FFH. Alternatively analysts
could have ulterior motives such as protecting their principal source of information: company
contacts. Consequently much care would be taken before correcting for any window dressed
item publicly. Further evidence refuting widespread belief in the EMH can be found in Hines
(1982), Evans et al (1978), Horwitz and Kolodny (1980) and Mayer-Sommer (1979).
Common examples of window dressing as evidenced by research conducted by Breton and
Taffler (1990) will follow. This research was based on a random sample of fifty of the largest
41
companies listed in the UK. Financial statements from 1985, 1986 and 1987 were examined
to ascertain the degree of window dressing present in the accounts.
3.5.1 Extraordinary items
A large amount of debit exceptional items, as per SSAP 6, were classified as

extraordinary items and thus not included in the profit before tax figure. Examples include
goodwill written off, foreign currency deficit arising on consolidation, and a US subsidiary's
pre-production expenditures written off. These items represented a material amount in
relation to the magnitude of reported profit announced. Conversely, some credit

extraordinary items were taken above the line when they should have been classified below it.
69% of the companies examined had evidence of both practices in their accounts.
3.5.2 Non Capitalisation of Leased Assets
Gearing ratios were manipulated by 17% of the sample, the most striking illustration
can be found in the accounts of Thom EMI, through the omission of finance leases from the
face of the balance sheet, together with any corresponding liabilities. This practice is now
prohibited via SSAP 21.
3.5.3 Creating Profit via Asset Disposal.
This item can only be considered as window dressing if the intentions behind the
disposal is to aid income smoothing or to highly inflate profits, e.g. Fine Art Development
plc.. Appropriate adjustments are therefore necessary to discover the underlying profitability
of the firm. 13% of companies examined had evidence of this type of window dressing in
their accounts.
3.5.4 Non-consolidated Subsidiaries.

BAT Industries, Thom EMI, Bunzl and Pearson among others were observed to have
set up a separate subsidiary to finance their credit sales. Consolidation of the subsidiary into
42
the group accounts was avoided, using the 'dissimilar activities' exemption clause and
consequently manipulation of the gearing ratio.
Other examples of window dressing evidenced in Breton and Taffler's research
include hidden interest charges, evidence of the use of merger accounting to appropriate the
profit of the acquired company from the preceding year to acquisition and the use of
subsidiaries to hide large proportions of group debt.
3.6 SUMMARY
This chapter attempted to highlight the behavioural response of the investment
community towards accounting choice. A detailed examination of the stock market reaction
to the adoption of LIFO over FIFO for stock valuation during the late 1970s in the US and the
UK debate on accounting for intangible assets was undertaken. These two examples were
chosen to illustrate the markets' response to a real accounting choice, the LIFO adoption in
the US, and a cosmetic accounting choice, accounting for goodwill or brands in the UK.
Looking firstly at the LIFO adoption in the US, researchers were concerned at
whether investors and analysts would react positively to the increase in expected future cash
flow from adopting firms, due to lower taxation liabilities, or negatively to the decrease in
profit levels these firms reported under LIFO. Empirical evidence was shown not to be
conclusive. Sunder (1973, 1975) and Biddle and Lindahl (1982) both evidenced a positive
reaction to adopting finns' share prices (thus in accordance with EMil). Brown (1980)
showed that there was no significant association between this accounting choice and share
prices, and Ricks (1982) and Abdel-Khalik and McKeown (1978) reported negative
associations (in conflict with EMil). There were some problems experienced with research
design as indicated in section 3.2. However, Jennings, Mest and Thompson (1992) improved
considerably on the earlier studies and still failed to produce conclusive evidence as to the
way the market reacts to such accounting choices. Other theories stemmed from this failure
to convincingly explain market behaviour. These included signalling models (e.g.
43
Fellingham, 1988; Beaver's contracting perspective, 1989 p 41), and the suggestions for other
variables for example firm size and political costs.
The debate surrounding goodwill and the capitalisation of brands in the UK is a good
example of a cosmetic accounting choice. If the market was efficient there would be no
change to the share price of a company that suddenly decides to capitalise its 'home-grown'
brands. Thus, if this is so the issue of 'why companies spend valuable resources valuing these
'assets' and including them in their financial statements', needs to be addressed. Furthermore
the concern for capitalising brands is so great that eleven leading companies commissioned
Arthur Andersen, the chartered accountants, to prepare a report on the valuation of
intangibles. Empirical evidence in this area is also inconclusive: Mather and Peasnell (1991)
stated that there was no market reaction to the capitalisation of brands but again this does not
explain the behaviour of managers that persist in capitalising brands.
Further accounting choices were also reviewed within this chapter, including current
cost accounting, the treatment of extraordinary items, the treatment of leases, creating profits
via asset disposals and the creative use of non-consolidated subsidiaries. The principal reason
for examining these accounting differences and the effect they have on share price, was to
illustrate the complexities involved in evaluating a company from a domestic perspective.
The problems that have been highlighted within this chapter are expected to be far greater for
an analyst trying to evaluate international companies with unfamiliar accounting regimes. It
is a difficult enough task to try to predict the share price movement, and thus to separate
cosmetic accounting choices from real accounting choices, with an accounting system with
which there is some familiarity. This issue of international accounting choices is dealt with
in the following chapter.
44
CHAPTER 4
DIFFERENCES IN INTERNATIONAL FINANCIAL REPORTING
4.1 INTRODUCTION
Considerable differences in accounting policy, practice, theory, legislation and
language exist between and within countries. As accounting is such a fundamental part of
commerce, which is increasingly becoming more international, it is imperative that the users
of published fmancial reports are well informed of these differences and the problems that
need to be addressed when undertaking any form of comparative international financial
statement analysis.
The benefits to be gained from a better understanding of international accounting

differences are numerous and far reaching. Apart from improving the quality of decisions of
policy makers dealing with foreign firms, and obvious benefits for Investment analysts who
need to assess the performance of foreign firms, international portfolio diversification should
increase. This should lead to an increase in the efficiency of security markets through the
demise of these barriers, enabling a greater supply of investment grade securities to become
available on major markets. Furthermore, the cost of capital for firms raising it overseas
should decrease through a greater supply of long term funds in the major markets such as
NYSE or LSE.
The issue to be addressed here lies not in the causes of the differences, e.g. type of
legal system, prevalent type of business organisation, influence of tax system, strength of
accountancy profession, accidents of history (Nobes and Parker, 199 lb pp, 10-21), but in the
differences themselves. The type of differences that could complicate the appraisal of
financial statements could include:
45
• availability of published accounting data;
• extent & type of audit;
• language problems;
• differences in financial culture;
• formats of financial statements;
• frequency of reports;
• quantity of data disclosed;
• different currencies;
• biases in accounting data;

• user friendliness of annual reports;
• valuation of assets;
• measurement of profits.
The intent of this research is to examine the extent that such differences are perceived
by analysts/investors and affect their behaviour. Previous research has investigated the range
of permissible accounting policies under different GAAP regimes but without focusing upon
the effect of GAAP on the measurement process, only recently has the attention shifted
towards this area (Weetman and Gray, 1991; Simmonds and Azières, 1989; Rees, Pope and
Graham, 1992). In order to make any sensible analysis for the purposes intended it is
therefore imperative actually to quantify these differences, not merely qualify them.
This chapter is intended to introduce the significant differences that effect reported
earnings, between a range of accounting systems, principally UK, US, Germany, Japan,
Sweden, The Netherlands, France and Belgium. The remainder of the chapter will be
organised as follows: Section 4.2 gives an overview of previous research which has
attempted to illustrate the effects, on profits and net assets, of the differing accounting
practices employed within a range of countries; Section 4.3 describes the effect of the most
significant items on a line by line basis; Section 4.4 summarises the chapter.
46
4.2 EXISTING LITERATURE
Radebaugh and Gray (1993, p 390) compiled an earnings adjusted index using audited
US GAAP reconciliation of earnings of large non-US companies listed on the New York
Exchange, in order to examine the comparative impact of international accounting differences
on earnings (See Table 4.1). Taking the US as the benchmark (equal to 100), the results
highlighted vast discrepancies between the countries examined, ranging from 125 for the UK
to 66 for Japan. The disparity occurs because of the different accounting techniques employed
in the countries examined. Moreover, the differences are probably understated as some of the
companies used for the study had already adjusted their domestic practice to US GAAP to
some degree.
Simmonds and Azières (1989) conducted a case study of seven countries in Europe in
order to discover the divergence of reported operating and net profit and the effect on net
assets, between and within countries. Practising accountants from Belgium, Germany, Spain,
France, Italy, The Netherlands and UK, were asked to prepare individual and consolidated
accounts for a chosen company using the accounting principles and policies that are 'most
likely'to be used in their respective countries. In addition the principles that result in the
'lowest attainable'and 'highest aainable'net profit were also required (See Table 4.2).
The results obtained clearly highlighted the lack of homogeneity within Europe and
the possibilities for divergence within the individual countries. To cite the extremes, reported
profit was found to vary between 27 Million ECUs (lowest possible scenario in Germany)
and 194 Million ECUs (maximum net profit permissible in UK). However, Sirnmonds and
Azières (1989) only focused upon one company, which may bias these results. The use of an
actual listed company, or indeed a different set of figures, would have led to different results,
which may or may not have been as impressive.
47
Table 4.1. The comparative impact of international accounting differences on
earnings: earnings adjustment index based on US GAAP (US1OQ)'
140
120
100
80
60
40
20
UK US F NL B D E J
Table 4.2. The divergence of reported operating and net profit in a sample of
European countries.2
__________ Belgium Germany Spain France Italy NE UK

________ ECUs m ECUs m ECUs rn ECUs m ECUs m ECUs m ECUs m
Operating 274 261 250 264 243 264 289
profit__________ ___________ _________ _________ _________ _________ _________
Netprofit 193 140 192 160 193 156 194
maximum
Most likely 135 133 131 149 174 140 192
net_profit __________ ___________ _________ _________ __________ _________ _________
Minimum 90 27 121 121 167 76 171
profit_________ ___________ _________ _________ _________ _________
'Source: Radebaugh and Gray (1993, p 390).

2 Simmonds and Azieres (1989) table 4.3 profit sensitivity.
48
Weetman and Gray (1991) examined whether material quantified differences existed
between the profits reported under US GAAP, UK GAAP, Swedish GAAP and GAAP in the
Netherlands. The latter two examples were chosen for comparative purposes as Nobes
(1 989b, p3 5) had placed them at extremes to each other in his classification structure. The
analysis was based around Form 20-F, a document that reconciles foreign firms' financial
statements with US GAAP, a requirement of the SEC prior to listing. The results observed
indicated that Sweden was the most conservative, and therefore reported lower profits,
especially when transfers to reserves are analysed, followed by the US. The UK was found to
be the least conservative, with the Netherlands in a similar position but slightly more so as
GAAP in the Netherlands shows similarities to both US and UK. The research design
involved the construction of a 'conservatism index', to establish the degree of conservatism
relative to the US. Single-tailed t-tests were then applied to measure the relative effect of
each adjustment that the sample companies made in compliance to Form 20-F. The results
were further subjected to tests based on the Wilcoxon statistic. An analysis of specific
accounting differences will be dealt with in the following section. However, before
proceeding, two examples of the extent to which there are material quantitative differences in
profit reported under different GAAPs will be examined.
In 1986, Pharmacia Corporation, a Swedish health care company, reported a loss of
1 l7M SEK, under Swedish GAAP. This was reduced to a loss of 8M SEK when reconciled
to US GAAP. The adjustment was mainly due to adding back an estimated transfer from the
deferred tax provision of 75M SEK and the capitalisation of interest of 33M SEK.
In 1988, the discrepancies between US and Swedish GAAP was even more evident in
terms of the effect on reported earnings as a 3M SEK loss under Swedish GAAP was adjusted
to a profit of 900M SEK after reconciling to US GAAP. 11 56M SEK was added back to
Swedish net income in order to comply with US GAAP on business combinations, a further
363M SEK was added back from a deferred tax provision and 636M SEK needed to be
49
deducted in respect of sale and leaseback profits which would not be recognised under US
GAAP.
The magnitude of the adjustments that were required by the SEC illustrates the extent
of the differences between different GAAP regimes, and highlights the need to fully
understand the accounting policies behind reported figures. If any comprehensive and
meaningful comparative study is to take place, analysts/investors must firstly realise that
these differences exist, for example can they see through the extra conservatism of German or
Japanese accounts? Secondly they must realise that the differences are great and fmally that
they can not be adjusted by a simple rule of thumb or multiplier. One must be well informed
of the differences and the effect that they have on profit, earnings and asset measurement.
This would imply a move away from the common practice of focusing upon a few aggregate
accounting numbers and ratios, such as EPS & P/E ratio. If any reliance is to be given to the
final analysis, a comprehensive and complete adjustment must take place on a line by line
basis, at the very least for the major items. This is the approach adopted in the following
section.
4.3 EXAMPLES OF MAJOR DIFFERENCES
4.3.1 Purchased Goodwill
Numerous studies, Simmonds and Azières (1989), Weetman and Gray (1991), have
found that one of the most significant factors affecting net profit is the treatment of goodwill.
Weetman and Gray, observed that in 1986 the reported profits, of the 41 UK firms listed with
the SEC in their sample, under UK GAAP were 10.2% higher than US GAAP due to the
effect of not writing off goodwill through the profit & loss account. In 1987 this was 16.3%
and in 1988, 15.1%.
so
Purchased goodwill is merely the excess of consideration given over the fair value of
the net assets acquired by a company. There exists a choice between several alternative
methods of how to account for this. Practice varies from amortisation through the profit and
loss account, immediate write off to reserves or immediate write off to the profit & loss
account. The divergency of practice exists depending upon whether goodwill is viewed as an
asset, i.e. capitalise it and write it off over its useful life, or as a consolidation difference,
which needs to be accounted for in a manner that causes as little detriment to the company as
possible. Furthermore one could argue that being an intangible asset it is extremely difficult
to determine the useful life of goodwill and therefore it should not be written off until
evidence suggests that its value has diminished.
The following rules are adopted:
. UK. Write off to reserves immediately or capitalised and amortise over estimated life
(SSAP 22). The former is preferred.
• US. Capitalise and amortise over a period not exceeding 40 years through the profit and
loss account (APB Opinion 17).
France. Capitalise and amortise over estimated life, but in exceptional cases may be
written off against reserves.
• Germany. Write off through profit and loss account over 4 years or over estimated
useful life. May also be written to reserves.

• Spain. Capitalise and amortise over 5 years.
• Sweden. Capitalise and amortise over a period not exceeding 10 years.
• NL. Write off to reserves, amortise against income within one year or amortise over
estimated life. The former is preferred.
• Japan. Write off to profit & loss account, usually over 5 years.
51
The effect on net profit is therefore extremely diverse. At one extreme, in the UK,
there is no effect as the charge can be avoided altogether, whereas profits will be reduced by
the entire amount of goodwill in Japan. The American pharmaceutical group, Roberts
Pharmaceutical Corporation, provide a good example of the effect of the write off of
goodwill on income. In the 1993 consolidated accounts amortisation amounted to $4,484,000
out of operating income of $7,228,000. Thus, restating to UK GAAP would result in an

increase in US GAAP operating income of a staggering 62%.
4.3.2 Deferred Tax
Deferred tax arises because of the reversible timing differences between tax and
accounting revenues. Such causes of reversible timing differences include depreciation and
inventoiy valuation methods. Due to the close relationship between accounting and taxation
numbers in most of continental Europe, the method of how to account for this is not an issue,
and often it is not recognised by either GAAP or in law. The need to account for deferred tax
can however arise when preparing group accounts. The Seventh EC Directive stipulates that
where tax-based values for assets have been used in individual accounts, these should either
be disclosed (as in Germany) or corrected (as in France) for the consolidated financial
statements. It is in the case of the latter that the need to account for deferred tax arises.
UK practice is based on partial provision of deferred tax using the liability method
(SSAP 15). This gives a reasoned assessment of the tax effects of the transactions
undertaken, as deferred tax is only recognised as a liability when there is reason to believe it
will crystallise in the foreseeable future, usually within three years. Some companies in the
Netherlands, Italy and Denmark also follow this practice.
In the US deferred tax is fully accounted for. Practice changed from the deferral
method to the liability method (SFAS 96, 1986) According to APB Opinion 11 the accounts
had to recognise the tax effects, whether current or deferred, of all transactions occurring
within the accounting period. Either method leads to the creation of 'deferred income tax
52
credits' which can be of some magnitude. For example in the 1988 accounts of General
Motors, a deferred income tax credit of $l,618.7M was created, being the equivalent to a
quarter of reported earnings for that accounting period. This tax credit has the effect of
reducing earnings, as taxation for the year is increased in the income statement to resemble
what the expense would have been without the presence of any generous tax rules that exist.
The corresponding entry is to create the deferred income tax credit in the balance sheet, as a
liability to pay more tax in the future. Both entries would therefore, in the opinion of
management, have a detrimental effect to the published reports.
4.3.3 Inventory Valuation
Differences that occur in the valuation of stocks principally stem from the method
employed for determining 'cost', as the underlying principle of 'lower of cost and market
value' is generally accepted, following the doctrine of prudence. However practice is not
homogeneous as various definitions of cost and market value exist. A minority of companies
in the Netherlands, for example, use a form of current cost accounting whereby stocks are
valued at the lower of cost and replacement value, however, except for valuing part of their
fixed assets at current value (e.g. property) the use of the current value accounting system by
Dutch companies and group is near abolition. The prominence of both taxation rules and
conservatism within German accounting has led to the statement of stocks at 'the lower value
of historic cost, replacement cost, net realisable value or other value perm itted by tax rules
Practice embodied within Japan generally values stock at cost with necessary provisions for
any significant irrecoverable decline in value. The lower of cost and market value may be
used. The definition used in the US for market value refers to the current replacement cost,
however it is stipulated that this may not exceed net realisable value.
As the above illustrates there is a disparity between nations as to the definition of

market value. This divergence is even more pronounced if one examines the definitions and
techniques employed to obtain a cost figure for stock valuation. Within Europe, despite the
attempts of the EU towards harmonisation, there still remains great scope for the
53
development of divergent practice as the 4th Directive permits member states to use LIFO,
FIFO, weighted average cost or any similar method.
FIFO is commonly employed in the UK, following the ruling of a Canadian tax case
that called for the rejection of LIFO and SSAP 9 explicitly stating that the use of LIFO would
not be consistent with the overriding principle of truth and fairness. LIFO is also prohibited
in France in individual company accounts, resulting in widespread use of FIFO and AVCO.
However, LIFO is permissible for French consolidated accounts. In Germany AVCO is the
principal method for determining cost, although FIFO is allowed. LIFO is also now
permitted for tax purposes (1990 onwards). The Netherlands permit the use of LIFO but FIFO
and AVCO are more commonly employed. LIFO is common among Italian companies.
Japanese principles suggest the use of actual cost for stock valuation, but the use of
AVCO, FIFO, LIFO or any similar method is permissible. In practice AVCO is the most
popular method with some use of LIFO and many companies employing a number of
different methods.
To illustrate the effect of LIFO on net profit and asset measurement examples from
the US will be considered, as the use of LIFO here is extensive and permissible for tax
purposes. The process of restating profit to a FIFO equivalent is relatively straightforward as
the SEC require disclosure as the effect of divergence from FIFO. The method of stock
valuation chosen can have real economic consequences for the firm as in an environment of
rising stock prices, LIFO leads to lower reported profits. This occurs because the most recent
purchases are disposed of first, resulting in a higher cost of goods sold figure. Consequently,
closing stock is valued at the price of the oldest item of stock, resulting in a lower balance
sheet value. The effects can be quite material, for example in 1990, General Motors
Corporation's closing stock, using LIFO was valued at $9,331.3M, whereas IIFIFO had been
employed this figure would have been 28% higher at $ll,930.1M. The tax advantage to be
gained is even more evident where closing stock accounts for a high proportion of current or
net assets. The tax advantage for GMC from using LIFO in previous years amounted to
54
$244.8M in 1989. The 1986 accounts of Caterpillar illustrate the effect LIFO adoption on
shareholder funds and asset levels (see Table 4.3).
Table 4.3 Extracts from the 1986 accounts of Caterpillar illustrating the
difference between the cost of stock determined by LIFO and by FIFO.
1986 Results Effect of changing to FIFO

___________________ $ Millions (%)3
LIFO stock valuation 1,211 136
FIFO stock valuation 2,845 -
Shareholder Funds 2,363 69
Net Total Assets 3,149 52
NetCurrentAssets 1,183 138
As shown in Table 4.3 the closing stock figure would have been 136% higher if FIFO
had of been used. This is equal to 69° o of shareholder funds and 52° o of net total assets.
Such material differences would have a dramatic effect upon the ratios used for investment
analysis, for example, the current ratio would increase from 1.54:1 to 2.29:1.
A further area of concern involving the computation of cost involves the decision as
to which related expenses should be included. The UK and Netherlands' approach is to
include only production overheads whereas an appropriate proportion of administration

expenses may be incorporated in Germany, although in practice this rarely happens as this
leads to increased profits for tax purposes. Japanese practice is similar to the UK's,
including all expenses of bringing the stocks to their present condition and location, including
fixed and variable overheads.
3 This data represent the increase in stock valuation (as a result of using FIFO rather than LIFO) as a percentage
of the key financial figures detailed within the table.
55
4.3.4 Long-term Contracts
The recognition, or not, of profits on long term contracts prior to completion is
another example of an international accounting difference that may need to be adjusted in
order to undertake a thorough comparative analysis of financial statements between countries.
Two alternatives exist, the completed contract method and the percentage of completion
method. The philosophy behind the two practices relates to the conflicting doctrines of
prudence and accruals. In the UK, despite SSAP 2 stating that '...where the accruals concept
is inconsistent with the prudence concept the latter prevails', the 1985 act does not state this
and conversely SSAP 9 favours the percentage of completion method. Using this method a
proportion of the total profit expected to arise over the duration of the contract is recognised
in the accounting periods over which the contract spans to the extent that fairly reflects the
amount of work attributable. The resulting asset is recorded as a debtor, being amount
recoverable on contracts.
The percentage method is also employed in the Netherlands although the resulting
asset is recorded as a component of stock. This would have obvious effects on the quick
ratio (current asseticurrent liabilities) and acid test (current assets - stock I current liabilities)
which are used in financial statement analysis, the profit figure will also be affected. As
expected in more conservative countries, with less emphasis on the true and fair view, long
term contracts are accounted for using the completed contract basis. This reflects practice in
France, Germany and Japan. In the US practice is akin to the UK, with the percentage of
completion method is preferred in circumstances where the costs to complete a contract and
the extent of progress made to date are reasonably determinable. However, if estimates are
of a more uncertain nature, the completed contract basis should be used. In this case the two
methods are not deemed acceptable substitutes for each other as each contract should be
treated according to the circumstances prevalent in each case.
56
4.3.5 Fixed Asset Valuation
There are numerous methods employed concerning the value assigned to fixed assets
in the balance sheet and the related depreciation charge. The following practices exist:
• US, Germany, Japan: strict adherence to historical costs with no revaluation;
• France, Italy, Spain, Greece: revaluation allowed with a result of an increase in tax.
Consequently this acts as a deterrent to revaluation, except for occasional cases were they
are tax exempt;
• UK: revaluation allowed to market value on an ad hoc basis with flG
deferred taxation, due to roll over relief;

• The Netherlands: revaluation allowed, followed by accounting for deferred tax.
The 4th EC Directive has failed to harmonise European practice through the
acceptance of many options in the area of fixed asset valuation. The UK and the Netherlands
have been insistent on the acceptance of alternatives that diverge from the EU 1s basic rule of
valuation based on purchase price or production cost. Consequently both replacement cost
and net realisable value are used for various types of fixed assets in the Netherlands, a
practice commonly employed, especially by large listed companies. The use of replacement
cost for some or all assets is also permissible in the UK. Restatement to historical cost
figures is however a relatively easy exercise, as the 4th Directive stipulates the need to
disclose the effects of any divergence from the basic rule.
The possible effects that can distort an international analysis of financial statements
can be illustrated by the 1990 accounts of Marks & Spencer. Several revaluations have
occurred resulting in the reinstatement of land and buildings, which originally cost £358.7M,
at £1325.9M. This increase due to revaluation is equivalent to 45% of shareholder funds
(2l74.6M) and 44% of total net assets. Thus through revaluation the balance sheet appears
far stronger.
57
Depreciation practice tends to be dichotomous, depending upon the authority
implementing it. Accounting systems that are highly influenced by the market and
shareholders, base depreciation practice on set standards, with depreciation for taxation
purposes, i.e. capital allowances, being a separate and entirely different issue. Such countries
include the UK and the Netherlands, although in the latter case depreciation for taxation
purposes usually follows the accounting depreciation. Depreciation is calculated, in theory,
with respect to the estimated useful life, residual value and the expected benefit/wearing out
of the asset. In practice, the straight line method, being the most simple and inexpensive
method, is usually employed regardless of the above considerations.
In France, Germany and Japan depreciation is determined by tax laws thus eliminating
any implication of deferred tax for this purpose. The allocations made each year are
calculated using specific taxation tables so there is no requirement to estimate the useful life
or residual value of the assets in question. Accelerated depreciation is permissible for tax
purposes leading to extreme examples whereby a newly acquired asset is written down to a
zero book value in the year of purchase. In Japan, for example, additional allowances
pennissible for tax purposes are charged against earnings and credited to a special
depreciation reserve.
The treatment of investment properties as per SSAP 19 in the UK is similar to policies
advocated in New Zealand. Lobbying by the property industry and others led to the
exclusion of investment properties from SSAP 12, which requires all assets with useful lives
to be depreciated. This exclusion was contrary to the EC 4th Directive that calls for the legal
obligation to depreciate assets. However, the true and fair override was invoked as it was
deemed inappropriate to depreciate such assets on the principle that it is the current value of
such properties which is the indicator for performance. This practice will obviously result in
larger asset values and larger profits compared to the normal practice employed in other
countries.
58
4.3.6 Intangibles
Intangible assets include concessions, patents, licences, trade marks and other similar
assets and rights. Within Europe, as per the 4th Directive, such assets can be included in the
balance sheet at purchase cost. However, it is possible, in the UK, to revalue intangibles,
except goodwill, to current cost. Assets that are not specifically identifiable or whose cost or
value is difficult to determine are excluded from the accounts, e.g. non purchased goodwill,
research expense, human assets etc. Formation expenditure and expenditure relating to the
issue of securities cannot be capitalised in the UK or the US, unlike French, German,
Japanese and Dutch GAAP which pennits capitalisation with amortisation over five years.
Contrary to UK practice, research expenditure may be capitalised in Japan, as long as a
separately identifiable project is visible. Expenditure on pure and applied research should be
written off in the year it is incurred in the UK, US and Germany. Applied research
expenditure can, under certain conditions, be capitalised in France and Spain as can
development expenditure. Development expenditure can be capitalised in the UK if certain
criteria are met, capitalised and amortised over 5 years in Japan and written off in the year it
is incurred in the US.
The effect of such disparity on profit can be illustrated using a simple example
whereby £1 OOM research and development expense has been incurred, comprising £20M
pure research, £30M applied research and £50M development expenditure. The following
possible charges against profit could result:
• US, Germany: £100M

• Japan: £0-lOOM
• UK: £50-100
• France, Spain: £20-lOOM
59
An area of recent controversy in the UK, is the capitalisation of brand names such as
newspaper titles. Within the EU purchased brand names may be capitalised if they are
separately identifiable. Some companies within the UK have gone even further incorporating
internally produced brand names into their balance sheets and thus inflating asset values. The
practice is legal although ED52 states that the valuation of such 'assets' is not reliable enough
to justify capitalisation. According to ED52, intangibles that are capitalised should however
be amortised over economic life or a period not exceeding 40 years.
4.3.7 Reserves and Provisions
Reserves and provisions can have a material effect on reported earnings. A provision
is created by a charge against profit for expected future losses or expenses, whereas a reserve
is an appropriation of profit. It is common practice in continental Europe and Japan to
allocate a proportion of profits each year to create a legal reserve until a percentage, in some
countries 10%, of share capital is reached. Such reserves can have a significant effect and
will need to be adjusted for if any comparison is to be carried out with companies that do not
employ such practices.
In complying with prudence, provisions must be made for probable future specific
losses or expenses in UK and the Netherlands. The extent of provisions made are totally
unrelated to the amount of profit as either a contingent liability is expected or not. More
general provisions can be found in the accounts of French or German companies to the extent
that it is questionable whether the financial statements reflect a true and fair view.
There are cases of the blatant use of reserves and provisions for income smoothing,
increasing them in times of high profits and drawing upon them when profits are not so
good. This is evident in the group accounts of Total Oil CFP as illustrated in Table 4.4.
60

Table 4,4: An illustration of income smoothing through the use of provisions:
extracts from the accounts of Total Oil CFP (Group)
___________ 1977 1978 1979 1980
mIT mFF mFF mFF
Income 111 728 1771 1993

Provisions 90 (362) (800) (1000)
Reported 201 266 971 993
profit_____________ _____________ _____________ ____________
Source Nobes (1991, pp 72, 73)
The use of these 'provisions' resulted in a bottom-line increase in earnings of only
31°c from 1977 to 1978 as opposed to a 555% increase, without the use of such provisions.
The extent of provisioning in Germany can also be partially explained through the issy
to use financial profit for tax purposes. For example for three major German banks:
Deutsche; Dresdner; and Commerzbank; the average tax liability has been reduced by 41.7%
through the use of provisioning over the period 1991-93 (see Table 4.5).
The German group, AEG, reported zero profits for 1985,1986 and 1987 also through
the use of provision accounting: "income smoothing on a heroic scale" (Nobes and Parker
1995, p 48). Analysts are becoming increasingly aware of the conservatism in German
accounts exemplified through the widespread use of provisioning. The DVFA, the German
analysts' society, has attempted to make adjustments for such conservatism to aid
international comparison of financial statements. One example of the extent of such
adjustments was highlighted by Natwest (1993, p 17): For the two German holding utilities
RWE and Veba 1991 DVFA adjustments amounted to equivalent of 32° a and 19% of net
assets respectively. The total extent of provisioning amounted to 54° a of the balance sheet
total in RWE's case and 40° a for Veba.
61
Table 4.5 The use of provisioning and the effect on taxation in Germany:
Deutsche Bank, Commerzbank and the Dresdner bank.
Source Derived from Natwest (1993) p20
Benetton is a clear example of the use of provisioning adopted by Italian companies.
In the 1991 consolidated accounts, Benetton reported a provision for doubtful debts equal to
3.3°o of total revenue. This is exceptionally prudent given the general Italian guidelines
recommend a provision of O.5° of trade accounts receivable until the provision reaches 5%
of trade debtors. Further provisions were made in general expenses resulting in an 18.4%
increase in administration costs. This has led to distorted ratios which show an increase in
cost over the period 1989 to 1991 of l25° whereas sales has risen by 39% for the same
period.
4.3.8 Capitalised Interest
There are basically three possible accounting methods for the treatment of borrowing
costs. These are:
62
• Account for interest on borrowing costs as an expense of the period in which it is
occurred.
• Capitalise the interest as part of the cost of the asset.

• Capitalise interest on debt and imputed interest on shareholders' equity as part of the cost
of an asset when prescribed conditions are met.
International differences exist as to the treatment of interest on funds borrowed to

finance the production of an asset. There is no explicit standard on this issue in the UK but
the Companies Act 1985 permits the capitalisation of interest with related disclosure.
However, there are no rules laid down as to how this should be applied if alopted, apart from
brief proposals adopted in ED 51, accounting for fixed assets and revaluations, which deals
with this in passing. Capitalisation is also permissible in France and Germany but is
prohibited in Japan. The US practice is more definitive on this subject calling for the
compulsory capitalisation of interest costs relating to specific assets during their construction.
The IASC published lAS 23, "Capitalisation of borrowing costs" wherein, capitalisation is
optional, but certain rules are laid down if policy capitalisation is adopted.
The effect of capitalisation is to inflate the balance sheet through the creation and/or
recognition of borrowing costs as an asset. This can be justified by recognising that the
borrowing costs incurred during the period of time to bring a fixed asset to the condition and
location necessary for its intended use, are part of the cost of purchasing the asset.
Furthermore, in favour of capitalisation, it can be argued that this achieves a closer matching
of income and expenditure compared to accounting for the interest costs as an expenses in the
period that they are incurred in the profit and loss account. The failure to capitalise the
borrowing costs associated with fixed asset purchases reduces reported earnings as a
consequence.
On the contrary, the opposing school of thought would argue that it is inconsistent to
treat borrowing costs as a period expense in any other circumstances than as a direct cost of
63
an asset during its period of construction, reverting to writing the expenses off to the profit
and loss account once completion of the asset is achieved. Inter-company comparisons are
hindered as the carrying amount of the asset, if capitalised, depends upon the method and
conditions relating to the type of fmance adopted. Most companies arrange finance for the
enterprise as a whole and therefore any attempt to associate certain borrowing costs with
specific assets can be deemed arbitrary.
4.3.9 Leasing
A lease is a contract between a lessor and a lessee for the hire of a specific asset. The
lessor retains ownership of the asset but conveys the right to the use of the asset to the lessee
for an agreed period of time and consideration in the form of rental payments. The
capitalisation, or not, of leases can have a dramatic effect on gearing and the rate of return on
assets, and therefore adjustments should be made. International practice differs depending on
whether economic substance is taken over legal form or vice versa, for international
comparisons. The capitalisation of a lease results in an increase in assets in the balance sheet
and reported earnings are not reduced, as they would be through the inclusion of lease
payments as an expense in the period that they are incurred in the profit and loss account.
In the UK, substance over form prevails, but there are depreciation and finance
charges for certain long leases so as to comply with the true and fair view, as the nature of
leases are equivalent to ownership of the assets, as all risks and rewards have been transferred
to the lessee. According to SSAP 21 finance leases should be capitalised in the balance sheet
of the lessee as an asset and as an obligation to pay future rentals. Finance leases are defined
as those leases where consideration at the inception of the lease is equal to 90% or more of
the initial fair value of the asset. Operating leases are those leases that do not fall within this
definition and these are not capitalised. US practice is along the same lines as the UK, SSAP
21 being based on SFAS 13 "Accounting for Leases", except the definition of a finance lease
is more comprehensive, incorporating alternative criteria to be fulfilled to warrant
64
capitalisation. There are no rules for individual company accounts concerning the treatment
of leases in France but finance leases can be capitalised when preparing consolidated
accounts.
More conservative, tax based countries such as Japan and Gennany focus upon form
over substance and therefore one would not expect the capitalisation of leases. Capitalisation
is permissible in Japan but rarely practised.
4.3.10 Foreign Currency Translation
The rate at which balance sheet and profit and loss items from foreign subsidiaries are
translated into the parent company's consolidated accounts can have a dramatic effect. There
exists a choice of three possible rates, the closing rate as at the balance sheet date, the historic
rate prevailing on the date of the actual transactions and the average exchange rate occurring
throughout the accounting period. The fourth and seventh directives governing Europe do
not explicitly state any rules relating to foreign currency translation thus resulting in a variety
of practices. The Netherlands and the UK have relevant standards and this has also been
implemented into law in 1989 in Spain. France and Germany do not have such a standard.
Most countries in the community use the current rate method which involves translating
balance sheet items at year end rates and profit & loss accounts at average rates for the year.
Any differences resulting from translation is posted to reserves. In the UK and France the
closing rate method is the most common practice, although the temporal method is
pennissible in France, and in the case of closely held subsidiaries in the UK. German
companies tend to use the temporal method far more. This involves translating items with the
exchange rates that are specific to them, e.g. fixed assets at historical cost, monetary items at
closing rate and non monetary items at the average rate. Assuming that the domestic
currency is strong against the currency of the subsidiary, this will result in higher fixed asset
values, compared to the closing rate. This was implemented in the US, SFAS 52, with any
gain or loss on translation being taken to the profit and loss account as opposed to reserves.
Japanese practice distinguishes between long and short term monetary items. Long term
65
monetary items are translated at historic rates so that no loss or gains on translation will
materialise until settlement occurs. This is very different from practice in other countries.
Short term monetary items are treated the same as in the US and UK.
4.4 SUMMARY
This chapter has highlighted the major differences existing between the GAAP
regimes of UK, US, The Netherlands, Germany, France, Japan, Spain, Italy and Sweden.
These differences have been quantified and qualified with respect to the resulting affects on
net profit and asset values in order to make a sensible analysis of the purpose for which the
information is intended in international equity valuation.
Specific examples of major differences have been examined and empirical evidence
shows that goodwill was most often the most significant factor affecting net profit Two
other principal differences were found to be significant: the treatment of deferred taxation
and; methods adopted for the valuation of stocks. Other differences thought to be material
included the valuation of fixed assets, long term contracts, the treatment of intangibles,
accounting for reserves and provisions, the treatment of capitalised interest, leasing and
foreign currency translation.
Due to the magnitude of diversity of the three principal aforementioned accounting
choices, this research will focus upon these with respect to gathering empirical evidence as to
how professional users of non-UK financial statements perceive these differences.
66
CHAPTER 5
INTERNATIONAL FINANCIAL STATEMENT ANALYSIS
5.1 INTRODUCTION
Financial statements are typically prepared according to the accounting principles and
standards accepted in the country where the accounts originate. The diversity in accounting
measurement, standards, fmancial disclosure and accounting choice across different GAAP
regimes is both apparent and material. The cause of this is that there are considerable
environmental, economic, political, legal and cultural differences that exist between countries
which have a significant impact on the accounting numbers reported. It would therefore be
reasonable to suggest that difficulties may atise foi analysts ot in'Qestors when interpreting
and analysing financial statements that originate from unfamiliar accounting environments.
This chapter attempts to address the following questions:
• Are analysts and investors aware of accounting differences?
• Is accounting diversity perceived to be a problem?
• How do analysts deal with diversity?
• What are the capital market effects of international accounting diversity?
5.2 ARE ANALYSTS AND INVESTORS AWARE OF INTERNATIONAL
ACCOUNTING DIFFERENCES?
Ignorance of analysts, investors and the press relating to accounting principles and
policies on an international basis appears to be declining. This statement is conjectural, based
upon the increase in demand for relevant literature such as the Baring's report (Nobes 1991),
a reference book relating to international accounting differences specifically commissioned
by Baring Securities to aid investment appraisal. Natwest Securities (1993) have also
67
produced a reference booklet, "European Accounting: Bridging the GAAP" outlining the
main differences in European GAAP regimes and those factors that are largely accountable
for their existence. The emergence of such literature is a step forward in educating the
investment community of the existence of accounting diversity across GAAP regimes.
However, little has been written relating to the role analysts play in international financial
statement analysis and the methods employed to reduce the heterogeneity of financial
statements for comparative purposes.
It is important for the users of financial statements to know how the accounts have
been prepared and what accounting principles have been used. The problems relating to
financial statement analysis on a domestic level have been highlighted in Chapter 2.
Applying fmancial statement analysis in an international setting is even more problematic.
Additional difficulties occur in the following possible ways:
• accounting diversity is not recognised as a problem or is ignored, for example because
the users of the financial statements are fixated with the bottom line or certain ratios.
This results in wrong decisions being made with capital being inefficiently allocated;
• accounting diversity is recognised and acts as a deterrent to international portfolio
diversification, having a detrimental effect upon efficient wealth distribution;
• accounting diversity is recognised and attempts are made to make financial data
more comparable across countries, firms and across time. Various methods have been
endorsed. Furthermore, all methods are expensive and many are insufficient, not
comprehensive and can result in misleading capital market decisions. For example there
is no straightforward method that encompasses the social, legal and economic

circumstances which need consideration. Naturally all methods are expensive to
implement, generally the more comprehensive the method the more expensive it will be
to adopt. This can act as a deterrent if believed to offset possible benefits gained from a
more comprehensive analysis.
68
5.3 IS ACCOUNTING DIVERSITY PERCEIVED TO BE A PROBLEM?
It is important to know whether accounting diversity acts as a deterrent towards
international portfolio diversification because of implications for efficient wealth distribution.
The growth in international financial markets in recent years would suggest that accounting
diversity is not an overwhelming hindrance. Choi and Levich (1991) for example, noted that
at least one in nine US equity trades has a foreign investor on the other side. I-lowell and
Cozzini (1989) found that, as of the 1988 year end, 6.7% of world equity market
capitalisation was held by cross border investors. Foreign direct investment in the US had
increased by 300% since 1980 and foreign holdings of US equities had increased by 200% in
the same period. These facts taken in conjunction with the voluntary disclosure, by many
firms listed on foreign exchanges, of information in excess of those countries' accounting
requirements, suggest that accounting diversity is not an insuperable obstacle to both foreign
investment and to raising funds on foreign exchanges.
Conclusions drawn from field research in this area are not consistent with these
observations. Choi and Levich (1991) interviewed major international fmancial statement
user groups, including institutional investors, underwriters, corporate issuers, market
regulators and rating agencies, to attempt to ascertain whether accounting diversity is seen to
be a problem. Those interviewed were domiciled in either New York, London, Zurich,
Frankfurt or Tokyo. Approximately half of the fifty two institutions interviewed felt that
their capital market decisions were affected by differences in GAAP regimes, therefore
indicating that accounting diversity is perceived to be a widespread problem. Furthermore,
Choi and Levich note that "...this finding is conservative as it does not include second-order
behavioral effects"; i.e. it does not include users who changed the way in which they analyse
foreign investments as a result of the accounting diversity problem, indicating that the
problem is even more serious than evidenced in this research.
69
The GAAP regimes most commonly cited as being an area of concern for the sample
interviewed were Japan, Switzerland and Germany. Others mentioned included Australia,
Continental Europe, France, Hong Kong, Korea, Latin America, Luxembourg, Norway,
Portugal and the US. Berry (1987), in an attempt to adjust the earlier classification taxonomy
of Nobes (1 984a), has visualised the differences between accounting systems by highlighting
the difficulties involved in comparative financial statement analysis between the countries in
the model (Figure 5.1). The farther apart the countries are in the classification, the greater the
required effort to analyse and compare, as the cultural differences influencing accounting
development are more pronounced.
The accounting principles that exhibited problems for the sample interviewed by Choi
and Levich related to ".. multinational consolidation, valuation offixed assets, deferred
taxes, pensions, marketable securities, discretionary reserves, foreign currency transaction
and translation, leases, goodwill, depreciation, long-term construction contracts, inventory
valuation and provisions."
Problems were also experienced relating to disclosure. The level of detail of
disclosure for specific items varies considerably both within and between countries. Lack of
information relating to specific items can cause interpretation problems. The infrequency of
disclosuie is also a hindrance towards comparative international financial statement analysis.
This can be contrasted with the US and Spain, where quarterly reports are required, with most
other counties reporting on either a semi-annual or an annual basis. Therefore it is not
possible to compare the first, second or third quarter reports of American or Spanish
companies with most foreign counterparts.
70
Table 5.1: Classification of international accounting practices; capitalist
accounting measurement.'

Government Sweden
Economics
Law based ___________________________ Japan

MACRO Germany
UNIFORM
Switzerland
Government, France
Tax, Legal European Belgium
Based on plans Italy
and tax Spain
rules
- Argentina
South American Brazil
H Bolivia
Chile
Columbia
Paraguay
Uruguay
Mexico
Peru
Bermuda
US influence Philippines
US
Canada
Venezuela
Business
practice UK
pragmatic UK Ireland
MICRO origin Bahamas
UNIFORM Fiji
Jamaica
Kenya
Malaysia
UK influence Nigeria
Singapore
Zimbabwe
South Africa
New Zealand
Australia
Business The
economic theory Netherlands
1 Source Berry (1987) adaptation from Nobes suggested classification of accounting systems
71
5.4 INTERNATIONAL COMPARATIVE FINANCIAL STATEMENT
ANALYSIS: TECHNIQUES.
There are numerous different techniques advocated by analysts in order to cope with
international accounting diversity. These include the reliance on macroeconomic data,
avoiding accounting differences altogether, e.g. adopting a 'lop-down' investment approach,

trend analysis, ratio analysis and the restatement of financial statements to a more familiar
GAAP. With reference to Choi and Levich (1991), 60% of investors interviewed responded
that accounting diversity is a problem. Of this 60%, 78% cope by restating the financial
statements to a more familiar GAAP, 11% choose to limit foreign investment to government
bonds, 11 % cope by adopting a top-down approach. For the 40% of investors who responded
that accounting diversity is not a problem, 57% cope by developing a 'multiple principles
capability'; i.e. adopting a local perspective by familiarising themselves with the different
GAAP regimes (see section 5.6 for a further explanation). The remaining 43% deal with
accounting diversity by relying on information less sensitive to accounting principles; i.e.
relying on macroeconomic data or developing a dividend model. The following section will
discuss these different techniques in detail.
5.4.1 Reliance on Macroeconomic Data

A predominant method employed by investors when analysing foreign securities is the
'top-down' approach. This is a passive investment strategy which relies upon economic
variables such as market capitalisation rates or GNP weights to determine the country
weightings for asset allocation decisions. Once a country is selected, diversification occurs
within the country, eliminating the need to perform cross-country comparisons. Assets are
usually selected according to their market weights, thus aiming to match, not outperform, the
market index. This technique avoids the problems related to international accounting
diversity.
72
This top-down approach and indexation technique was not developed in response to
the accounting diversity problem but arose in the US due to the difficulty in gaining abnormal
returns from available accounting information with such high levels of market efficiency
present. A less passive approach would be to adopt such methods only in those countries
where the accounting diversity poses a problem, but where there are good investment
opportunities due to growth prospects or favourable capital market regulations.
5.4.2 Trend Analysis
This technique involves the comparison of companies by way of certain trends
calculated, e.g. annual revenue trends, annual revenue changes, aimual net income trends,
geometric (compound) revenue growth rates etc. Published accounts typically include data
on the past two or three years, with up to ten years on some selected items. Trend analysis
generally involves comparing successive years with the base year so that growth rates from
the base year can be calculated. This is a major problem of this technique as the results are
extremely sensitive to the base year chosen, therefore it must be applied with care. It is also a
problem if accounting rules change without restatement of priors. This is a typical problem
in Europe in the late 1 980s, as a result of implementation of the fourth and seventh directives.
5.4.3 International Financial Ratio Analysis.
It is well documented (Arnold and Moizer,1984; Pike et al,1992) that domestic
analysts focus on certain accounting numbers and ratios, such as earnings, gearing levels and
the P/E ratio, when undertaking analysis. The increase in international financial statement
analysis leads to the application of such techniques on foreign companies. Problems will
arise if the analyst or investor is fixated with the resulting figures obtained, thus ignoring the
environmental factors that are inherent in shaping the original financial statements. Examples
of restatement are described in the next section (5.4.4). Restatement is a preferable approach
to many rule of thumb or functionally fixated techniques. It involves endeavours to carry out
a line by line adjustment of the accounts. At a minimum, this should be for the material
73

reconciliation items, and any further analysis should be interpreted with a prior knowledge of
the accounting environments of the countries examined. An examination of the PIE ratios of
equities from different accounting regimes illustrates this, as shown in Table 5.2.
Table 5.2: Illustration of variations in PIE and P/CE ratios between different
accounting regimes2
P/E Ratio P/CE Ratio (1)/(2) (3)11.92* Adjusted. P/E

ratio (1)1(4)
_____________ (1) (2) (3) (4) ________________
UK 11.1 6.6 1.68 88 12.69
US 14.6 7.6 1.92* 100 14.60
France 9.5 4.7 2.02 105 9.03
Germany 12.7 4.0 3.18 166 7.67
L Japan 31.3 10.5 2.98 155 20.17
From table 5.2 it can be observed that the ambiguity surrounding this practice is
paramount in the example of an investor comparing Japanese with US or UK based PIE ratios
(31 .300 compared to 14.6° o or 11.1% respectively). The difference is still evident when price
to cash earnings (P/CE) is used (10.5 oo for Japan compared to 7.6 for the US and 6.6 for the
UK). This is expected as the definition used for cash earnings is profit plus depreciation, thus
all other accounting policy differences between the countries remain incomparable! It is well
documented that PIE ratios of companies listed on the Tokyo Stock Exchange are materially
larger than those one would expect to find for companies listed on the London or New York
Exchanges. For example, Aron (1991), quoting from MSCIP's September 1990 issue, found
that the average P/E ratio of companies in the Japanese stock index on 31 8 90 was 2.35
times higher than that of the US. The average PIE ratios were 34.3 for Japan and 14.6 for the
NYSE. This would immediately pose the question of what is the cause of such material
differences. Can the differences in earnings calculations elucidate the disparity or is it due to
incongruent expectations and investor analyst behaviour? Empirically the answer to this
2 Data taken from the InternatIonal Equity Market, 31 January 1991 (Aron, 1991).
74
question has not yet been reached. However, drawing upon a limited knowledge of the
accounting environments in question, conjecturally one's rejoinder would be "both are
responsible". The economic outlook and prospects for each country, each industry and each
company must be considered in conjunction with the differences in accounting policies. For
example US consensus GNP 1990 growth was 2% and Japan's 4.5%. Aron (1991) calculates
that each unit of growth is represented by 7.3 PIE units for the US and 2.78 PIE units for
Japan.
Cooke (1992) provides evidence of analysts making adjustments for accounting

differences in order to arrive at more comparable ratios (see section 5.4.4 (a-e). Choi et al
(1983) investigated the possible misinterpretation by the US investment community of
financial ratios calculated from the financial statements of Japanese and Korean companies.
The most frequently used ratios for investment appraisal were selected to compare the
accounting based liquidity, solvency, profitability and efficiency of the Japanese and Korean
companies with matched American counterparts. Two approaches were embodied in this
research, examining the original financial statements drawn up in accordance with domestic
GAAP and those adjusted for US GAAP, therefore attempting to discern the degree to which
the resulting differences in the ratios might be explained by differences in GAAP. Both the
adjusted and unadjusted financial statements were subjected to a rigorous financial ratio
analysis.
The results appeared quite striking, indicating that in both instances Japanese firms
appear less liquid, solvent, efficient and profitable. Consider the extract in Table 5.3,
comparing Polaroid (US) and Canon (Japan). The figures represent the percentage difference
between the calculated ratios; if for example the current ratio of Polaroid was 2.3 and Canon
I the resulting figure would be 55% [(2.3-1)12.3] i.e. the difference between the current ratio
of Polaroid and Canon is equivalent to 55% of Canon's current ratio. Conversely, a negative
figure denotes that the ratio calculated for Canon exceeds that of Polaroid.
75
The results obtained from this research are indicative of the problems encountered in
undertaking international financial ratio analysis. A straightforward interpretation would
render the Japanese companies examined, which were those most likely to seek listing on the
NYSE, subordinate to the US companies on all accounts. The magnitude of the differences
also illustrate the blatant incomparability of the accounting systems of Japan and the US
through the use of ratio analysis and the inappropriateness of adjustments that use rule of
thumb principles.
Table 5.3 Mean paired percentage differences in selected ratios: the

U.S.(Polaroid) compared with Japan (Canon)3
These numbers have little significance in themselves, they are indicative of the
prevailing differences that exist between the two countries' environments. Considering the
effect that the adjustments to US GAAP have had in explaining the differences, the principal
3 Source: Choi et al (1983).

4Unadjusted difference refers to the difference calculated between the original financial statements.
5Adjusted difference refers to the difference calculated between Japanese companies and their American
counterparts, afler adjusting for US GAAP.
76
explanatory factors would appear to lie in the environmental and culture arenas that are
influencing the accounting systems responsible for the production of the financial statements.
The following considerations are aimed at providing such an insight.
If one carried out a straightforward comparative analysis of a Japanese and an
American public company there would be a high probability that the Japanese company
would appear to have a frighteningly high level of gearing compared to its American
counterpart. Taking the Polaroid - Canon example, the debt ratio for Canon was almost three
times the debt ratio for Polaroid, for the period examined. Interpreting this without a prior
knowledge of the Japanese environment would lead to conclusions implying that there is a
greater amount of risk associated with the Japanese company. On the contrary, the level of
gearing is high not only because the accounting numbers are calculated differently, but also
because debt is actually more important in Japan. This environmental factor cannot be
incorporated directly into a straight numerical analysis but awareness of such factors should
be a prerequisite to analysis if results are to be considered purposeful and comprehensive.
Profitability is not such a predominant consideration to the manager in Japan as it is in
the US or the UK. 1-listorically the Japanese culture has placed much emphasis upon the
policy of life long employment, with workers retaining far closer contacts to their employers
than is observed in Anglo-American cultures. Consequently, Japanese managers are less
concerned with short term profits and concentrate upon alternative objectives such as
strengthening market share and obtaining sales growth. In a highly competitive market these
objectives lead to low profit margins. However, by taking this long term perspective, future
profits are assured along with a higher degree ofjob security. Furthermore, Japanese industry
is characterised by the existence of the 'keiretsu', enterprise groupings that were formed
around the major commercial banks. These were set up following the destruction of the
Japanese economic base during the second world war and the US-led break-up of zaibatsu
conglomerates, in an attempt to rebuild the economy. Over the years the independence of
these groupings have increased, developing very close relationships between members.
77
Shares of companies are often held by the keiretsu members who are also more interested in
the long term viability of the enterprise and not short term gains.
The risk associated by western analysts of high gearing is not applicable in the
Japanese example. Due to the close relationship of the banks and their clients within the
keiretsu, financial penalties on delayed interest payments or foreclosure on a loan rarely

occurs. Alternatively, loans are often refinanced on more favourable terms that the
borrower finds more manageable. Consequently the rate of liquidations in Japan is modest
compared to the US despite some firms obtaining up to 80% of their funds through long term
loans. This was shown to be the case earlier as stated in Choi et al (1983). A further
advantage of debt financing is that firms do not fret over meeting dividend payments. On the
contrary, dividends are often immaterial, with some companies paying as little as 10 yen (US
$0.07) per share. Similar dealings occur between suppliers and buyers. During difficult
financial times repayment extensions are granted to avoid placing the debtor in a potentially
illiquid position. Following this one would therefore expect efficiency indicators such as
average collection period to appear less promising than Anglo-American counterparts. This
is consistent with the aforementioned research with efficiency ratios of the US firms
examined exceeding their Japanese matched pairs on all accounts.
Due to the complexity of such factors, Aron (1991) calls for a single common
framework of accounting and of earnings capitalisation, for international equity valuation. In
his paper entitled "Japanese P/E ratios in an environment of increasing uncertainty" he
endeavours to calculate comparable PIE ratios for Japanese and US firms. Adjustments
include allowances for discrepancies in the time frame of the index used. This is necessary
because US firms generally report on a quarterly basis, whereas Japanese firms report semi-
annually, with yearly group accounts, thus the average accounting dates required adjustments
to render them comparable. Numerous accounting based adjustments were carried out
incorporating major items such as the ostensibly conservative Japanese reserves for bad
debts, goods returned, special repairs and product guarantees. Factors such as deferred
78
taxation, accelerated tax depreciation, expending of intangible assets, translation gains, and
delays in recognising profits from instalment and long-term contracts must all be calculated
together with their effect on the company's P/E ratio. Aron also carried out adjustments for
cross-holding, as 57.5% of listed equities in Japan are owned by other institutions, a
characteristic of the keiretsu. Aron likens this 57.5% of the Japanese securities market to US
treasury stock, and therefore adjustments are required to reflect the real capitalisation rate of
the shares that are freely traded by non-institutional shareholders. Finally, in order to ensure
that Japanese and American companies are capitalised on the same basis, an adjustment is
required to the risk premium for the two countries. This is evidence of a comprehensive
analysis, undertaken by an investment analyst (Daiwa Securities America, Inc.), recognising
the extensive need to do more than a straight comparison of basic accounting figures whilst
undertaking international financial statement analysis. This approach overcomes many of
the pitfalls of less thorough techniques yet it is evident that most analysts do not undertake
such extensive modelling techniques. A commentary on the significant accounting
differences perceived to warrant adjustment for Japanese companies in order to arrive at more
comparable ratios, as recognised by Cooke (1992), is detailed in the next section (5.4.4 (a)-
(e))
5.4.4. Restatement of financial statements to a more familiar GAAP.
A clear example of basic reconciliation for international comparative purposes, is the
US GAAP reconciliation requirement endorsed by the SEC. All companies wishing either to
list their securities on NYSE or the NASDAQ or to offer securities to the public in the US,
must first register with the SEC. Regulatory requirements endorsed by the SEC have
included that some degree of reconciliation of foreign GAAP to US GAAP be included, via
Form 20-F, since 1977. Compliance with Form 20-F involves disclosing information in the
financial statements that has a similar content to those prepared according to US GAAP. The
financial statements required can either be prepared in accordance with US GAAP or with
local GAAP supplemented by the following disclosures:
79
a discussion of the material variations in the accounting principles, practices, and the
methods used in preparing the financial statements from the principles, practices and
methods generally accepted in the US and in Regulation S-X;
a reconciliation of reported net income to net income according to US GAAP. Each
material variation identified has to be described and quantified as a separate reconciling
item. The reconciliation should be presented periodically for which an income statement
is presented and disclosed on the face of the income statement or in a note thereto;
. the amount of each material variation between an amount appearing in the balance
sheet and its equivalent determined using US GAAP and Regulation S-X.
Cooke (1992) provides evidence of analysts making adjustments for accounting
differences in order to arrive at more comparab(e PIE ratios for Japanese companies, (refer to
section 5.4.3). The following section contains a brief commentary relating to those
significant differences that are perceived to warrant adjustment by Cooke for Japanese
companies ((a) - (e)) and Pereira et al (1992) ((1) - (s)) for US companies.
(a) Depreciation of Tangible Fixed Assets.
Analysts sometimes make adjustments to compensate for the use of accelerated

depreciation rates in Japan that act to artificially reduce earnings and hence inflate the P/E
ratio. Earnings before depreciation is used as a proxy for cash earnings so a reconciliation for
depreciation, in order to carry out a US comparison, using the figures given in table 5.2,
would be to adjust Japanese earnings by 298/192. This is because US cash earnings were
192% of reported earnings and Japanese cash earnings were 298% of reported earnings. This
would reduce the Japanese P/E ratio from 31.3 to 21.17. The characteristics of such rule of
thumb adjustments cannot incorporate the reasons why depreciation charges are high in Japan
compared to other countries. For this reason it can be argued that this leads to further
distortion and misinterpretation of financial figures thus rendering analysis incomplete arid
ambiguous.
80
(b) Consolidation.
Group accounting is a recent phenomenon in Japan, the first legislation relating to
consolidation being passed in 1975, resulting in audited consolidated statements becoming
mandatory for listed companies. As a consequence many companies reduced their holding in
subsidiaries to below the 50% threshold to avoid consolidation. Furthermore they can be
excluded if the contribution of the subsidiary is less than 10% of the net profit of the parent.
This omission of subsidiaries causes the artificial inflation of PIE ratio of parent companies.
It is worth mentioning that a new Japanese consolidation law passed in September
1988 and effective for financial years beginning April 1, 1989, has caused PIE ratios to
decline to a more omparable level' for purposes of international financial statement analysis.
More meaningful information should now be reported as subsidiary contributions to the
financial position of the group will have to be included in financial reports. Smith New
Court, a London based stockbroker reviewed the new law, reaching conclusions that
consolidation added more than 20% to parent net profits in over 30% of all the companies
examined. The effect upon PIE ratios was generally to deflate them, e.g. Nagoya Railroad
was expected to halve its parent's P/E ratio of 272.73 to 134.33. Despite the dramatic effect
that such legislation has upon financial ratios, it should not be dismissed that the underlying
environments of Japan and the UK, US or any other country compared against it, are very
different and thus care still needs to be applied whilst undertaking comparative international
financial statenient analysis.
(c) Tax.
Accounting profit is closely related to profit for taxation purposes in Japan, giving rise
to a far greater use of provision and reserve accounting compared to accounting regimes that
separate the two systems. There are many designated provisions, such as those for bad debts,
that are allowable for tax purposes together with a number of reserves provided that they are
81
recorded in the accounts. This ultimately calls for adjustments to earnings and hence the PIE
ratio when comparing Japanese companies with foreign counterparts that do not employ such
practices.
(d) Inventories.
Adjustments are often required due to the flexibility of the permissible methods
allowed for inventory valuation: for example, FIFO, LIFO, unit cost, weighted average cost,
moving average cost, straight average cost, latest purchase price, retail inventory cost, or a
lower figure are all permissible.
(e) Goodwill (Japan).

All intangible assets must be recognised in Japanese accounts. Goodwill should be
amortised over a maximum of five years according to the requirements of the Commercial
Code. If goodwill is not taken into consideration when applying financial ratio analysis on
comparable UK, US and Japanese firms, misleading results will occur as Goodwill is taken
straight to reserves by most UK companies and amortised over a maximum of forty years in
the US.
Pereira, Paterson and Wilson (1992) of Ernst & Young carried out a survey of GAAP
reconciliation statements found in the 1991 published annual reports on Form 20-F of 39 UK
SEC registrant companies. Only 10% of the registrant companies examined filed financial
statements that had been prepared in accordance to US GAAP. The remaining UK
companies filing with the SEC, submitted UK GAAP financial statements with an additional
statement restating each material variation as a separate reconciling item. A commentary of

those significant differences that required separate disclosure under Form 20-F found in the
survey will follow.
82
(1) Goodwill (US)
Of the 39 companies examined, 38 disclosed material adjustments for goodwill. The
only company that did not disclose a material adjustment for goodwill was British Petroleum
(BP). This can be explained by the fact that BP is one of a small minority of companies in
the UK that amortise goodwill through the profit and loss account, as opposed to writing off
goodwill immediately to reserves. In the US, acquired goodwill is amortised over a period
not exceeding 40 years, hence resulting in necessary adjustments for most UK registrant
companies. The magnitude of this adjustment expressed as a percentage of both net income
(UK GAAP profit after tax and extraordinary items but before minority interest) and
shareholders' equity (comprising capital and reserves shown in UK group balance sheets plus
minority interest) is illustrated in Table 5.4.
The goodwill adjustment had the largest effect of all adjustments on net income
reported under UK GAAP in 19 of the 39 companies examined. In 12 instances this resulted
in a downward adjustment on net income of more than twenty percent. Similarly the effect
on shareholder equity is material, with 30% of companies increasing shareholders' equity
under UK GAAP by an adjustment exceeding 100% in order to arrive at a US GAAP
equivalent. This increase is due to the effects of capitalising goodwill under US GAAP.
Negative goodwill treatment also differs, its being credited directly to shareholders'
equity in the UK and allocated to reduce proportionally the values assigned to any fixed
assets acquired in the US. There was one instance of an adjustment with regards to negative
goodwill in the findings of Pereira et al (1992).
83
Table 5.4 The effect of US GAAP reconciliation for goodwill on UK SEC
registered companies.6
COMPANY NET INCOME EQUITY

% decrease % increase
Midland Bank plc 94.9 3.8
WPP Group plc 86.3 305.4
Medeva plc 86.0 185.8
British Steel plc 62.9 6.4
Saatchi and Saatchi Company plc 59.7 183.4
United Newspapers plc 56.5 257.0
National Westminster Bank plc 55.4 11.0
Carlton Communications plc 45.0 190.6
Ratners Group plc 31.9 164.1
Attwoods plc 28.3 220.6
Grand Metropolitan plc 28.0 58.2
Willis Corroon Group plc 22.7 197.8
London International Group plc 19.3 47.9
Imperial Chemical Industries plc 18.8 21.7
Smith and Nephew plc 18.0 90.5
BOC Group plc 15.5 14.9
Bass plc 14.7 32.7
Barclays plc 12.8 7.5
Tomkins plc 11.7 103.0
Reuters Holdings plc 10.8 12.0
Unilever Group plc 10.4 88.3
Hansons plc 8.5 103.4
ECC Group plc 8.0 13.8
BET plc 7.2 190.0
Vodaphone Group plc 6.1 27.8
Cable and Wireless plc 4.5 22.7
NFC plc 3.1 19.8
LEP Group plc 2.4 20.0
British Airways plc 2.3 26.1
Royal Bank of Scotland Group plc 1.9 10.8
SmithKline Beecham plc 1.9 47.6
British Gas plc 1.5 2.4
Racal Telecom plc 1.3 19.2
Wellcome plc 0.8 0.3
British Telecommunications plc 0.4 3.1
Glaxo Holdings plc 0.3 0.6
6 Source: derived from Pereira et al, 1992, pp 384-393.
84
(g) Deferred Tax
82% of companies reviewed exhibited adjustments to reconcile the differing treatment
of deferred tax under UK and US GAAP. Under UK GAAP, deferred tax is only accounted
for to the extent that it is probable that tax liabilities/benefits will crystallise. The liability
method is used whereby the tax rate used is the one ruling when the timing differences are
expected to reverse. In accordance with US GAAP, a full provision should be made for all
deferred tax liabilities. A further discrepancy between UK and US GAAP, as per FAS 96, is
the application of the tax rates ruling when the provision is made. FAS 96 introduced the use
of the liability method over the deferral method, but was postponed and has now been
replaced by FAS 109, confirming the liability method. Only LEP Group plc and Vodaphone
plc had adopted FAS 109 as at 3 1/12/91 and 3 1/3/92 respectively.
UK GAAP earnings were depressed in 56% of companies due to deferred tax
adjustments. Similarly shareholders' equity as reported under UK GAAP also reduces when
the reports are drawn up in accordance with US GAAP, as was evident in 82% of companies
reviewed.
(h) Pension costs

Pension costs were found to be a material adjustment in 77% of those companies
examined. Under SSAP 24, in the UK, the employer should recognise the expected cost of
providing pensions on a systematic and rational basis over the period during which benefit is
derived from the employees' services. In the US, FAS 87 states that net periodic pension cost
is made up of several components that reflect different aspects of the employer's financial
arrangements as well as the cost of benefits earned by employees. The actuarial method
prescribed by FAS 87 is the projected credit unit' method which uses the cost of securing
benefits accruing each year to scheme members. SSAP 24 does not stipulate the use of any
specific method, hence, a range of methods are adopted. FAS 87 attempts to match pension
costs more closely to individual accounting periods than SSAP 24. This is evident in that
85
under US GAAP the latest discount rate is used in actuarial calculations, whereas a long term
interest rate is used under SSAP 24. Furthermore, actuarial assumptions are reassessed
annually in the US but only every three or four years in the UK. As exhibited in the US
GAAP reconciliation statement for British Telecom, Figure 5.5, the US practice can give rise
to large yearly fluctuations compared to the pension costs reported under UK GAAP.
Table 5.5. Extract from the US GAAP reconciliation statement for British
Telecom plc. for the treatment of pension costs from 1990 to 1992.
1990 1991 1992

____________________________ Liii Lm Lrn
UK SSAP 24 Pension Cost 178 145 156
US FAS 87 Pension Cost 151 110 337
Further adjustments were observed with regards to the following (figures in brackets
represent the percentage of UK registrant companies examined that disclosed a

reconciliation):
(I) Dividends (77°o).
Under US GAAP dividends are only accounted for when they are declared, whereas
proposed dividends in the UK are recognised, necessitating an appropriate adjustment against
equity for all companies that had proposed a final dividend for the 1990 91 accounting period
in order to be consistent with American accounting principles. This would cause UK equity
figures to be adjusted upwards to US GAAP.
) Revaluation of fixed assets (67° o).

This adjustment had a pronounced negative effect upon UK shareholders' equity, the
extent was second only to those of goodwill. The adherence to strict historical cost principles
86
in the US and the allowance of revaluation on an ad hoc basis in the UK is the cause of this
adjustment.
(k) Business combinations (36%)
Although this adjustment was not made by the majority of companies examined, the
effect upon UK shareholders' equity in certain cases was by far the greatest of all
adjustments. The best illustration of this is provided in the case of SmithKline Beecham.
Under UK GAAP, the business combination was accounted for using the merger method of
consolidation, i.e. the assets of the group are represented by the total of the historical net
assets of both SmithKline and Beecham in the group accounts. For US GAAP reporting
purposes the business combination was not recognised as a merger. Consequently,
Beecham, being treated as the acquired company, was accounted for in the group accounts by
allocating independently fair values to its assets and liabilities, the remaining balance was
allocated to goodwill. This practice is known as the purchase method. The SmithKline/
Beecham merger occurred in 1989 yet the adjustment was still equal to 417% of UK
shareholders' equity for the 1990/9 1 accounting period. Furthermore the goodwill generated,
£2,688 million in this example, will need to be amortised and written off over forty years, in
order to comply with US GAAP. The effect upon UK figures for US restatement purposes
will therefore continue for niany years.
(1) Capitalised interest (26%).
There is no accounting standard governing interest capitalisation in the UK and the
Companies Act 1985 allows but does not require the capitalisation of interest on funds
borrowed to finance the production of an asset. This results in an array of practices within the
UK. On the contrary detailed rules are present in US GAAP (FAS 34, 58, 62), stipulating
when interest should be capitalised, the amount that should be capitalised and the period in
which capitalisation should take place. Generally, an adjustment to US GAAP leads to an
increase in equity.
87
(m) Revenue recognition (23%).
The majority of items falling within this category relate to real estate transactions. As
expected US GAAP is more prescriptive than UK GAAP, explicitly stipulating rules
governing the recognition of gains from real estate transactions. For example, the 10%
reduction in UK net income as reported by NFC plc, in the reconciliation statement
accompanying the accounts for the year end 5/10/9 1, was due to recognising profits on the
disposal of land and buildings when contracts have been exchanged. According to FAS 66,
the sale of the assets has to be completed before recognition can take place. The survey
found few other adjustments occurring within this category. Ratners Group plc made a
downward adjustment of3.991m in 1992, relating to the recognition of profit on the sales of
warranty agreements. These are taken into account immediately in the UK, whereas the
estimated profit is spread evenly over the period of the warranty agreement in the US.
Similar differences exist relating to the recognition of revenue from loan origination fees arid
costs that were included in the reconciliation statement of three of the four banks examined.
(n) Disposal of subsidiary (2 1%).
Reconciliation is required where UK companies have not included attributable
goodwill when calculating the profitlloss on disposal of a business segment. As reinforced in
UITF 3, December 1991, UK companies are now required to include goodwill, previously
eliminated against reserves, in such calculations, making practice more akin to US GAAP.
(o) Depreciation (2 1%).

Depreciation principles for properties differ between the UK and US, accounting for
the majority of the adjustments in this category. In the UK depreciation is not always
provided for on property with an expected useful life of over 50 years, whereas this is
mandatory in the US. Compared to other adjustments the magnitude of the depreciation
reconciliation was not found to be great in the companies examined.
88
(p) Leasing (13%).
This reconciliation is principally a result of the differences that exist between sale and
leaseback accounting under the two regimes. Again this reflects the more conservative
attitude embodied within US GAAP as the immediate recognition of profits arising on the
sale of an asset in a sale and leaseback transaction is prohibited in the US but permissible
under UK GAAP if the lease is an operating lease. The only companies disclosing this
adjustment were Barclays, British Airways, Midland Bank, Ratners and WPP. In all cases
except Midland the adjustment was less than 1.4% of UK GAAP net income.
(q) Foreign Currency Translation (10%).
The size of adjustments relating to the reconciliation of UK and US accounting

principles governing foreign currency translation were on average less than 2% of UK net
income and shareholder equity. These resulted from the application of year end rate in the
UK for revenues and expenses whilst the average rate is required in the US for these items.
(r) Debt/Share Issue Costs (8%).
UK practice in this area is moving towards that exhibited currently in the US.
However the proposals advocated by the ASB have not been adopted yet, giving rise for the
need of a reconciliation adjustment. Current practice is to charge any discount on the issue of
loan capital and expenses, directly to retained income and other reserves. Practice in
accordance with US GAAP would be to capitalise such items in the balance sheet as a
deferred charge, to be amortised over the life of the loan.
(s) Foreign Exchange Contracts (8%).
This adjustment is necessary if forward exchange contracts are entered into and
treated as hedges of future income under UK GAAP. Under US GAAP these instruments
require revaluation at the balance sheet date, taking any loss/gain to the income statement for
the period. The majority of companies, that reported material amounts relating to foreign
exchange contracts adopted US practice for UK reporting periods and consequently only
89
British Airways, The BOC Group and Willis Corroon Group were required to make
adjustments on Form 20-F.
(t) Amortisation of Intangible Assets (5%).
This adjustment derives from the unwillingness to amortise intangibles by a small
percentage of UK companies. In order to bring figures into line with US GAAP, intangibles
must be amortised over a period not exceeding forty years. The findings of the survey
relating to this category are conservative due to some adjustments being amalgamated with
those for goodwill.
(u) Restructuring Provisions (3%).
British Telecommunications plc 'was the only company exarnineà to make t'rñs
adjustment. Their disclosure stated "... a provision ofJ39O million was made as an
exceptional charge under UK GAAP for the costs of restructuring the group over several
years; the provision excluded the incremental pensions liability for pension benefits
attributable to employees taking early retirement. Under US GAAP, the requirements for
establishing provisions for restructuring costs are more restrictive than under UK GAAP, but
must also include any incremental pensions liability." Other companies included provisions
for restructuring in their filings, e.g. Unilever, Id, ECC Group, but as there is no specific
guidance in either country concerning the recognition of restructuring costs no adjustment

was made.
From Table 5.6 it can be seen that there are several major differences that are
recognised and reported between UK and US GAAP. These can have a significant effect on
both net income and shareholders' equity as reported in any one country. On average the
effect upon net income, as reported under UK GAAP, of reconciliating the above items was a
reduction of 41.2%. Shareholder equity rose, on average, by 66.4% explainable principally
through the effect of capitalising goodwill in the US.
90
Table 5.6 Average total adjustments made on form 20-F by UK registrant
companies in 1991
Number of Average effect on Average effect on

companies UK GAAP net UK GAAP equity
affected profit
(out of 39)
Goodwill 38 23.26 71.89
Deferred taxation 34 14.23 8.41
Pension costs 30 8.56 2.35
Dividends 30 5.84
Revaluation of fixed assets 26 1.03 14.31
Business combinations 14 17.88 32.99
Capitalised interest 10 8.36 3.22
Revenue recognition 9 14.30 5.41
Disposal of subsidiary 8 13.01
Depreciation 8 9.63 4.94
Leasing 5 12.06 2.42
Foreign currency translation 4 1.18 1.55
Debt/share issue costs 3 0.97 0.43
Foreign exchange contracts 3 1.03 0.67
Intangible assets 2 7.05 3.35
Restructuring provisions 7.20 8.25
This is an example of the need for reconciliation as perceived by a regulatory body,
the SEC, who require the disclosure of more comparable financial information for those
companies seeking listing. Germany, however, is the only country, according to a recent
working paper by Rees, Pope and Graham (1992) where analysts have developed and utilised
standard procedures relating to such restatement techniques.
The DVFA (Deutsche Vereinigung für Finanzanalyse und Anlageberatung) the
German professional association of financial analysts and investment advisors, adjust the
accounts of the largest German companies. Such an adjustment is deemed necessary for
purposes of equity valuation as it is widely recognised that the tax based financial statements
that are publicly available are highly conservative and lack shareholder orientation.
91
Although the DVFA historically advocated the application of the adjustments for domestic
purposes, comparing German companies, there is now evidence that international investment
appraisers have been employing the procedures to compare German companies with foreign
counterparts from less conservative accounting regimes. Similar procedures endorsed by the
Schmalenbach-Gesellschaft, the association of academics and practitioners devoted to the
advancement of theory and practice of business economics, have recently become reconciled
with the DVFA adjustments. The Institute of Investment Management and Research (IIMR)
have carried out similar adjustments for the UK from 1994. This was in response to FRS3:
Reporting Financial Performance, which through a restructuring of the profit and loss account
has focused analysts' attention towards the inadequacies of relying upon one profit figure
and the use of PIE ratios in analysis. FRS3 profit and loss accounts are now devoid of
extraordinary items and distinguish between profit from continued and discontinued
activities. The result is a statement with several "earnings" figures and EPS ratios. The
"Headline earnings" published by the IIMR in the Financial Times is an attempt to adjust
and consolidate FRS3 based results back into a single figure for analysis. However, the
resultant figure is more meaningful than earnings figures utilised prior to FRS3 as it is
forward looking, excluding all discontinued items, and is less 'fudgeable' because of the new
treatment of exceptionallextraordinary items (IIMR, 1992; Map Securities, 1992)
On average the adjustment results in an 18-30% higher reported earnings figure. The
main differences between German and Anglo-American practices can be found in an
examination of Chapter one and are therefore not discussed in detail here. The main items
adjusted by the DVFA however include the following, where material i.e. 5% of profit:
• reserves. Adding back associated provisions to net profit that have been used to create
medium and long term reserves;
• depreciation. The exclusion of any unnecessarily rapid accelerated depreciation
endorsed for tax purposes;
92
• pension provisions. Add back any provisions in excess of a standard 6% tax allowable
discount factor;
• accounting for associates. The attributable earnings of unconsolidated associates are
included in earnings;
• currency gains and losses. Those incurred outside normal trading activity are excluded
from earnings;
• stock valuation reserve. Reverse any write-off in stock valuation. Any adjustment
relating to LIFO is ignored;
• non-recurring items. Exclude all items that have been incurred outside the ordinary
trading activities of the company. This includes the cost of issuing new equity and the
profitiloss on the disposal of fixed assets. Contrary to UK GAAP no distinction is made
between routine disposal and the disposal of a major part of the business;
• goodwill.
These adjustments are successful in eliminating the major differences that act as a
deterrent towards international comparative analysis. This procedure provides a framework
in which the individual analyst can work exercising their own judgement and subjectivity in
order to gain a more useful assessment of the company in question.
5.5. INTERNATIONAL FINANCIAL STATEMENT ANALYSIS:
TRANSLATION PROBLEMS
A further concern of international financial statement analysis is the quality of
primary information used, especially where language and translation barriers exist, precluding
the use of the original statements. For example, the research conducted by Choi et al (1983)
to investigate the possible misinterpretation, by the US investment community, of ratios
calculated from the financial statements of Japanese and Korean companies (see section
5.4.3), did use the original Japanese financial statements, which the researchers translated into
English. However, most western analysts do not have the ability to do this and therefore have
to rely upon 'convenience translations', non-statutory accounts prepared by the company.
93
Only the Japanese companies registered with the SEC are required to prepare financial
statements in accordance with US GAAP or reconciliation statements on Form 20-F.
Convenience translations do approximate the original accounts but are characterised by a
reclassification of items and a varying degree of disclosure. This can result in a rather
ambiguous representation of the original, resulting in further inconsistencies if it is used as
the basis for investment appraisal. Nobes and Maeda (1990) investigated the inconsistencies
between the statutory demanded consolidated income statement (SA) and the convenience
translation (CT) of Fujitsu, for 1988-9. The following differences were observed:
gross profit was not shown in the CT;
operating income in the CT was 13% higher than in the SA due to the omission of
'Business Enterprise Tax' from the CT. No explanation was given for this in the attached
notes;
extraordinary items and taxes on them are not shown in the CT, presumably because they
would not be extraordinary under US GAAP. This results in 'other net income and
exchange losses' being reported as a debit of 3,742M Yen in the SA but a credit of
4,727M Yen in the CT;

income before taxes is different due to the above;
• 'orporate income and inhabitant taxes" in the SA amount to less than "income taxes" in
the CT, due to the treatment of the "Business Enterprise Tax".
Implications for international financial statement analysis are bound to arise from
such practices as the interpretation of the two statements will be different basically because
they are different financial statements. This is an example of the problems that analysts face
even before they attempt to apply any appraisal techniques. The final results can only be as
good and as informative as the initial data interpreted. What is of foremost concern however
is the degree to which the investment community can recognise such problems and attempt to
find suitable solutions.
94
5.6 APPROACHES ADOPTED WHERE ACCOUNTING DIVERSITY IS NOT
PERCEIVED TO BE A PROBLEM
Perhaps the most obvious scenario where accounting diversity is not perceived to be a
problem is where the analyst becomes completely familiar with the accounting principles
adopted in the countries examined for possible investment. In these circumstances the
analyst can adopt a local perspective, referred to as following a 'multiple principles
capability' (MPC): Choi and Levich, 1991, p7. This is based upon the belief that securities
are generally held by investors domiciled in the country of origin, who are very familiar with
not only the accounting principles followed but also the economic, cultural and institutional
norms of their environment. A foreign investor who is uncertain of these factors which rule
GAAP, will therefore need superior analysing techniques to outperform the local investors
alternatively a MPC can be adopted. This is a growing trend among finance houses who are
either basing a number of their analysts in the foreign country targeted for investment or
employing a local analyst to conduct research within his or her country of origin. Similarly, a
MPC could be easily achieved by an individual investor by contracting through a foreign firm
of stock brokers who are domiciled in the country in which investment is targeted.
5.7 THE EFFECT OF INTERNATIONAL ACCOUNTING DIFFERENCES ON
STOCK PRICES
Accounting differences can be either cosmetic or real, with only the latter having an
economic consequence on after tax cash flow. It would therefore follow that a company that
complies with more favourable accounting principles, purely by virtue of its nationality,
should not have a higher value attributed to it by the market than a foreign counterpart that
legally has to comply with less congenial rules; i.e. cosmetic accounting differences should
not affect market value as, if such differences are noted, analysts should be able to see
through the accounting figures to the underlying fundamental value of the company. An
inference made by Rees et al (1992), that relates to the informational content of the DVFA
adjusted accounts compared to the original financial statements, is both interesting and
relevant to market efficiency. The empirical research has evidenced that the DVFA adjusted
95
accounts are deemed to be more value-relevant than the original published accounts. As the
adjusted accounts are more akin to Anglo-American GAAP, these results are indicative of the
informational content of accounts produced by different accounting regimes. Consequently
this would imply that the market lacks the sophistication to see behind the accounting
principles and practices advocated by different national systems. This conflicts with existing
empirical evidence that unanimously supports the existence of semi-strong efficiency of the
major stock markets of the world. Conversely, the market could be held to be sophisticated
enough to realise that DVFA figures are more useful!
There is a distinct lack of empirical evidence relating to the efcts Gf&ccg

diversity on international stock prices. Research to date concerning accounting differences
has focused upon those accounting choices found within a single country, for example the
effect of bonus issues and the LIFO/FIFO choice in the US, on share prices. As previously
stated, it would seem apparent from the growth of financial capital markets in recent years
that accounting diversity is not an insurmountable barrier to international investment.
However, as evidenced in Choi and Levich (1991), accounting diversity does affect capital
market decisions. Such capital market effects include, for investors, the choice of country
chosen for investment, the industrial sector chosen, expected returns and information
processing costs, and for issuers, the type of security issued. Most issuers do not however
feel that accounting diversity affects their capital market decisions. This can be principally
explained through corporate funding strategies, for example, reliance upon internal funding
and private placements. In addition management rely on economic fundamentals and name
recognition which limits the need for any in depth analysis of foreign accounting principles.
One important implication that arose from the Choi and Levich study was that
accounting diversity was an important consideration that did affect capital market decisions,
regardless of nationality, firm size, experience, scope of international activity and

organisational structure. However the extent of such effects on share price and the choice of
firm for investment remains a question for future research to consider.
96
5.8 SUMMARY
This chapter sought to give an insight into international financial statement analysis
from a professional investors' perspective. The major techniques employed in equity
appraisal were examined with particular reference to the problems that the application of
some of these traditional methods can cause in international comparisons of securities. Such
problems include focusing upon certain accounting numbers without prior restatement to a
more familiar GAAP when undertaking ratio or trend analysis. Cultural differences were also
highlighted as an important consideration when appraising foreign securities. The example of

the divergencies in PIE ratios and gearing between Japan and UK or US illustrated this point.
Further problems that an investor in non-UK financial statements would experience relate to
language barriers and the availability of relevant translated information, or indeed the quality
of translation if it exists.
Coping mechanisms that have been developed by professional investors that do not
consider international accounting diversity to be a problem were also considered. These
included adopting a top-down approach, usually based upon macroeconomic data or adopting
a MPC, both avoiding the direct comparison of different accounting regimes. Discussion also
covered some examples of restatement principles, including those adopted by the DVFA in
Germany and empirical work conducted by Pereira et al (1992), showing a detailed account
of typical adjustments that would be necessary in order to undertake comprehensive

restatement.
Finally the effect of international accounting differences on share prices was briefly
discussed. However, this is a relatively new field of research and very little evidence has yet
to be discovered as to how international stock exchanges work, as suggested in the text, this
remains an area for further research.
97
CHAPTER 6
METHODOLOGIES PREVIOUSLY USED
6.1 INTRODUCTION
This chapter examines the various methodologies, i.e. systematic research methods,
available for use within the field of accounting research. There exists a dichotomy of thought
as to how scientific this field is. A popular conception of science is that it consists of a
developing body of theoretically coherent knowledge which enables scholars and
practitioners to make systematic predictions and control over their immediate environment.
This knowledge is based mainly on observation, experiment, induction and deduction. An in-
depth account of the debate as to whether accounting is a science, such as physics, can be
found in Stamp (1981).
Many theorists would argue that accounting is a science according to the above
description, in that users of accounting information utilise available data to make predictions.
This opinion has institutional support (FASB, 1978).
However, the view outlined above would refer more to the natural sciences than the
social sciences, of which accounting is often classified as being a part. Social sciences are
conditioned by particular social systems, relations of power, ideologies and institutional
frameworks. Therefore, due to these social, political and economic influences, observation
and experiment will not result in as definite and precise predictions as those within the
natural sciences.
A simple illustration of society and culture being reflected in a social science can be
examined when comparing the resulting accounting regimes that have arisen from vastly
different cultural systems. An in-depth analysis of these differences can be found in Chapter
98
4. However, Radebaugh and Gray (1993, p390) compiled an earnings adjusted index based
on US GAAP, which is illustrative of the effect that these divergencies have on bottom line
figures, see table 4.1, chapter 4. Index levels ranged from 125 for the UK to 66 for Japan, i.e.
to adjust approximately for the differences in earnings stemming from accounting policies
and practices advocated in these two countries, the earnings of the Japanese companies
surveyed would on average need to be scaled up by 189% to be more comparable to earnings
of an average UK company. Such large differences are the result of many interacting
variables which constitute a social structure. Social systems are not inert, thus rendering
observation within this field something that cannot be effectively predicted with precision
and certainty.
It is understandable that there are academics who proclaim accounting as a science in
an attempt to give more weight to their theories. By appealing to theoretical depth and
empirical comprehensiveness, it may be possible to show that some theories are a more
adequate description and explanation of reality than others. A'ong the same lines of
reasoning, the use of buzz-words such as 'theory', 'truth' and 'objectivity' may be used to win
scientific approval. For the purposes of this chapter, the issue being raised attempts to
highlight that there are fundamental differences between the natural and social sciences.
Consequently, the application of methodologies designed in the realms of the natural
sciences should only be used in the social sciences when they seem valuable. Beyond that
point they can be supplanted with direct understanding, possible because of the relationship
that the researcher has with the subject of research, i.e. being a member of society, an
accountant, shareholder and so forth.
However, most social scientists believe that social phenomena are orderly enough to
be explained and predicted. It is the degree of accuracy of such explanations and predictions
that varies, due to margins of error caused by random variables and the limitations of data
analysis which is insufficient in explaining social phenomena completely.
99
There are numerous scientific methods available to the social science researcher and
thus an overview is considered to be useful in providing an insight into the relative

advantages/disadvantages of those methods ultimately chosen for this thesis. The remainder
of this chapter will focus upon the various methodologies that have been employed in
accounting research. These fall into two sections: A) research methods focusing upon
individual behaviour, and B) market-based research methods. Firstly, it is considered to be
important to clearly define two related terms, the hypothesis and observation:
Hypothesis. An hypothesis is a suggested explanation for a group of facts or phenomena,

either accepted as a basis for further verification or accepted as true. The complete
method of explanation involves (a) collection and classification of data, (b) formulation of
a hypothesis, (c) designing and carrying out experiments for testing the hypothesis or
refuting it and (d) continued verification by repeated experiments. By defining the
hypothesis to be tested the researcher is documenting his/her expectations. This is a clear
and concise method of explicitly stating the purpose of the research intended to be
undertaken.
Observation. A scientific hypothesis should be: derived from observation; testable by

destruction. This brings objectivity into the research, and thus depicts it as being more
scientific. There are various types of observation which can be classified into two general
groups, those relating to market based studies and those attempts to study the individual.
Specific research techniques falling within the realms of market based research include
statistical investigations of share price movement, logistical regression and other similar
modelling exercises. Interviews, surveys, questionnaires, case studies, laboratory
experiments, structured and unstructured observation such as 'shadowing' are all research
methods which attempt to observe the individual. All methods exhibit their own strengths
and weaknesses and no single method is likely to fulfil the criteria identified within the
research completely. A combination of techniques therefore, may well provide the means
of collecting the most valuable information, which should be as reliable and thus non-
distorted and unbiased as possible. Non-participant observation is the only method of
eliminating bias generated by the researcher, which is extremely difficult to achieve.
100
6.2 RESEARCH METHOD FOCUSING UPON INDIVIDUAL BEHAVIOUR
Research methods falling into this category attempt to study individual behaviour at a
detailed level. Due to the focus upon a far lower level of aggregation than is implied in
market based research methods, the information tends to be more expensive and difficult to
gather, analyse and interpret. Furthermore, within the field of accounting, this type of
research method has been far less popular than market-based research to date. This is
partially due to such methods being generally considered less scientific than their market-
based counterparts. However, the major advantage of focusing upon such a detailed level
involves gaining a deeper understanding of the behavioural aspects that govern the overall
market reaction. There are three main research methods which focus upon individual
behaviour: interviewing, questionnaires, and observation, both structured and unstructured.
6.2.1 Interviewing
An interview is an organised and disciplined conversation designed to achieve a
specific purpose. Interviews are widely used within the realms of the social sciences due to
the richness and spontaneity of information that can be collected by the interviewer. The
quality of response gained is generally far greater than that of a mailed questiounaire. This is
due to the scope available to further explain the objectives of the research undertaken and the
flexibility to probe further for more specific answers or to repeat the questions asked in
instances where the person responding has misinterpreted or misunderstood what has been
asked. Due to heterogeneity of the sample, it may be appropriate to adopt different questions
for different interviewees. The interview provides the opportunity for the researcher to
anticipate this, unlike the mailed questionnaire that requires all questions to be written down
in advance.
The advantages of conducting a detailed and well organised interview may outweigh
the disadvantages such as interviewer bias and the limitation of statistical significance due to
small sample size. Further control is achieved by the interviewer by ensuring that all the
questions are answered and in the intended order. By standardising the environment, the
101
greatest possible attention is given to answering the questions by the interviewee. Spontaneity
is a major advantage as the researcher is able to record the precise reactions and response of
each individual to all the questions. The quality of this information outweighs that obtained
from a mailed questionnaire in which answers can be rescinded and resubmitted, perhaps
after investigative research and discussion by the respondent with colleagues to discover the
'correct' or expected answer. Such spontaneity will of course diminish if the members of the
sample receive a copy of the interview questions prior to the interview: Choi and Levich
(1991) found that many subjects had written responses ahead of time. On the contrary, this
can be beneficial as many interviewees will not necessarily know the answer of posed
questions instantaneously and may need to recap or consult a colleague. This can lead to
more useful answers than if the respondent had been asked the same question without prior
knowledge of what to expect. The interview is also more complete in that the entire actions
and reactions of the subject are observed through body language and the manner in which
questions are addressed, enabling the interviewer to assess the validity of the responses
obtained. The complexity and number of questions asked can be increased in an interview
situation compared to a questionnaire, as the interviewer is in the advantageous position of
being able to force the respondent to state an answer or to explain any technical or complex
question in other terms. Conversely, the presence of a multitude of questions or number of
complex or technical questions in a questionnaire deters even the more capable members of
the population examined.
Ideally, in order to give more weight to the results obtained, it would be preferable to
interview the entire population that is being studied, for example the investment community.
This is impractical for many reasons such as the unwillingness of members of the population
to participate, and the presence of resource constraints including time, finance, the
availability of competent interviewers and logistical constraints. These constraints can act as
insuperable barriers, leading to insignificant results due to focus being placed on a sample
that is not representative of the population, or even deterring the researcher from choosing
this form of methodology.
102

For these reasons a sample must be carefully chosen that will act as an approximation
of the population, reliably reflecting their behaviour and attitudes once sampling errors are
taken into consideration. For this to be achievable the population has first to be strictly
defined. Lee and Tweedie (1981, pp 2-4) illustrate this point very clearly through the detail
and degree of attention paid in defining and identifying the 'sophisticated shareholderç the
subject of their analysis. This was taken to be financial experts. Insurance companies,
merchant banks, pension funds, unit and investment trusts and stock-broking firms were
identified as representatives of the 'universe' examined and duly invited to participate in the
study. The sample frame was designed to attempt to obtain representatives from each of
these institutions in the proportion of the distribution of institutional ownership of quoted
shares in UK companies, at the time of the research (December 1973). The relatIve
shareholdings, number of firms approached within each category and the number of firms
accepting are illustrated in Table 6.1.
Table 6.1 An illustration of the construction of a sample frame and relative

response rates.'
Number Number
Category of company % of ordinary approached participating
shares in issue 2 (% of total) (% of no.
__________________________ _________________ __________________ approached)
Insurance 39 32(16.3°o) 29(91°o)
Pension funds 29 67 (34.2° o) 18 (27° o)
Investment and unit trusts 24 65 (33.2°o) 18(28°o)
Merchant banks 8 32 (16.3°o) 14 (44°o)
100°c 196 (100 0 0) 79(40.3°o)
1 Source: Lee and Tweedie (1981, p 14)

2Distribution of institutional ownership of UK companies at 30 December 1973. The Royal Commission
'Distribution of income and wealth', report no.2, Crnnd 6171, HMSO, 1975.
103
There are considerable differences in attitudes, habits etc., from one social group to
another. This will result in large sampling errors if a disproportionately large or small
number of people from one section of the population is selected. Although the effect of these
errors can be calculated, the results will be enhanced if the sample is chosen without bias,
thus representing each section of the population proportionately.
The following variants of random sampling overcome these difficulties, and they are
used either singly or in combination:
• multi-stage sampling involves dividing the population to be examined into separate
geographic areas. A sample of these areas are then chosen and further subdivided into
districts and a random sample of the population living in each district is then interviewed.
• stratified sampling is used to reduce the effects of variability in the population. Samples
are randomly chosen from sections of the population and then combined in proportion to
the size of the sections. A sample can be stratified in a number of ways, for example
geographical location, age, sex, company size, professional or social status and length of
experience.
Interviews are often lengthy and costly processes, so sample sizes are limited.
Establishing a sample size that fills both of the aforementioned criteria (i.e. to sufficiently
represent the population being examined and to be practically viable) is complex and
problematic.
A further limitation of the interview is the presence of interviewer bias. This results
when the interviewer misunderstands or misinterprets the respondent's answer, may
understand it but makes a clerical error in recording it, or may record an answer when the
respondent failed to reply. Furthermore, the interviewer is not free from bias, as everyone is
conditioned by society and holds his/her own beliefs and preconceptions. Thus the recorded
answers can be affected by factors such as the respondent's sex, social class, race, age, accent,
appearance or level of education. Great pessimism has been expressed about the possibility
104
of the interview as a method of collecting unbiased information. However, interviewer bias is
not totally insurmountable. Protocol analysis is one example of attempts to overcome this
problem. This distinct methodology design was pioneered by Clarkson (1967) and later
adopted by Day (1986) in attempts to reduce bias. A 'protocol is a transcript of the
verbalised thoughts and actions of a subject when the subject has been asked to 'think aloud'.
Thus, as the transcript is a record of the thought process of the respondent, it avoids some of
the problems inherent in interviews and questiormaires where the researcher has to decide
what the subject really means by the answers given. Day (1986) recorded all the interviews
undertaken on tape, further reducing bias caused by recording errors and the omission of
information.
Within the area of cognitive psychology, support for the use of protocol analysis is
held, as it is deemed that the process of'thinking aloud' is a behavioural aspect that is as
capable of being analysed in a meaningful manner as a specific action is. Subjectivity is not
completely eliminated through the removal of interviewer bias, however, as a degree of
subjectivity is involved in attempting to make inferences about the reasoning and applied
logic that lies behind the thought processes that have been verbalised by the respondent. Day
(1986) did not attempt to make such inferences as it was considered to be the subject of
analysis for the psychology researcher and not one founded in the field of accounting. Such
psychological analysis would of course have added to the findings made. An inherent
problem of protocol analysis is that the situation that is being monitored is not a real life one,
because it is being monitored. Resulting biases will occur, for example, the respondent may
feel hindered by the presence of observers and respond in a different, perhaps more cautious
and less frank manner, than if carrying out the same exercise within his/her normal working
day. This can be overcome to a degree by shadowing the subject throughout the day within
the normal working environment. However, this would be extremely time consuming and
costly in terms of resources and could result in such an open ended situation that the data
collected is "indigestible" (Day, 1986).
105
6.2.2 Questionnaires
The questionnaire is a pre-determined set of questions that is handed or mailed to the
respondent and filled in by himlher without any assistance from the researcher. First and
foremost the questionnaire must be relevant: to the research being undertaken and to the
respondent. If the latter does not hold response rates will be extremely poor as the recipient
of the questionnaire will not invest time and effort responding. It is important to clarify the
purpose of the questionnaire in 'layman's terms', as the research goals are not always evident
outside of their scientific context.
The format, content and wording of the questionnaire is of critical importance. The
questionnaire should not be so long as to act as a deterrent for all except the most keen
recipient, neither should it be so concise and summarised as to substantially hinder the results
and information obtained. The content should firstly be of relevance to the recipient and
written in as simple fashion as possible to make it easily understood by the reader, thus
aiming to avoid ambiguity surrounding the questions. A badly written questionnaire can
suffer from misinterpretation, thus resulting in unsuitable responses which, uniike in
interviews, cannot be corrected unless another version of the questionnaire is circulated
appropriately altered. This possible pitfall can be overcome by piloting the questionnaire to
a population that resembles the intended recipient sample prior to the official questionnaire
being circulated. For example, Choi and Levich (1991) pre-tested their questionnaire relating
to the respondent attitude and behavioural effects of international accounting diversity,
among academic colleagues specialising in accountancy, economics and behavioural science.

Nobes and Parker (1991 c) sent out a pilot questionnaire concerning directors' actions with
respect to the true and fair view, to the finance directors of the smallest 100 companies in the
Times 1000 index, 1985. The actual questionnaire, after slight amendment resulting from
this piloting exercise, was distributed to the remaining 900 listed companies. An efficient
piloting exercise should iron out most of the erroneous areas.
106
The style of the questionnaire should include as few open- ended questions as
possible. The purpose of this is twofold: firstly, multiple choice style questions, those which
require a yes/no response and questions in which the respondent is asked to rank information
according to a given scale are more user friendly than open ended questions in which the
respondent has to rely upon his or her own initiative and judgement in deciding what the
research requires and the answer to be given. Secondly, the aim of the questionnaire is to
gather information that, after analysis, will lead to interesting inferences being made by the
researcher. Analysing a questionnaire that is composed mainly of open ended questions will
be extremely time consuming. Furthermore if the questions are interpreted differently by the
respondents the resulting information will be indigestible.
An illustration of the above points can clearly be found in Nobes and Parker (1991c),
'True and Fair: A Survey of UK Financial Directors'. This questionnaire, a research study
sponsored by ICAEW, was confined to a double side of A4 yet the scope and line of
questioning was sufficiently comprehensive to examine the extent to which finance directors
ensure that their company's financial statements give a true and fair view. This involved
examining the extent to which the detailed provisions of the Companies Act and accounting
standards were complied with and the whether companies would be/had departed from either
of these in order to give a true and fair view. Of the 13 questions posed, nine required a
yes/no answer, with four of these prompting the respondent to give further details or
examples if the answer was affirmative. One question involved a ranking exercise, asking the
respondent to state whether his or her company relied upon auditors to ensure compliance
with the detailed provisions of the Companies Act, accounting standards and the requirement
to give a true and fair view either i) fully, ii) partly, or iii) not at all. The remaining three
questions were of an open ended style, two of which required finance directors to state what
methods they eniployed to ensure that accounting standards and the detailed provisions of the
Companies Act were complied with in the preparation of their companies' accounts. The
final question, being the most ambiguous, was a mere request for further information relating
to each company's experience of giving a true and fair view, if the finance directors wished to
107
provide such. The main benefit of this format is clearly visible in the high response rate
achieved: 51% of a sample of 900 companies listed in the Times 1000 index, 1985/86.
However, some benefit can also be gained from including many open-ended questions
in a questionnaire, Choi and Levich (1991), for example stated that:
"in addition to the response of the yes/no' variety, most questions were left open-
ended to enable us to learn more about why a particular response was given and the nature
of such a response."
A major limitation of the questionnaire is the problem of non-response bias. It is
therefore imperative, for the validity of conclusions drawn, that tests are incorporated into the
analysis of the completed questionnaire.
Notwithstanding the relative drawbacks of the questionnaire as a form of research
method, if the questionnaire is coherently developed and successfully piloted, it can provide a
useful source of information in addition to the richer, more spontaneous information derived
from interview based observation. The principal advantage is the size of population that can
be invited to assist in the research, far exceeding any sensible sample that could be
approached by an interviewer, even after consideration of poor response rates.
6.2.3 Structured and unstructured observation

This form of research method involves the close observation of subjects within their
natural environment. This can include a structured observation, whereby the researcher
observes the subject within a situation that he/she has devised. For example, Jensen (1978)
investigated the effect of accounting choice on share price, by designing an experimental field
study of security evaluation by analysts by supplying to them data generated from different
accounting procedures. He concluded that, primarily through the impact of accounting choice
108
on EPS, accounting differences did affect the level at which analysts valued the securities.
However, such conclusions should not necessarily be taken at face value because in a real
market, accounting statements are but one of a number of information sources that analysts
use, others including share price, professional/insider knowledge and that gained from other
investors. Thus the examination of one source of information in isolation will have little
meaning in a competitive market.
Unstructured observation involves 'shadowing' the subject whilst they continue to
perform their everyday tasks. This can be beneficial as subjects will generally forget that
they are being observed after a period of time and hence begin to act naturally, so that quality
information can be gained. However, this method is particularly time consuming and may
give rise to a vast amount of indigestible information for research purposes.
6.3 MARKET-BASED RESEARCH METHODS

These research methods attempt to study the population as a whole. Within the field
of accounting this is generally considered to be 'the financial market' for example the London
Stock Exchange, the Paris Bourse, New York Stock Exchange (NYSE) and so forth. Thus,
the information that is considered to be of importance relates to items which determine the
level of, or changes in the level of, the price of a security. Inherent within this form of
research is the concentration on aggregate market reaction and not the individual processes by
which such reaction is caused. Examples that are illustrated in the following section include
the summarisation of statistical data, correlation, regression and time series investigations.
More complex statistical analysis such as significance testing through the use of t-tests and F
tests are also commonly employed in accounting research and shall be briefly discussed in
turn.
109
6.3.1 Statistical measures of dispersion
(a) Frequency distribution and the interquartile range
Statistics is the science of gathering and analysing numerical data. Basic statistical
techniques firstly involve grouping the relevant data into a number of classes, thus
establishing a frequency distribution' i.e. a list detailing how often each variable occurs. The
data is then analysed, for example, by computing the sample average and comparing this with
the average for a previous sample, different industrial sector and so forth. It is possible to use
secondary information, i.e. information that has previously been collected, such as the widely
available computerised data banks of share price information. The use of such information is
relatively inexpensive but there are certain risks attached. These arise from the definitions
used, assumptions made and when the information was collected, possibly being out of date.
Statistical methods of summarising information include calculating the dispersion of
the sample either by the definition of the range, quartile dispersion or the standard deviation;
the coefficient of variation; and the coefficient of skewness. These will now be discussed.
One method of dispersion, or spread, is the 'range' of the sample, simply the
difference between the highest and lowest recorded values. This is valuable for identifying
extremes, but can lead to misleading results if taken in isolation. A method of dispersion
that overcomes the dependency upon extreme data values is the 'interquartile range'. This
measure of dispersion is the differences between the third quartile Q3 and the first quartile
Qj Thus, this is the ranges of the middle 5O 0 o of the data. The interquartile range can be
defined as:
Interquartile range
IQR=Q3 -
110
Both of the aforementioned methods do not take into account all the data. However,
the tandard devialion' does not suffer from this limitation and, consequently, is the method
most commonly employed in research methodologies for calculating dispersion. To calculate
the standard deviation, one first ascertains the difference between each item of data, e.g.
share price, with the sample mean (x). In order to eliminate the effect of negative values
when the differences are totalled, the results are squared, giving the 'variance'. In order to
produce results that are not measured in squared units, the square root of the variance is taken
to give the standard deviation:
Standard deviation
S.D=
(b) The coefficient of variation

This indicates the amount of variability present in the data. It is expressed by
expressing the standard deviation as a percentage of the mean:
Coefficient of variation
[(x)2
(c) Coefficient of Skewness

This measures the extent to which the mode of the sample departs from the mean.
Thus, a symmetrically distributed sample would have a zero coefficient of skewness:
hi
Coefficient of Skewness
mean - mode
standard deviation
6.3.2 Statistical Correlation and Regression
Correlation is the determination of association between two variables. If correlation

exists regression can be carried out to establish what the relationship is. Correlation is not
concerned with identifying a mathematical equation relating an independent variable and a
dependent variable but concerned on'iy vith determining the extent to whIch the variables are
linearly related. Neither regression nor correlation analysis can be interpreted as establishing
cause-and-effect relationships but can only indicate to what extent the variables are associated
with each other. The conclusions that the researcher makes relating to cause-and-effect
relationships based on these research techniques are therefore subjective interpretations of the
information provided. Simple linear regression and correlation techniques, including the least
squares method, the co-efficient of determination, Pearson correlation coefficients, the
Spearman rank correlation coefficient and Wilcoxon test will now be discussed. This will be
followed by techniques employed by researchers to test for the significance of relationships
between two variables, i.e. t-tests and F-tests. Finally the use of these methods in existing
literature will be reviewed.
(a) Least squares method
The least squares method is used to find the 'line ofbest fit', otherwise referred to as
the 'estimated regression line' where values for independent and dependent variables are
plotted against each other in a scatter diagram. Independent variables are shown on the
horizontal axis and dependent variables on the vertical axis. The estimated regression line
can be defined as:
112
Estimated regression line
5' = + b1
where: b 0 = y intercept of the line

b 1 = slope of the line
5' = estimated value of dependent variable
The least squares method provides an estimated regression equation that minimises
the sum of squared deviations between the observed values of the two variables. The
criterion for the least squares method can therefore be defined as:
Least squares criterion

min(y, _5',)2
where: y1 observed value of the dependent variable for the ith observation
5' = estimated value of dependent variable
(b) The coefficient of determination

This indicator shows how close the fit of the estimated regression line is to the actual
data. The larger the values of r2' the better the degree of correlation there is. The coefficient
of determination can be defined as:
The coefficient of determination
r - -,
(y, —y )-
The use of r2 alone will not provide evidence as to whether the relationship between
the two variables being tested is statistically significant. Any conclusions based upon
statistical significance must first consider sample size and distribution.
113
(c) Testing for significance
The principal test that exists for determining the significance of a relationship
between two variables is the I-test. When more than one independent variable exists the F
test must be used. The F test can be used in regression models with only one independent
variable and should give results in agreement with the f-test.
In social sciences only probabilistic models exist. This occurs where the value ofy
cannot be determined exactly from the value of x. Models where the value ofy can exactly
determined from values of x are known as deterministic models. With probabilistic models,
in order to determine the exact value ofy the error of estimation must be considered. This
measures how far the actual values of y are above or below the estimated regression line. To
test for significance using the f-test the following hypotheses are used:
H0:B1O
Ha : 13 ^ 0
The logic behind these hypotheses stems from the fact that in social sciences there is
rarely a relationship between x andy in which the value of x influences the value ofy to the
degree that could not equal zero (see section (a) 'estimated regression line' for originating
equation).
(d) The Wilcoxon test

This test provides insight into the differences between pairs in a matched sample
situation. Each enquiry generates two paired, or matching, observations, one from the
variable under examination and one from its counterpart which acts as a control. The
observed differences between the two samples can thus provide an insight into the differences
between the two populations under examination.
114
(e) Pearson Product Moment correlation coefficient.
This is a statistical measure of the linear correlation between two variables. It can be
defined in the following terms:
Pearson correlation coefficient

x,y,
Sxy - ____
SxSy - _( xI)/ J2
This is fundamentally the sample covariance divided by the product of the sample
standard deviation of x multiplied by the sample standard deviation of y. A result of +1
would indicate a perfect positive correlation, i.e. a upward sloping regression line, whereas -1
indicates a perfect negative linear association between x andy. If r, is zero, no linear
relationship exists and if the result is near to zero the relationship is very weak.
(1) Spearman rank correlation coefficient
This test was developed to measure the association between two variables when only
ordinal data is available. It is otherwise equivalent to the Pearson correlation coefficient.
6.3.3. Previous research employing market based research techniques
Due to the widespread availability of computerised data banks of security prices a

substantial amount of statistical research has developed, the cost factor being minimal
compared to that involved with individual based research methods. Much of the previous
research in this field has focused upon examining whether a correlation exists between share
price and a testable variable. For example, Firth (1976, 1979, 1980) examined the effect of
take-over announcements on UK share prices and, similarly, Keown and Pinkerton (1981) did
so in the US. Other information releases studied include secondary issues (Scholes, 1972),
115
earnings (Firth, 1976, in the UK and Ball and Brown, 1968, in the US) and the effect of
accounting choice on reported profit (Sunder, 1973 and Kaplan and Roll, 1972). In order for
a variable to be testable using correlation, it has to be significant and separately identifiable.
This is important as many factors can influence share price concurrently, such as
simultaneous information releases, which may contribute to the degree of correlation
exhibited. For this reason the researcher can only rely on the presence of an information
release that is expected to dramatically alter share price, as his/her testable variable.
The ordinary least squares method was employed by Grinyer et al (1991) in order to
test a theory concerning the establishment of the fair value of an acquired company's tangible
assets and consequently the value of the acquired goodwill. Once correlation was established
(-tests were carried out to discover the degree of significance the relationship tested held.
Both the Spearman rank and Pearson correlation coefficients were used. Within the social
sciences r2 values as low as 25% are considered useful (for Grinyer Ct al 9 % was achieved)
compared to much greater values of over 60% for the natural sciences. This method was also
adopted in varying degrees by the following: Mather and Peasnell (1991); Brown (1980);
Ricks (1982); and Tinic (1990).
Examples of the Wilcoxon test employed in previous research can be found in Choi
and Lee (1992). In this instance premiums paid by US acquirors were matched to those paid
by foreign acquirors of US target companies in merger activity. The mean differences
between the premiums were observed on a four period basis: one day, one week, one month
and two months.
The more complicated methodologies that employ statistical methods usually require
a model to predict future share prices. The aforementioned tests for the semi-strong form of
market efficiency, for example, employ various models to predict what the share price would
have been without the observed information release. The model employed is usually the
Capital Asset Pricing Model (CAPM) or the market model. However, any useful modelling
116
exercise necessarily simplifies a complex environment in order to focus clearly upon a
phenomenon. Thus correlation and regression, as with all methodologies, suffer from
limitations i.e., if the assumptions were relaxed or the model enhanced in any way to reflect
reality closer, would the phenomenon still exist?
A specific research method that has been widely used in accounting and finance
research is the analysis of time series data. A time series consists of successive values of a
variable which changes over time. This is a special case of a two-variable regression, with
time being the independent variable. Fluctuations generally occur with most variables over
time due to trends, seasonal variations and residual fluctuations caused by unspecified
variables.
Time series analysis is one of numerous methods employed by analysts tracking share
prices. A principal version adopted is the calculation of moving averages which involves
establishing the average share price for a rolling period to determine the existence of trends
and assist in developing forecasting models.
Examples of the use of time series analysis in previous methodologies can be found in
tests for the weak form of market efficiency. Statistical investigations of the time series of
historical share prices of various mechanical trading strategies that are advocated by analysts,
were undertaken in the following stock markets: Bachelier (1900) for the French Bourse;
Working (1934) for the NYSE, Kendall (1953) for the LSE; Roberts (1959) for the Dow
Jones index. These all involved the examination of serial correlation between successive
price changes in a security. If statistical independence is found, i.e. price changes are
random, EMH holds.
6ASUMMARY
This chapter has examined the previous methodologies that have been utilised in the
field of accounting and finance research with a view to selecting the most appropriate method
117
for the intended research by the author. It has been outlined that two distinct methods of
research are available to the social science researcher, individual and market based
techniques. The former, incorporating the more subjective methods which are open to
judgement and interpretation, include observation, interviews and questionnaire based
surveys, and the latter, being more formal, include statistical regression and correlation.
The ultimate selection of research methods chosen are interview and questionnaire
based surveys. The rationale behind this decision, together with the methodology design and
formulation of hypotheses are detailed in the following chapter (chapter seven).
118
CHAPTER 7
1ROPOSAL FOR STUDY - HYPOTHESIS, METHODOLOGY
7.1 INTRODUCTION AND PURPOSE OF STUDY
This chapter attempts to outline in detail the purpose of this research, highlight the
hypotheses to be tested and state the methodologies to be used in light of the various
advantages and shortcomings discussed in chapter six Methodologies previously used'.
This research is concerned with international financial statement analysis or, more
simply the presence of international accounting differences and how users of international
accounts perceive and deal with accounting diversity. The importance in understanding the
differences in reported earnings and the comparative quality of earnings is increasing as
financial markets continue to internationalise. The issue to be addressed here deals with the
use and interpretation of foreign accounts by the investment community, it does not
concentrate upon the content or way in which information should be disclosed. The research
focus is centred upon the awareness of international accounting differences that could
complicate the appraisal of financial statements and the practical techniques employed, if
such perceptions exist, in international investment appraisal to cope with the heterogeneous
nature of financial information from different accounting regimes.
Although there is a multitude of users of published financial statements, it is generally

agreed that investors, either directly or indirectly via analysts, form the most important and
largest of the user groups of present and potential users (Day, 1986; Lee and Tweedie, 1977,
p5). However, investors seem to make little direct use of financial accounts and it is therefore
difficult to assess their behavioural aspects towards accounting diversity. One reason cited is
that in general investors appear not to fully understand published accounting information (Lee
and Tweedie, 1977, chapters 8 and 9; Baker and Haslem, 1973.) In their research, Baker and
Haslem (1973) statistically support the conjecture that investors make little use of financial
119
accounts. Only 7.9% of individual investors surveyed considered financial statements as an
important information source for investment decisions,. Stock brokers and advisory services
made up 62.4 % collectively.
"Financial statements are relegated to a position of minor importance.. (which) may
be due to analysts 'greater ability to interpret the statements... (being) perhaps the most
informed and articulate user group." (Baker and Haslem, 1973, p68). However, Lee and
Tweedie (1981, p 43) show that the understanding of financial statements by investment
analysts themselves is far from perfect.
Furthermore, the aforementioned research is confined within a domestic context.
Problems relating to the understandability of financial statements in a foreign context can
only be amplified.
For the reasons listed herein, the focus has been given to professional users of
international accounting information, such as the investment analyst, brokers and bankers, as
the principal and most informed user group from which the population sample has been
drawn (hereafter referred to collectively as analysts). The role played by analysts in the
capital markets is a very important one. It is within their advisory function that the greatest
potential impact upon the capital market lies and it is therefore of interest to examine how
they deal with accounting diversity.
Little evidence has been documented concerning the behavioural aspects of
investment analysts dealing with foreign securities and the techniques employed in coping
with diversity. Choi and Levich (1991) conducted a survey of 52 major capital market
participants from New York, London, Zurich, Frankfurt and Tokyo, concerning the
behavioural effects of international accounting diversity. Of the interviewees, comprising
corporate issuers, investment underwriters and market regulators, representatives of rating
agencies, an international financial data service and an organisation working towards
120
international accounting harmony, over half felt that accounting diversity affected their
capital market decisions. Of the 17 analysts interviewed over half stated that accounting
differences made it more difficult for them to measure their decision variables. A variety of
techniques employed to cope with accounting diversity were reported by the respondents
ranging from restating the foreign financial statements into a more familiar GAAP, to the
development of a dividend discount model or the reliance upon macroeconomic variables
only. Due to the scope of this research, spalming four continents, Choi and Levich were
limited to the sample number within each of the testable categories. Consequently only three
UK analysts were interviewed.
The present research examines several aspects of accounting diversity, similar to those
investigated by Choi and Levich. Firstly, it is necessary to examine whether accounting
differences are recognised, especially those items that affect the reported level of earnings.
Empirical evidence to date strongly supports the efficient market hypothesis (see Chapter 2
for a full account). Thus, only those areas of accounting diversity that have real economic
consequences,(for example the associated tax saving resulting from the use of LIFO stock
valuation in an inflationary environment, as opposed to the use of FIFO, AVCO etc.), should
affect the market price of a security. Due to the difficulties in testing EMIL-I on an international
basis, i.e. doubts about the efficiency of stock valuation in foreign markets and the pricing of
foreign shares listed on domestic markets, empirical evidence to date has focused upon the
domestic context. It could be argued that a greater degree of efficiency is expected within a
totally domestic arena due to the higher level of familiarity domestic analysts have with
domestic accounting principles, practice and disclosure. For example, Damant (1992),
asserts that the lack of comprehensible information (contained in foreign accounts) raises the
cost of capital of companies raising it overseas because investors demand a premium to offset
uncertainty.
Thus, if the analyst is aware of a number of accounting choices available to the

company and the associated effect, whether of real economic consequence or not, on the
121
reported profit figure and level of assets within the financial statements, he/she should be able
to easily adjust the figures for appraisal/valuation purposes. However, when analysts are
dealing in foreign securities are they as fully aware of the accounting choices available within
international arenas and the related effects on the reported figures in the financial statements?
If accounting differences are recognised do analysts perceive these as a problem?
Does diversity in international accounting practice act as a insuperable barrier to efficient
international investment? The existing level of foreign trade within the world's stock markets
would suggest that if a barrier does exist it is definitely not an insurmountable one. However,
the sheer volume of trade does not shed light upon whether capital market decisions are
hindered or affected and whether shares are being priced correctly and thus traded efficiently.
Finally, if the heterogeneous nature of financial accounting between different GAAP regimes
is recognised, what measures are taken by analysts to cope with the diversity and are these
measures adequate?
7.2 HYPOTHESES
My hypotheses are drawn from the work of others and from the discussion of the
previous chapters. Overall there are 14 hypotheses that have been formulated, and the
justification for each will be given later in this section. Firstly, expressed in testable form,
my hypotheses are as follows:
Hi: accounting diversity has some effect on capital market decisions;
112: accounting differences are a significant hindrance to the measurement criteria used
in the assessment of foreign companies by professional users of foreign financial
information;
H3: most professional users of non-UK financial information restrict foreign investment
to countries with more familiar accounting practices;
. 114: most professional users of non-UK financial information restrict foreign investment
to more familiar sectors;
122
• 115: most professional users of non-UK financial information restrict foreign investment
to more familiar companies;
116: most professional users of non-UK financial information cope with international
accounting differences partly by reliance on other information that is less sensitive to
corporate reporting such as macroeconomic data;
• 117: most professional users of non-UK financial information cope with international
accounting differences partly by trend analysis using published accounting data;
accounting differences partly by ratio analysis using published accounting data;

• 119: most professional users of non-UK financial information cope with intematiQ
accounting differences partly by restatement of accounts to more familiar accounting
rules, followed by analysis;
accounting differences partly through the adoption of other techniques;
. H 11: most professional users of non-UK financial information are aware of the existence
of international accounting differences that effect/distort reported earnings;
• 1112: most professional users of non-UK financial statements are aware of the differences
existing between major corporate financial reporting countries, with respect to the
treatment of goodwill;
in the treatment of the determination of cost for stock valuation between major GAAP
regimes;
in the treatment of deferred taxation between major GAAP regimes.
All of the above hypotheses are closely related, as illustrated by means of a flow-
diagram in Table 7.1. This diagram gives an overview of the thought processes that led to the
fourteen hypotheses being fornrnlated. However, it is necessary to justify each in turn.
123
Table 7.1 Flow diagram illustrating the relationship between the fourteen formulated
hypotheses.

Is accounting diversity recognised? No Consequences for
• the effect on profit [Hill ieaIth distribution
Specific examples:
• goodwill 111121
• stock valuation [11131
• deferred tax 1H141
•1
IYesI
No consequences
Does accounting diversity affect No Is accounting information
capital market decisions? important in analysis? for wealth
IHII distribution
IYesI Yes

Is accounting diversity a No L
Do coping mechanisms exist? No Consequences
significant hindrance to the • macroeconomic data [H61 for wealth
__f
measurement criteria used? [1121 • trend analysis [H7] distribution
• ratio analysis 11181
• restatement [119]
Yes • other techniques [HlOJ
Is investment restricted? IYesl

• Countries [H3J
• Sectors[H4] No No consequences
• Companies[H5J for wealth distribution
4'
IYesI
Consequences for wealth

distribution
124
The first hypothesis (HI) relates to the extent that analysts experience problems with
differences in international accounting. If such problems exist, decisions relating to asset
allocation could ultimately be affected. It is my belief that accounting diversity has some
affect on capital market decisions and possible implications for the efficient distribution of
wealth. This belief has empirical support from previous research (Choi and Levich, 1991).
The second hypothesis (H2) suggests that analysts perceive traditional analysis
techniques as inadequate when transferred to the assessment of foreign companies, due to the
differences in accounting practice. This would suggest that some techniques (measurement
criteria) would be redundant, other techniques would require adjustments or new techniques
would be developed. Consequently, it is my belief that accoirntin, cii'itsity Ss a igDf1car11
hindrance to the measurement of the criteria used in international investment.
Hypotheses H3 to H5 relate to the extent to which international accounting diversity
restricts the investment activities of analysts and fund managers. Any avoidance of
investment due to the lack of understanding of foreign accounting numbers would have
serious implications for the distribution of wealth. The worst case scenario for inefficient
wealth distribution would be if countries were avoided because of incomprehensible
accounting (H3). Hypotheses H4 (sector avoidance) and H5 (company avoidance) would
have thr less reaching implications as portfolio diversification could still be achieved by the
individual investor but the avoided companies and sectors could experience difficulties in
raising funds overseas. It is my belief that investment is restricted to some degree because of
the difficulties experienced in analysing non-UK financial statements.
Hypotheses H6 to HlO relate to possible mechanisms that analysts use to cope with
the problems of international accounting diversity. The mechanisms selected: reliance on
macroeconomic data (H6); trend analysis (H7); ratio analysis (H8); restatement of financial
statements to a more familiar GAAP (H9) and ; other techniques (H 10), have arisen from
previous research: Arnold and Moizer, 1984; Pike et al, 1993; Choi and Levich, 1991 and;
125
Cooke, 1992. It is also important to establish that these coping mechanisms are used
correctly in international financial statement analysis, e.g. the problems associated with the
incorrect use of ratio analysis in an international context can have serious implications for
wealth distribution (Aron, 1991).
As illustrated in Table 7.1, hypotheses Hi ito H14 relate to the principal issue of
whether accounting diversity is perceived by analysts. The interpretation of the other
hypotheses (HI to H1O) is dependent upon whether this perception exists. If analysts do not
perceive any differences between international profit figures (HI 1), serious implications for
the efficient distribution of wealth would arise if accounting based valuation teclmiques are
used in analysis. Previous research suggests that some countries are substantially more
conservative than others (Simmonds and Azières, 1989; Radebaugh and Gray, 1993, p390).
Thus, if analysts are fixated with certain accounting numbers (profit) or ratios (PIE) it is
important to establish whether they can see through the international accounting differences
when valuing securities.
H12 to H14 relate to specific accounting differences. The three examples of goodwill
(H 12), stock valuation (HI3) and deferred taxation (H14) were selected as hypotheses due to
previous research. Both Simmonds and Aziéres (1989) and Natwest Securities (1993) found
that the treatment of goodwill was the largest single factor which affected reported profit and
asset figures between different GAAP regimes. The method of determining 'cost' for stock
valuation and the treatment of deferred taxation were the second and third largest differences
found. Consequently, if analysts are aware of these three major differences in international
accounting and can adjust accordingly, a crude, but adequate, proxy is reached and can be
used sensibly in analysis to create more meaningful results.
126
7.3 METHODOLOGY
The aims of this research are factual and descriptive, seeking to establish the extent of
how analysts' perceptions of accounting diversity affect share price via the techniques
analysts employ in the analysis of share price, as outlined in the previous section. A market
based study that could examine the direct effect of accounting diversities upon the valuation
of shares would highlight the extent of distortion that possibly exists in the distribution of
wealth due to the treatment of such differences. However, in order to present this in a testable
form, a solitary item of accounting information, constituting a significant difference in
practice between different accounting regimes, would have to be isolated in order to discover
the degree of correlation between share price and accounting treatment. All other accounting
differences that have a direct influence upon the share price should be held constant.
Otherwise the resulting correlation, if any, could not be scientifically attributable to the
variable under examination.
Previous studies examining the degree of correlation between share price and
accounting choice have relied upon the release of items of information that are significant.
Fama, Fisher, Jensen and Roll (1969), for example examined the relationship between share
price and stock splits (bonus issues); Charest (1978a) examined dividends as a source of data
for residual analysis.
Furthermore, in a real market, the financial statements are only one of the many
channels from which the analyst receives information, others include the price, insider
information etc. In experimental situations all channels of information are difficult to

incorporate and thus the value of financial information evaluated in isolation will have very
little meaning in competitive markets. A further objection to the use of the valuation
approach of a market based study to examine share price reaction is that the models available
consider the pricing of each stock in isolation and ignore the cross-sectional association that
exists among stock price changes.
127
Therefore, due to the absence of a substantially relevant isolated information release
that is both relevant to the research undertaken and statistically testable, market based
research methods have been rejected as a basis for the choice of methodology advocated.
Hence, in attempting to analyse how analysts deal with accounting diversity, the research
method that has been chosen will focus upon individual behaviour as opposed to that of the
market. This supports the desire to focus upon the behavioural aspects of analysts and how
this impacts upon the market as a whole. Research methods that focus upon individual
behaviour are generally not deemed to be as scientific as market based studies. However, the
main advantage of taking this perspective is that a deeper understanding of the behavioural
aspects that govern the overall market reaction should be permissible. The methodology
chosen of survey based research methods available is that of a detailed questionnaire
enhanced with a series of interviews.
7.4 THE QUESTIONNAIRE
The principal advantage of the questionnaire, that is commonly cited, is the size of the
population under examination that can be invited to assist in the research. Even after
consideration of poor response rates, the number should positively outweigh that practically
possible to approach for interviews, due to constraints such as time, financing, the availability
of competent interviewers, logistical problems and so forth. However, if response rates are
exceedingly low, the questionnaire is still deemed a worthwhile exercise as data collected is
capable of being digested and analysed to a greater extent than interview data due to the
stricter format of the questionnaire and the presence of less interviewer bias.
In the case of the present research, the questionnaire (see appendix A) was circulated
in the November 1993 edition of 'The Professional Investor', the IIMR's (formerly the society
of Investment Analysts) monthly magazine. This magazine is circulated to all members of

the IIMR plus additional private subscriptions as discussed in more detail below. However,
as the questionnaire was addressed to any member of the IIMR who used non-UK financial
128
statements as part of their work, the private subscription group is not relevant for this
research.
The form of the questionnaire was relatively concise, being ten questions spanning
two sides of one sheet of A4 sized paper. The principal reason why such a concise format
was adopted was so that recipients would not be deterred from responding. In order to avoid
ambiguity that may surround the questions, the questionnaire was piloted with analysts and
bankers at a leading finance house in London. Following slight amendment resulting from
the findings of this piloting exercise, the final document was submitted to the IIMR.
The questionnaire is divided into two broad sections. The first focuses upon analysts'
perceptions of accounting diversity, how this affects their capital market decisions and the
coping mechanisms adopted within the role of investment appraisal. The second section
involves a series of more technical questions in order to examine the extent of awareness of
some of the major accounting differences that affect the reported level of earnings.
The style of the questionnaire was developed to include as few open ended questions
as possible. Four of the questions involved a ranking exercise, using a scale from ito 5,
recipients being prompted to briefly explain any answers given that exceeded 3. Of the
remaining six questions, four were of a multiple choice nature and only two were open ended.
The reason behind this adopted style was to formulate a highly user friendly questionnaire
which is simple and straightforward to fill in. Open ended questions can be preferable due to
the quality of response received as the respondent has to use his or her own initiative and
judgement in deciding what the researcher actually requires from asking the question.
However, many recipients may find that the time and effort required to respond to many
detailed open ended questions outweighs any good intentions to actually respond.
Furthermore, as the questionnaire is supported and enhanced by the use of a more detailed
interview methodology, the questionnaire should be kept as straightforward as possible to aid

analysis. It can be argued that open ended questions are far more suitable for the interview as
129
within such an environment any question that has been misinterpreted can be restated and
clarified by the researcher. A heterogeneous interpretation of the contents of a questionnaire
by the respondents will merely lead to a mass of indigestible data that cannot be analysed to
any useful extent. Therefore, through the efficient use of a piloting exercise and exclusion of
open ended questions, the response should produce data that is useful for the intended
purpose of the research. These points are discussed in more detail in section 6.2.
7.5 THE INTERVIEW
The obvious advantages of the interview, if conducted efficiently, outweigh the
disadvantages such as small sample size targeted and interviewer bias (see section 6.2).
Positive steps should be undertaken to minimise or eradicate where possible any potential
problems, for example, interviewer bias.
Semi-structured interviews were carried out as part of the present research. The
interviews were based upon the design of the questionnaire. However, respondents were
allowed to expand on any particular areas of interest and questions were altered to the precise
circumstances of the respondent. For example, it is meaningless asking an analyst how he or
she allocates funds between domestic and foreign markets as this will already have been
decided by the appropriate fund manager, also an emerging European markets analyst would
not need to know the specific accounting treatment for goodwill, stock valuation or deferred
tax in France or Germany etc.. To help avoid the misunderstanding or misrepresentation of

respondents' answers, or clerical errors in recording the response, two interviewers, the
author and one other researcher, were present at all interviews. The author designed the
questionnaire upon which the interviews were based. However, both interviewers questioned
the respondents to ensure that all applicable points were adequately covered. All interviews
were written up immediately and the contents checked against the data captured by the other
interviewer in attempts to avoid clerical errors and misinterpretations that can arise in
attempting to record respondents' answers as they are received, a difficult task to undertake
unless proficient in shorthand!
130
7.6 SAMPLE SELECTION AND SIZE
The population focused on in this research, for both interviews and the questionnaire,
was defined as "professional investors who use non-UKfinancial statements as part of their
work". It is not possible to state precisely how many analysts/fund managers this relates to
as no data on this precise population is available. However, all professional investors in the
UK are members of the IIMR. This membership at the time of the questionnaire was 25001,
being currently 3436 (1996). Not all the members of the IIMR use non-UK financial
statements as part of their work so the precise number of relevant professional investors
falling into this category is not known. However, a crude estimate of this population can be
made with regards to the average resources employed in intemaiona1 analysis )y the broking
houses that were interviewed. Approximately 60% of all analysts employed by the large
broking houses interviewed engaged in international analysis. It was generally considered by
these organisations that smaller broking firms would not employ such resources to
international investment but concentrate primarily on the analysis of UK companies.
Therefore 60% is a generous estimate, with the actual percentage of IIMR members interested
in non-UK financial statements expected to be closer, or below 50%2. Hence the estimated
population for this research is 1250, being 50% of the membership of the IIMR at the time of
this research.
There were fifteen responses to the questionnaire, which is approximately 1.2% of the
population. As the average attributes of this population are not known and this sample only
represents 1.2% of the population, the results from the questionnaire cannot therefore be seen
as representative of the entire population. Indeed, some bias may have occurred in the
response of the questionnaire as the respondents would have been self-selective, for example
only responding if they were interested in the issues being queried. The low response rate
does not render the results from the questionnaire uninformative merely because they are not
1 Approxirnate figure given by the IIMR.

2 Thiswould be congruent with the fact that in 1992, 43.2% of average daily turnover on the London Stock
Exchange was via foreign turnover (Cochrane, 1994) so assuming that broking house would employ resources
according to turnover, 43.2°o of analysts would focus on non-UK accounts.
131
statistically testable. In this case they will be used to support or contrast the results obtained
from the interview study which forms the major part of this research.
The sample for the interviews consisted of seventeen London based international
analysts and fund managers (approximately 1.4% of the total estimated population). These
were restricted to the finance houses that were kindly prepared to be interviewed and thus
some bias would have occurred at this stage, for example institutions that were uncomfortable
with their level of international accounting knowledge may have been reluctant to participate.
A further source of bias may be the institutions' corporate ethos, as some institutions like to
be seen as aiding research and others take the contrary view. The seventeen interviewees
worked at five major institutions, one controlled from the UK, one from the US, one from
Canada and two from Europe.
The sample size compares favourably with previous behavioural based accounting
research: Breton and Taffler (1995) interviewed participants from five firms as a sample for
"UK investment analysts" which is a larger population than the one in question for this
research; Day (1986) interviewed eighteen individuals, for the same population as Bretton
and Taffler; and Choi and Levich (1991) interviewed twelve London based firms for a similar
population as the one defined in this research. Therefore, it is considered that a sample of
seventeen is a larger proportion than that used in previous literature.
However, statistical analysis is inappropriate as a 1.4% sample cannot accurately represent
the entire population. Furthermore, much of the information collected within the interview
process is qualitative and incapable of quantifying. As with previous research, the results can
be seen as case studies and providing indications and examples of practice.
132
7.7 SUMMARY
The purpose of this research has been outlined in this chapter, together with the
methodologies chosen to test the hypotheses that have been formulated. The purpose of this
research can be summarised as seeking to establish whether professional investors in foreign
securities recognise differences in international accounting regimes and whether this affects
their capital market decisions, e.g. acting as a barrier to certain foreign investments.
Stemming from this issue it is also of interest to establish how analysts and fund managers
cope with international accounting diversity and whether these coping mechanisms are
successful.
As the research is based on the behaviour of individuals, their perceptions and
reactions, market based research techniques, as outlined in the preceding chapter, are of
limited use here. Consequently, the selected research techniques are the questionnaire and
interview based surveys. The design of these together with results from each will be
discussed in the following two chapters.
133
CHAPTER 8
QLLESTIONNALRE SURVEY RESULTS
8. UINITRODUCTION
The survey questionnaire, as described in section 7.3, was circulated in the November
1993 edition of "The Professional Investor"the IIMR's monthly magazine. A copy of the
questionnaire appears in Appendix A. The content of the data collected through the
questionnaire survey undertaken, the analysis of this information and the conclusions drawn
are presented in this chapter. A total of fifteen responses were received. The findings from
this survey and conclusions drawn are therefore not intended to be representative of the entire
population of professional investors who use non-UK financial statements in their work.
Furthermore, as the questionnaire was intended to be anonymous, the companies which the
professional investors represent are unknown, hence it is not possible to state that this sample
is of a normal distribution. Nevertheless, a considerable amount of data has been collected,
allowing an indication of the behaviour of a selection of professional investors. A summary
of the overall findings of the questionnaire appears in Table 8.1, 8.11-12, 8.14, 8.16 and 8.18.
Additionally, each area of enquiry has been cross-tabulated using the extent of international
broking/fund managing experience, the existence of any formal accounting qualification and
the field of employment (Tables 8.2- 8.10, 8.13 a-c, 8.15a-c and 8.17a-c). Some of the data
obtained through open ended questions was not capable of formal analysis and requires a
narrative description. The conclusions reached will ultimately lead to the rejection or
acceptance of the previously defined hypotheses (refer to section 7.6).
134
Table 8.1. Summarised results for hypotheses Hi -1110'
Not at Not Some Much Very

___________________________________ all Much _______ _______ Much
% % % %
Do accounting differences affect your
capital market decisions? 13 13 20 20 34
Are accounting differences a significant
hindrance to the measurement of criteria - 13 7 53 27
used for assessment of foreign companies?
Is foreign investment restricted to:
• countries with more familiar
accounting practices? 60 13 7 7
• more familiar sectors 46 27 7 7 -
• more familiar companies 402 20 20 - 7
To what extent do you cope with
internationalaccounting differences by: ________ ________ ________ ________ ________
• reliance on other information e.g. -
macroeconomic data? 20 7 27 46
• trend analysis using published
accounting data? 20 13 27 27 13
• ratio analysis using published
accounting data? 7 20 27 40 7
• restatement of accounts to more
familiar accounting rules followed by 13 7 20 33 13
analysis? ________ ________ ________ ________ _______
• other techniques? 47 20 - 13 20
'Refer to section 7.6 for a complete list of the hypotheses.

was not relevant for l3 0 o of the sample
135
2LSURVEY FINDINGS
2J Is Accounting Diversity Recognised?
Accounting diversity is generally recognised, as Table 8.1 shows. Overall, 74% of
respondents feel that accounting differences affect their capital market decisions (i.e.
responded 'come'or greater, being options 3 to 5). As argued by Choi and Levich (1991), it is
difficult to incorporate second-order behavioural effects into the analysis of closed ended
questions, especially in those circumstances dictated by the questionnaire. This renders the
above percentage conservative, as it is unlikely to include users who have altered their
techniques of foreign investment analysis as a result of the difficulties experienced with
accounting differences. The response was consistent throughout all cross-tabulated
categories, although fund managers were proportionally less likely to experience difficulties
that affect their capital market decisions (66%), as illustrated in Table 8.2.
The general impression received from respondents is that they perceive market
inefficiency. For example, one consultant stated that "..perceptions ofprofit affect
short/medium term share performance more than basic reality does ". Thus, respondents
believe that expectations of a company and the information generated from profit figures are
of more importance in the price setting mechanism of the market than are market share,
liquidity, commercial risk etc.. This is reinforced through the words of an experienced
broker: "accounting rules and practices seriously distort both profit and loss and balance
sheet data and distort cash flow more than markets believe". There is further evidence
of this belief as analysts attempt to develop trading rules through "adding value by identi5iing
anomalies and using these as a marketing tool" or ".. take advantage of the discrepancies
between Anglo accounting conventions and European standards".
136
Table 8.2. Summary findings by professions experience and guaJification: do
accounting differences affect your capital market decisions?
Yes No Total
PROFESSJON % % %
Broking analyst 20 7 27
Fund manager 40 20 60
Other3 13 - 13
_________________ 74 26 100
EXPERIENCE_____________ _____________ _____________
Long> 5 years 47 13 60
Short<5 years 13 13 27
Unspecified 13 - 13
__________________ 74 26 100
ACCOUNTING
QUALIFICATION____________ ____________ ____________
Qualified 7 7 13
Unqualified 67 20 87
74 26 100
3 Banking, consultancy, insurance
137
Thus, there is some evidence that knowledge of the existence of international accounting
differences is likened to that of privileged information. There is the belief that broking
analysts are able to use their additional knowledge concerning different accounting practices
to gain excess returns, as the pricing mechanism within the market is not sophisticated
enough to analyse the foreign accounts and incorporate all the relevant information into the
share price.
Therefore, hypothesis Hi: accounting diversity has some effect on capital market
decisions must be accepted on the basis of the beliefs expressed here.
8.2.2 Are accounting differences a significant hindrance to the measurement of the
criteria for assessment of foreign companies?
Upon enquiring whether accounting differences are a significant hindrance to the
measurement of the criteria used for the assessment of foreign companies, 87% of
respondents responded in the affirmative, see Table 8.1. This was actually 100% amongst
broking analysts, bankers and the consultant, and 78% for fund managers (Table 8.3). Thus,
it can be inferred that accounting differences are a significant hindrance to the measurement
criteria used in the assessment of foreign companies. The effect of this was widespread,
ranging from a complete aversion/reluctance to deal with foreign companies "i.. where
information is either lacking or unreliable"to being aware of the accounting differences but
failing to adjust for them. One consultant stated that he would "..apply formulae to extract
data for analysing real profits but I have to assume consistent relationship for some items to
extrapolate my data from their numbers", thus employing guesswork in basing analysis upon
standard relationships rather than employing full, more accurate measurement criteria.
Problems are experienced with the "lack of comparability... "which ultimately makes
accurate valuation extremely dfJIcult".
138

Table 8.3. Summary findings by profession, experience and qualification: are
accounting differences a significant hindrance to the measurement criteria you
use for assessment of non-UK companies?
Yes No Total
PROFESSION % % %
Broking analyst 27 - 27
Other 13 - 13
____________________ 87 13 100
EXPERIENCE_____________ _____________ _____________
Short < 5 years 20 7 27
Unspecified 13 - 13
_____________________ 87 13 100
ACCOUNTING
QUALIFICATION____________ ____________ ____________
Qualified 7 7 13
Unqualified 80 7 87
87 13 100
139
Thus, hypothesis 112: accounting differences are a significant hindrance to the
measurement criteria used in the assessment of foreign companies by professional users of
foreign financial information, would be accepted on the basis of this data.
8.2.3 Do analysts restrict investment to countries/sectors/companies with more familiar
accounting practices?
The majority of respondents do not restrict foreign investment to countries with more
familiar accounting practices, or more familiar sectors or to companies with well known
reputations/financial performances (see Table 8.1). However, as shown in Table 8.4, brokers
are more likely than others to restrict foreign investment to more familiar companies; 100%
of those brokers who considered the question applicable to their work stated that familiarity
with the company was an important investment criterion. This is further strengthened by the
banker in the survey sample, the only respondent to state that familiarity with the company
was paramount in foreign investment as there was "a reluctance to lend where information is
either lacking or (particularly) unreliable ". The cross-tabulated analysis of the lack of
restriction of foreign investment to either more familiar accounting practices or more familiar
sectors (Tables 8.5 and 8.6), revealed no apparent correlation of the results with either
professional status, length of experience involved in analysing non-UK accounts or the
presence of any accounting qualification.
Therefore the following hypotheses would be rejected on the basis of these results:
. 113: most professional users of non-UK financial information restrict foreign investment
to countries with more familiar accounting practices;
• 114: most professional users of non-UK financial information restrict foreign investment
to more familiar sectors.
40
Table 8.4. Summary findings by profession, experience and qualification: do
you restrict foreign investment to countries with more familiar accounting
practices?
______________________ Yes No N/A Total
PROFESSION % % % %
Broking analyst - 13 13 27
Fund manager 7 53 - 60
Other 7 7 - 13
____________________ 13 74 13 100
EXPERIENCE_________ _________ _________ _________
Long> 5 years 7 47 7 60
Short < 5 years 7 20 - 27
Unspecified - 7 7 13
_____________________ 13 74 13 100
ACCOUNTING
QUALIFICATION_________ _________ _________ ________
Qualified - 13 - 13
Unqualified 13 60 13 87
13 74 13 100
141
Table 8.5. Summary findings by profession, experience and qualification: do
you restrict foreign investment to more familiar sectors?
_____________________ Yes No N/A Total
PROFESSION _________ ________ ________ %
Broking analyst 7 7 13 27
Other - 13 - 13
___________________ 13 74 13 100
EXPERIENCE__________ __________ __________ _________
Long> 5 years 13 40 7 60
Short <5 years - 20 - 27
____________________ 13 74 13 100
ACCOUNTING
QUALIFICATION_________ _________ _________ ________
Qualified 7 7 - 13
13 74 13 100
142
Table 8.6. Summary findings by profession, experience and qualification: Do
you restrict foreign investment to more familiar companies?
______________________ Yes No N/A Total
PROFESSION % % % %
Broking analyst 13 - 13 27
Other 7 7 - 13
__________________ 27 60 13 100
EXPERIENCE_________ _________ _________ _________
Long>5 years 27 27 7 60
Short < 5 years - 27 - 27
____________________ 27 60 13 100
ACCOUNTING
QUALIFICATION_________ _________ _________ _________
Qualified 7 7 - 13
27 60 13 100
143
I lowever, in drawing any inferences from the results of whether foreign investment is
restricted to more familiar companies it is important to consider the individual professions
separately. For fund managers the formulated hypothesis H5 (most professional users of non-
UK accounts restrict foreign investment to more familiar companies) would be rejected.
However, based on the results obtained, this hypothesis should be accepted for broking
analysts who consider such criteria with their foreign investing activities.
8.2.4 How do users of non-UK accounts cope with accounting diversity?
All the professional users of foreign accounts attempt to cope with accounting
diversity in some way (see Table 8.1). Most respondents cope through the application of a
variety of methods. One of the two most popular practices (75% of respondents) was through
the reliance on information less sensitive to corporate accounting treatment and thus
accounting differences, for example macroeconomic data. The precise methodology adopted
and nature of information employed is however unknown as this was outside the scope of the
questionnaire. The other principal method advocated is ratio analysis using published
accounting data. Further analysis of these results, as shown in Tables 8.7 - 8.10, indicates
that there is a strong correlation of both practices being employed simultaneously by the same
users, this includes three quarters of the brokers in the sample, two thirds of fund managers
and all the other professions responding. Trend analysis using published accounting data is a
less popular method of coping with international accounting differences overall, but is more
popular with brokers (100% adopt this method as per Table 8.8). The process of restatement
of foreign accounts to a more familiar GAAP, followed by analysis is utilised by 67% of
respondents. This method is highly popular with the fund managers questioned, 91% of fund
managers utilising this approach to some degree, as illustrated in Table 8.10. Other methods
advocated include the use of non-accounting data other than macro economic data to compare
quasi-accounting ratios such as staff numbers. Cash flow analysis is also a popular method of
144
dealing with diversity. 20% of the sample adopt cash flow analysis in some fashion, this
includes straightforward cash flow comparisons, and examining the relationships between
price and cash flow and also price and book ratios. These methods are viewed by the users as
being "...less subject to accounting dfferences" but still "..hindered by accounting

dfft'rences".
Anecdotal evidence, such as weekly magazines and talking to other companies in the
same industry are also used. Other areas of source information to enable a better
comprehension of what lies behind the accounting numbers includes examining the quality of
the shareholder base or the providers of loan capital and the receipt of data from tax returns.
As noted by Bhushan and Lessard (1992), the adoption of each of these styles implies
particular views of market efficiency. For example, the adoption of trend analysis, whereby
past security prices are tracked with a view to discovering patterns in share price behaviour
that can be exploited, is in direct conflict with market efficiency even in its weakest form. On
the contrary, applying a top down approach or depending upon macro economic information
to assess securities indicates a perception of efficiency within the market to assimilate all past
information regarding share price into the current market valuation. However, it should be
noted that the methods adopted to cope with accounting diversity are not always ,freely'
chosen in that analysts tend to specialise in either particular industry sectors or geographic
domains, depending upon the structure of the organisation for which they are employed.
Thus, "creating a matrix of styles reflecting both the target securities of the manager and the
skills/procedures applied" (Bhushan and Lessard, 1992).
The following hypotheses relating to the extent that users of non-UK accounts deal
with international accounting diversity should all be accepted on the basis of these results:
'45
116: most professional users of non-UK financial information cope with international
accounting differences partly by reliance on other information that is less sensitive to
corporate reporting such as macroeconomic data;
. 117: most professional users of non-UK financial information cope with international
accounting differences partly by trend analysis using published accounting data;
accounting differences partly by ratio analysis using published accounting data;
accounting differences partly by restatement of accounts to more familiar accounting
rules, followed by analysis.
However, hypothesis HlO: most professional users of non-UK financial information

cope with international accounting differences partly through the adoption of other
techniques, would be rejected on the basis of this data, although this would be accepted for a
significant minority(33%).
146

Table 8.7. Summary findings by profession, experience and qualification: to
what extent do you cope with international accounting differences by reliance on
macroeconomic data?
Yes No Total
PROFESSION% ____________ %
Other 13 - 13
________________ 73 27 100
EXPERIENCE_____________ _____________ _____________
Unspecified 7 7 13
73 27 100
ACCOUNTING
QUALIFICATION____________ ____________ ____________
Qualified 13 - 13
87 13 100
147

what extent do you cope with international accounting differences by trend
analysis using published accounting data?
Yes No Total
PROFESSION% % ____________
Broking analyst 27 - 27
Other 13 - 13
___________________ 67 33 100
EXPERIENCE____________ ____________ ____________
Short <5 years 7 20 27
Unspecified 7 7 13
____________________ 67 33 100
ACCOUNTING
QUALIFICATION____________ ____________ ____________
Qualified 13 - 13
67 33 100
148
what extent do you cope with international accounting differences by ratio
analysis using published accounting data?
Yes No Total
PROFESSION % % %
Other 13 - 13
___________________ 73 27 100
EXPERIENCE____________ ____________ ____________
Long>5 years 47 13 60
Unspecified 13 - 13
____________________ 73 27 100
ACCOUNTING
QUALIFICATION____________ ____________ ____________
Qualified 13 - 13
73 27 100
149
what extent do you cope with international accounting differences by restatement
of accounts to more familiar accounting rules, followed by analysis?
Yes No Total
PROFESSION % % %
Other 13 - 13
___________________ 87 13 100
EXPERIENCE_____________ _____________ _____________
Short < 5 years 27 - 27
Unspecified 13 - 13
______________________ 87 13 100
ACCOUNTING
QUALIFICATION____________ ____________ ____________
Qualified 7 7 13
Unqualified 80 7 87
87 13 100
150
8.2.5 How do analysts perceive relative reported profit levels of different GAAP
regimes?
In examining how users of international accounting statements perceive the 'bottom
line' of the profit and loss account in a number of chosen countries, respondents were asked
to rank the countries in order of diminishing reported earnings, i.e. placing the least
conservative accounting regimes first. The results are contained in Table 8.11. 20% ranked
the countries in the order most frequently cited by academics within this field, being UK, US,
France, Germany and lastly Japan. Further analysis showed that there was no obvious
correlation between the responses given and any of the cross-tabulated categories. 26%
ranked two of the countries in a different order to that taken as academically accepted (see
4.2), perceiving Japan to be less conservative than Germany in two cases, US to report larger
profits than the UK in one case and perceiving French accounting to be more conservative
than German accounting. 14% of respondents' perceptions of the relative profits that would
be reported under identical conditions in each country were in a totally different order to
academic doctrine. These were both fund managers with an extremely large amount of
experience gained in analysing non-UK accounts, 29 and 44 years. One, a qualified

accountant, appears to have ranked the countries in virtually the opposite order, thus this
may be a misunderstanding of the instructions. 20% of respondents admitted that they did
not know rather than wanting to hazard a guess, and 13% stated that the country was
irrelevant in deciding the magnitude of reported profits. Conversely "i.. it depends upon the
state of the business cycle or the state of the company", or 'for European companies it is the
sector which may influence profits, for example, banks/insurers can follow different
principles to manufacturing companies". These are of course two valid arguments.
Overall there appears to be a general understanding of the absolute expected

differences in reported earning for these countries but not by the majority of respondents.
Therefore, hypothesis Hi i: most professional users of non-UK financial information are
151

aware of the existence of international accounting differences that effectldistort reported
earnings; would be rejected. However, Hi I would be accepted for a significant majority

(46%).
Table 8.11. Summarised results for h y pothesis Hi!
Given identical economic facts relating to a company, which country's

rules would lead to the largest reported profit? 4 _________ ____________
UK US France Germany Japan %
2 3 4 5 20
1 2 3 5 4 13
Ranking 1 2 4 5 3 7
____ 2 4 3 5 7
2 1 3 4 5 7
3 5 2 1 4 7
4 5 3 2 1 7
Do not know 20
Country irrelevant 13
8.2.6 Are analysts aware of specific accounting differences?

(a) Goodwill
The final area of results focuses upon the existence of knowledge of the specific
accounting differences that cause the niost diversity in reported financial statements. A
significant area that distorts profits in international financial statements is that of goodwill.
The most popular practice in the UK is to write off goodwill to reserves, but it can also be
capitalised and amortised to the profit and loss account over its estimated life. Results are
exhibited in Table 8.12 showing that 66% of respondents were aware of this treatment,
4 Countries are ranked from I to 5, 1 being the country in which largest profits are expected.
152
Table 8.12. Summarised results for hypothesis H125
although 33% considered capitalisation and amortisation over a period not exceeding 15 years
as common practice in the UK! The treatment of goodwill in the US involves capitalisation
and amortisation over a period not exceeding 40 years. Only 25% of respondents were aware
of this, one fund manager considered immediate write off to reserves as a popular practice
under US GAAP, but most respondents (5 9%) suggested that the practice of amortisation
over less than 15 years as the most popular practice. German GAAP states that goodwill can
either be written off over 4 years or the useful life, or it can be written to reserves. The
practice to write off over four years or less was only recognised by 23% of respondents. The
majority considered that German GAAP would involve goodwill being shown as an asset and
amortised. Overall 8% did not know the US treatment and 15% did not know the German
treatment of goodwill. Cross-tabulating the results, Tables 8.13 (a) -(c), did not show any
5 Hypothesis H 12 states that most professional users of non-UK financial statements are aware of the differences
existing between major corporate financial reporting countries, with respect to the treatment of goodwill.
6 Shaded areas within the table represent the method most commonly practised in that country.
7The 15 year period chosen for this category has no particular relevance. It is only intended to highlight the
differences between the US practice of allowing a maximum write-off period of forty years compared to much
shorter periods in some other countries, e.g. 5 years in Spain and Japan. See section 4.3.1.
153

correlation between the responses and the cross-tabulated categories: experience,
qualification or field of employment.
Table 8.13 (a). Summary findings by profession. experience and qualification:

which is the most common treatment of goodwill in the UK?
Generally accepted practices relating to the treatment of goodwill
Immediate Shown as Shown as Shown as Don't

write off to an asset an asset and an asset and know! no Total
reserves and amortised amortised response
amortised over 1 5 over more
years or than 15
lessyears ___________ _________
PROFESSION % % % % % %
Broking analyst 25 - 8 - - 33
Fund manager 25 - 25 - - 50
Other 16 - - - - 16
______________ 66 - 33 - - 100
EXPERIENCE________ _______ ________ ________ _______ ______
Long>5 years 42 - 16 - - 58
Short < 5 years 8 - 16 - - 25
Unspecified 16 - - - - 16
_______________ 66 - 33 - - 100
ACCOUNTING
QUALIFICATION________ _______ ________ ________ _______ ______
Qualified 8 - 8 - - 13
Unqualified 58 - 25 - - 87
66 - 33 - - 100
154

Table 8.13 (b). Summary findings by profession, experience and qualification:

which is the most common treatment for goodwill in the US?

amortised over 15 over more
years or than 15
lessyears _____________ __________
PROFESSION % % % % % %
Broking analyst - - - 8 8 16
Fund manager 8 - 42 17 - 68
Other - - 17 - - 17
_______________ 8 - 59 25 8 100
EXPERIENCE_________ ________ _________ _________ ________ ______
Long> 5 years - - 33 16 8 58
Short < 5 years 8 - 16 - - 25
Unspecified - - 8 8 - 16
8 - 59 25 8 100
ACCOUNTING
QUALIFICATION________ _______ ________ ________ _______ ______
Qualified - - 16 - - 16
Unqualified 8 - 43 25 8 84
8 - 59 25 8 100
155

Table 8.13 (c). Summary findings by profession, experience and qualification:

which is the most common treatment of goodwill in Germany?

amortised over 15 over more
years or than 15
lessyears ___________ _________
PROFESSION _______ ______ % _______ % %
Broking analyst 8 8 8 - - 23
Fund manager 8 31 15 - 8 61
Other - 8 - - 8 16
______________ 15 47 23 - 15 100
EXPERIENCE _________ _______ ________ ________ _______ ______
Long>5 years 15 31 8 - 8 61
Short < 5 years - 8 8 - 8 23
Unspecified - 8 8 - - 16
_______________ 15 47 23 - 15 100
ACCOUNTING
QUALIFICATION _________ _______ ________ ________ _______ ______
Qualified - 15 - - - 15
Unqualified 15 31 23 - 15 85
15 47 23 - 15 100
156
On the basis of this information, hypothesis H 12 (most professional investors in non-
UK financial statements are aware of the differences existing between major corporate
financial reporting countries, with respect to the treatment of goodwill) would be rejected.
(b) Stock Valuation
The method of determining cost for the valuation of stock varies among the countries
chosen for examination. Despite the attempts of the EU towards harmonisation, there still
remains scope for the member states to use LIFO, FIFO, weighted average cost or any similar
method. In Germany average cost is the principal method for determining cost, although
FIFO and LIFO are allowed. In the UK, a Canadian tax case called for the rejection of LIFO
for tax purposes and SSAP 9 (para 39) explicitly states that the use of LIFO would not
normally be consistent with the overriding principle of truth and fairness. Consequently, the
most common method employed is FIFO. Conversely, in the US, LIFO is widely used as it
is allowable for tax purposes, resulting in large tax savings as a lower profit is reported under
this method of stock valuation in an inflationary environment. However, some US firms have
not adopted LIFO because the effect upon reported profit levels is believed to be detrimental
to share valuation.
Practices in the UK and US are better known than those in Germany (see Table 8.14).
Of the respondents, 47% were aware of the aforementioned methods adopted in the US and
UK, but only 33% were aware of the German practice. Further analysis of these results
showed that fund managers had a clearer perception of the methods adopted in the UK and
US. Cross-tabulating the results by profession, Table 8.15 (a), shows that 63% of fund
managers who responded, opted for the expected method, whereas only 33% of brokers
considered FIFO to be the most common practice in the UK. 50% of other professions stated
FIFO as the principal method for stock valuation in the UK for the UK and LIFO for the US
(Table 8. 15b). No brokers considered LIFO a commonly employed method in the US. As
157
reflected in Table 8.15c, 20% of respondents admitted that they did not know which practice
was most commonly employed in Germany, rather than wanting to hazard a guess. This
compares to 6% for both the UK and US. 33% stated that FIFO is the principal method used
for determining cost for stock valuation. This is acceptable as many firms have not chosen to
adopt LIFO in the US despite possible tax savings. No respondents considered the use of
average cost commonly employed in the US. 20% of respondents, each with an average of
over twenty three years' experience in this field, considered the use of LIFO in the UK as the
principal method advocated, as previously stated this method is prohibited. LIFO was also
perceived to be frequently used in Germany by 20% of respondents. 13% of the sample did
not respond to this question.
Generally accepted methods relating to the

determination of cost for the valuation of
stocks8
Country LIFO
Do not FIFO
No response Average cost
know
___ ____ ____ ____ % ____
UK 20 47 13 7 13
US 47 33 - 7 13
Germany 20 20 33 20 13
Therefore, hypothesis H 13: most professional users of non-UK financial statements
are aware of the differences in the treatment of the determination of cost for stock valuation
between major GAAP regimes, would be rejected on the basis of this data.
8 The shaded areas within the table represent the method most commonly practised in each of the countries.
158

Table 8.15 (a). Summary findings by profession, experience and qualification:

which is the most common method for determining stock valuation in the UK?
Generally accepted practices relating to the determination of cost for stock valuation
LIFO FIFO Average cost Don't know!

no response Total
PROFESSION % % % % %
Broking analyst 8 8 8 - 23
Fund manager 8 38 8 8 62
Other 8 8 - - 15
_______________ 23 54 15 8 100
EXPERIENCE_________ _________ _________ _________
Long> 5 years 23 23 8 - 54
Short < 5 years - 23 - 8 31
Unspecified - 8 8 - 15
23 54 15 8 100
ACCOUNTING
QUALIFICATION_________ _________ _________ _________ _________
Qualified - 8 8 - 15
Unqualified 23 46 8 8 85
23 54 15 8 100
I 59


which is the most common method for determining stock valuation in the US?

no response Total
Broking analyst - 15 - 8 23
Fund manager 46 15 - - 62
Other 8 8 - - 15
_______________ 54 38 - 8 100
EXPERIENCE_________
Long> 5 years 23 23 - 8 54
Short <5 years 23 8 - - 31
Unspecified 8 8 - - 15
________________ 54 38 - 8 100
ACCOUNTING
QUALIFICATION_________ _________ _________ _________ _________
Qualified - 15 - - 15
Unqualified 54 23 - 8 85
________________ 54 38 - 8 100
160

Table 8.i5 (c). Summary findings by profession, experience and qualification:

which is the most common method for determining stock valuation in Germanyl

no response Total
Broking analyst 7 7 7 - 22
Other - - 7 7 14
_______________ 21 21 36 21 100
EXPERIENCE__________ _________ _________ _________ _________
Long>5 years 14 14 21 7 57
Short < 5 years 7 7 7 7 29
Unspecilied - - 7 7 14
21 21 36 21 100
ACCOUNTING
QUALIFICATION__________ _________ _________ _________ _________
Qualified 7 - 7 - 14
21 21 36 21 100
161
(c) Deferred Taxation
Deferred taxation arises because of the reversible timing differences between taxation
and accounting revenues, for example, the cause of such differences could be depreciation or
stock valuation methods. Due to the close relationship between accounting and taxation
numbers in Germany, the method of how to account for it is not an issue and is not
recognised in either law or accounting GAAP. Only 31% of those responding to this question
were aware of this (see Table 8.16). However, this option was marginally preferred by all
respondents who were generally split between the three alternative treatments. 23% stated
that they were unaware of the treatment in Germany, rather than attempting to guess.
____________ Generally accepted practices elating to the treatment of deferred tax

Country Full basis Partial basis Generally does Do not know
not arise
______ 00 % % %
UK 31 53 8 8
US 53 8 8 31
Germany 23 23 31 23
UK practice, in accordance with SSAP 15, is based upon partial provision of deferred
taxation using the liability method. That is to say that tax is only recognised as a liability
when there is a reason to believe it will crystallise in the foreseeable future, usually within
three years. The majority responding to this question, 54%, recognised that partial provision
of deferred taxation was the method advocated in the UK (see Table 8.16). There was no
obvious correlation between these results and the cross-tabulated categories, although both
qualified accountants were not aware of current UK practice, one stating that a full basis was
9 Hypothesis H 14 states that most professional users of non-UK financial statements are aware of the differences
in the treatment of deferred tax between major corporate financial reporting countries).
162
used and the other stating that generally the issue of deferred tax does not arise in the UK!
(see Table 8.17a-c)
In the US deferred taxation is accounted for on a full basis. The majority of fund
managers, 75%, correctly identified this practice, although the score for the total sample was
only 53%. 30% of respondents admitted that they did not know the US practice relating to
deferred taxation.
Therefore, on the basis of this data, hypothesis H14: most professional users of non-
UK financial statements are aware of the differences in the treatment of deferred taxation
between major GAAP regimes, would be rejected.
8.2.7 How do analysts allocate funds between domestic and foreign markets?
The question of how professional users of non-UK accounts allocate funds between
domestic and foreign markets was addressed by all the fund managers responding to the
questionnaire and by the banker. For the nine fund managers, 40% use a top down approach
of some fashion in allocating funds between domestic and foreign markets (see Table 8.18).
This method involves first selecting promising countries then diversifying within countries,
through attractive sectors and finally attractive companies. The methodology employed upon
which the top down approach is executed included the consideration of information less
sensitive to corporate accounting treatment such as macroeconomic data, and detailed

analysis of stock market fundamentals and anomalies, some fund managers employing both
methods. Other allocation methods included examining expected performance returns and
decisions driven by valuation measures, for example analysing liquidity and spread valuation
measures and risk control analysis.
163
Table 8.17 (a). Summary findings by profession, experience and qualification:
which is the most common treatment of deferred tax in the UK?
Generally accepted practices relating to the treatment of deferred taxation
Full basis Partial basis Does not Don't know!

arise no response Total
Broking analyst - 15 8 - 23
Fund manager 3 1 23 - 8 62
Other - 15 - - 15
______________ 31 53 8 8 100
EXPERIENCE__________ __________ __________ __________ _________
Long> 5 years 8 38 8 - 54
Short < 5 years 15 8 - 8 31
Unspecified 8 8 - - 15
_______________ 31 53 8 8 100
ACCOUNTING
QUALIFICATION_________ _________ _________ _________ _________
Qualified 8 - 8 - 15
Unqualified 23 53 - 8 85
31 53 8 8 100
164
which is the most common treatment of deferred tax in the US?
Full basis Partial basis Does not Don't know!

PROFESSION ________ % % % %
Broking analyst 8 - - 15 23
Other - - - 8 15
_______________ 54 8 8 31 100
EXPERIENCE__________ _________ _________ _________ _________
Long>5 years 23 8 8 15 54
Short < 5 years 23 - - 8 31
Unspecified 8 - - 8 15
54 8 8 31 100
ACCOUNTING
QUALIFICATION_________ _________ _________ _________ _________
Qualified 15 - - - 15
54 8 8 31 100
165

Table 8.17 (c). Summary findings by profession, experience and qualification:

which is the most common treatment of deferred tax in Germany?
Full basis Partial basis Does not Dont know!

Broking analyst 8 - - 15 23
Other 8 - 8 - 15
23 23 31 23 100
EXPERIENCE__________ _________ _________ __________
Long>5 years 15 15 15 8 54
Short<5 years - 8 15 8 31
Unspecified 8 - - 8 15
______________ 23 23 31 23 100
ACCOUNTING
QUALIFICATION_________ _________ _________ _________ _________
Qualified 8 8 - - 15
23 23 31 23 100
166
A further method using macroeconomic data, although the use of a top down approach was
not explicitly mentioned, was to establish target weights based upon gross domestic product
and market capitalisation adjusted for future expectations. The banker stated that the choice
of country is not a criterion in theory, but small or unstable countries are avoided.
Once a country has been chosen for foreign investment, according to the various
aforementioned methods advocated by professional investors, further criteria are required in
order to select the specific securities to be targeted. In the sample questioned these methods
ranged from the adoption of a top-down approach, i.e. selecting attractive sectors and then
attractive companies within the chosen sector, to traditional value criteria. Of the nine fund
managers, three adopted a top down approach. This can be achieved, for example, with
reference to the local stock market index in order to weight the sectors which are considered
to outperform. Value driven information, such as the calculation of companies' P/E ratios,
price to cash flow, price to book value, growth and yield, and the comparison of these
between companies, also plays an important role in this process. Other information employed
included "dollar exposure, quality, good story in vogue sectors, individual research based on
meetings with company directors". One fund manager preferred to call upon the expertise of
local research analysts for advice rather than to perform specific calculations himself. The
two brokers to which this question was applicable adopted similar approaches to those of the
majority fund managers, i.e. top down approach using value driven criteria. The
consideration of macro and micro economic and environmental information was employed by
the consultant in order to find the inflation adjusted return on capital employed, excluding
stock market windfalls. In addition, information regarding the extent of competition existing
in the market being examined, the quality and degree of the company's finances, quality of
the management and technology and finally price were endorsed.
167
Table 8.18; summarised results of how analysts allocate funds between domestic
and foreign markets
Basis of allocation %
Top down basis! economic and market analysis 40
Expectations 20
Value drivenl liquidity and spread valuation 20
Most attractive companies in most attractive sectors of developed countries 10
No criteria but small unstable countries avoided 10
100
8.3 CONCLUSIONS AND IMPLICATIONS

Several implications have arisen from the findings of the questionnaire survey
outlined in this chapter. Firstly, based on the data collected, it can be shown that accounting
differences are important and are said to affect capital market decisions of professional
investors. These conclusions drawn are consistent regardless of professional status, length of
experience or the presence of an accounting qualification or not. As previously stated the
actual statistics given are conservative because it is impossible to include second order
behavioural effects. However, as with all the inferences made, it must be considered that this
questionnaire does not purport to represent an unbiased, normally distributed, representative
sample of the entire population. This is due partly to the small sample. However, these
findings are consistent with some findings of Choi and Levich (1991, p11): that international
accounting differences are important and do affect the capital market decisions of a
significant number of market participants, regardless of size, experience and scope of
international activity; Germany was cited as being a source of concern with country
avoidance occuring because of difficulties in understanding the accounting numbers by some
168
of the Choi and Levich respondents; and the financial services industries were the most
commonly avoided sectors because of confusion surrounding the accounting numbers
generated.
Accounting differences are also considered to be a significant hindrance to foreign
investment, as manifested by 84% of respondents. This has vast implications for capital
distribution, as many professional investors, in this sample, rely on guess work in formulating
investment criteria as "accurate valuation is extremely dfJIcult". This problem is coped with
to varying degrees, so that foreign investment is not principally restricted to countries with
familiar GAAP regimes, familiar sectors or familiar companies. The coping mechanisms
adopted do not appear adequate. Only 66% of respondents attempt to restate accounts to a
more familiar GAAP prior to analysis, 33% performing ratio and trend analysis on foreign
accounts without first attempting to bring them all down to a comparable basis.
The fact that the majority of those respondents attempting restatement were also
reliant upon information less sensitive to corporate financial reporting means one of two
things:
• the investors were not confident in the results obtained;
• due to the awareness of the inadequacies of restatement taken in isolation, accounts that
are restated to the principles of a more familiar accounting regime are not directly
comparable. This is because of the differences in social, economic, political and even
business/cyclical environments.
The former inference is supported by the clear absence of knowledge relating to
specific divergencies in accounting practice between three major countries in which foreign
investment occurs, the US, UK and Germany. Overall, only 47% of the sample were aware
of the stock valuation methods for determining cost in the UK and US, and 33% aware of the
169
German GAAP. The correct treatment of goodwill in the UK was recognised by 53% of
respondents, but only by 20% of respondents for US and Germany. Finally, the awareness of
the treatment of deferred tax was marginally better: 75% acknowledged the correct US
treatment of full provision, 53% recognised the UK practice of partial provision, but only
30% recognised that there was generally no need to account for deferred tax in Germany.
Thus, how can adequate restatement occur if the person restating the accounts is unaware of
fundamental differences? This question must be seen in the context that no information was
given regarding the actual countries that the respondents deal with, although knowledge of
UK accounts is a pre-requisite to the efficient and comprehensive restatement of any foreign
accounts to UK GAAP, and the other countries chosen were of major importance to the UK.
170
CHAPTER 9
INTERVIEW SURVEY RESULTS
9J INTRODUCTION
This chapter presents the data collected through a series of interviews
undertaken between March and August 1994. The interview structure and sample size
are detailed in sections 7.5 and 7.6. Analysis of the data collected will appear within
this chapter. Notes on the content of the interviews can be found in Appendix B.
Interviews were conducted in order to gather detailed information to enhance
the questionnaire previously carried out (see chapter eight). The content of the
interviews therefore closely followed that of the questionnaire, consisting of a

standard set of ten questions directed towards all interviewees (see Appendix A).
Each interviewee was seen separately'. The interviews took on average half an hour
per session. Notes were independently taken by the two interviewers and then cross-
referenced for any anomalies after the interview was complete. All interviews were
conducted in London at the respective addresses of the five fmance houses

participating. Of the seventeen interviewees, six acted as international analysts, eight
as fund managers and three interviewees acted as both. Table 9.1 contains details of
each respondent's investment area targeted, length of experience, age, and accounting
qualifications. As may be seen, the average length of experience of working with
international accounts was ten years and the average age of this sample was 38 years.
Only one respondent held a professional accounting qualification and one other
respondent had attempted some accounting exams but had failed to qualify as a
professional accountant. These categories are used to cross-reference the results in
exception to this was the first interview undertaken. This was exploratory in nature, acting as a
piloting exercise. This comprised a joint interview of four fund managers. Collective arguments and
comments were formed by the four fund managers as discussion was held at a group level. This group
is taken to represent one interviewee for the purpose of the results obtained.
171
order to establish any correlation that may exist (See Tables 9.3 - 9.10; 9.12 (a)-(e);
9.15 (a) - (e);and 9.17 (a) - (e)).
Interviews were not tape recorded as it was considered that this would
seriously affect a respondent's attitude towards the interview and thus the results
obtained. Interviewer bias was , however, reduced through the presence of two
interviewers. The sample selected was not a random one and is thus considered
appropriate for indicative purposes only. The sample size, of seventeen interviewees
from five major London finance houses, is relatively small, but of comparable size to
the samples used in several published works in this area: Day (1986) interviewed
eighteen firms of stockbrokers; Choi and Levich (1991) interviewed twelve London
based firms and; Bretton and Taffler (1995) interviewed participants from five major
UK accounting firms. Thus, the consequential analysis and conclusions inferred from
this research are intended to be illustrative and not definitive and may not represent
the entire population of "analysts who use non-UKfinancial statements in their
work".
9.2 SURVEY FINDINGS

The data collected through the interview procedure is not capable of formal
analysis to the same degree as the questionnaire using the methods adopted for the
analysis of the questionnaire data. Although a similar analysis is undertaken where
appropriate, much of the data is unquantifiable and requires qualitative rather than
quantitative analysis. This was expected, as field data sourced from interview based
surveys is far richer and is of a greater quality than straightforward "yes/no" style
responses that are gained through questionnaires. The principal reasons for this are
the spontaneity of the information obtained and the ability for the researcher to
expand or clarify a point raised. This can often lead to interesting points being
considered that had not been directly targeted within the proposed content and format
of the interview.
172
Table 9.1: Interview Sample Details
Countries/Sectors Length of Experience Fund Manager Accounting Age
Covered in International or Qualification
Investment (years) Analyst _____________ ______

UK and Continental Europe 10 Fund Manager None 30-35
North America and Far East 15 Fund Manager None 40-45
Continental Europe 4 Fund Manager None 25-30
All Areas (General Manager) 34 Fund Manager None 55-60
Japan 10 Fund Manager None 35-40
Continental Europe 3'h Fund Manager None 35-40
Asia 25 Fund Manager Partial 45-50
South East Asia 6'12 Fund Manager None 30-35
UK (US in the past)
Consumer goods, Beverages, 12 Fund Manager Yes 50-55
Media, Pharmaceutical
Far East: Mining 4 Analyst None 25-30
Tobacco, Food & Beverages ____________________ _____________ ____________ _______
USA and Canada 12 Both None 40-45
Europe: Chemicals, Oil, 4 Both None 30-35
Pharmaceuticals,_Paper ______________________ _______________ _____________ _______
Capital Goods: UK, US,
France, Germany, Sweden 5 Both None 40-45
Switzerland,_Italy,_Luxembourg ______________________ _______________ _____________ _______
European Chemicals 6 Analyst None 40-45
Transport & Aviation: 14 Analyst None 30-35
Europe, US, Japan _____________________ ______________ _____________ ______
France 4 Analyst None 30-35
Switzerland & Belgium 2 Analyst None 25-30
Food, Oil & Gas in UK
173
However, in order to ensure that the data obtained was susceptible to some structured
analysis, certain standard questions were addressed to each respondent.
9.2.1 Is accounting diversity recognised and does it affect capital market
kcisions?
All interviewees were asked whether international accounting differences
affected their capital market decisions. Before analysing the results obtained through
this survey, a very important distinction should be made between fund managers and
analysts as this is vital to the deductions and conclusions drawn.
Broking analysts carry out the initial analysis of companies, incorporating
international financial statement analysis. Reports of a standard nature are then
prepared detailing traditional company valuation indicators, for example, net asset
value, price/earnings and standard financial ratios. These reports are then sold to fund
managers from other financial institutions or are made available to in-house fund
managers. Fund managers, as evident in this survey, tend to rely upon these reports
when making asset allocation decisions, conducting a minimum of independent

analysis due to resource constraints such as time.
Many of the fund managers interviewed stated that they assumed that the
brokers preparing the reports were aware of the fundamental differences in
international GAAP regimes that affect reported profit levels and asset values and that
they adjusted accordingly in order to produce comparable reports for all companies.
Thus, as this assumption is made, fund managers do not generally consider accounting
diversity to be a problem because they believe that the analysts preparing company
reports have overcome this barrier by making all the appropriate adjustments.
Following this through to the findings made, it is not expected that fund managers
would perceive accounting diversity to be a problem which would affect their capital
174
market decisions This is evident in the results obtained, summarised in Table 9.2. Of
the 36 % of respondents stating that accounting diversity affected their capital market
decisions, 60 % were analysts (see Table 9.3).
With respect to the group not affected by accounting differences, 64% did not
undertake any internationally comparative financial statement analysis, either because
they relied on brokers' reports for this or because of organisational structure, e.g.
covering only the US market as opposed to the world-wide chemicals sector. Sector
analysts and fund managers are referred to hereafter as 'specialists' and country
analysts and fund managers as 'non-specialists'. The cross-tabulated results in Table
9.3 illustrate that 89% of respondents (i.e. 57 % of the above 64 %) stating that
accounting differences did not affect their capital market decisions were non-
specialists. Reasons stated for not perceiving accounting diversity to be a problem
included:
Accounting information is not heavily relied upon, being only one of many
sources of information utilised when undertaking analysis, with nothing of
importance contained within the accounts that would hinder or deter analysis.
Accounting differences are not perceived to exist and so all accounting

information is treated as comparable, with no adjustments taking place.
Nevertheless, the respondent stating this said later that he was aware of
international differences in reported profit levels and would be more likely to
believe a US profit figure than a German profit figure because the former has
tighter regulations controlling reported financial information!
. Markets should be viewed from a domestic perspective, as the price setters

within the market are domestic investors, not foreign investors.
175
The two respondents who undertook restatement of financial statements to a
more familiar GAAP, experienced problems with accounting diversity. Particular
areas singled out as problematic included: (i) reserve and provision accounting,
especially in Continental Europe, for example, Germany and Switzerland, where
income smoothing is apparent; (ii) detailed accounting policies for depreciation of
fixed assets and capital expenditure; (iii) the treatment of goodwill; (iv) the
recognition of profits on long-term contracts, and; (v) countries that have devalued,
e.g. Sweden and Finland.
Table 9.2: Summarised table of results for hypotheses Hi to HlO
Yes Slightly No
% % %
Do accounting differences affect your
capital market decisions? 36 - 64
Are accounting differences a significant
hindrance to the measurement criteria you 29 21 50
use for assessment of foreign companies?
Do you restrict foreign investment to:
• countries with more familiar 21 21 58
accounting practices?
• more familiar sectors? 21 ______ 79
• more familiar companies? 7 - 93
To what extent do you cope with
international accounting differences by:
• reliance on other information such as
macroeconomic data? 50 29 21
• trend analysis using published accounting
data? 100
• ratio analysis using published accounting
data? 100
• restatement of accounts to more familiar 7 14 792
accounting rules followed by analysis?
• other techniques? 14 86
27 o of the sample adjust but do not restate; l4 0 o of the sample use US GAAP but not restatement.
3 Other techniques would include: quality of management; company visits; technical analysis e.g. 3-
coefficients.
176

Table 9.3: Do accountinE differences affect your capital market decisions?4
___________________ Ycs Slightly No

PROFESSION____________ ___________ _____________
Analyst-specialised 5 14 - 7
Analyst non-specialised - - 14
Fund Manager non- 14 - 21
specialised___________________ __________________ ______________________
Both specialised 7 -
Both non-specialised - - 21
EXPERIENCE_____________ -
Long>5 years 21 - 43
Short<5 years 14 - 21
36 64
AGE____________ ___________ _____________
25-30 - - 14
30-35 7 - 21
35 -40 7 ______________ 14
40-45 14 - 7
45-50 - - 7
50-55 7 -
4 For the purposes of cross-tabulation it has been necessary to include the four fund managers
interviewed in the piloting exercise as one fund manager. The characteristics of this 'respondent' are
the average characteristics of the four fund managers. Consequently this represents a 'non-specialised'
fund manager with 15 years experience and aged 35-40.
5A distinction has been made between 'specialised' and 'non-specialised' analysts fund managers.
'Specialised' refers to those respondents that are an authority on specific sectors, whereas 'non-
specialiseci refers to country analysts that do not focus upon any specific sector when undertaking
analysis.
177
One consequence of accounting diversity was the avoidance, as far as possible,
of international financial statement analysis, reliance being shifted towards other
analysis techniques that are less sensitive to corporate reporting. For example, one
analyst only undertook comparative financial statement analysis between companies
within the same country. This particular respondent considered the differences to
surpass the figures within the accounts and to be rooted in deeper cultural differences.
Thus, it was considered that the behavioural differences between nations had to be
understood in order to evaluate companies comprehensively. As a result of this, the

respondent claimed only to make quantitative decisions, not qualitative ones.
The hypotheses relating to this research are contained within section 7.6. Two
of them relate to the issue in question here:
• Hi: accounting diversity has some effect on capital market decisions;
• 112: accounting differences are a significant hindrance to the measurement criteria
used in the assessment of foreign companies by professional users of foreign
financial information;
The survey shows that accounting diversity does affect capital market
decisions (for 36% of the sample) and is a significant hindrance to the measurement of
criteria used in the assessment of foreign financial information (50% of the sample to
some degree, refer to Table 9.4). Thus, hypotheses Hi and H2 would be accepted on
the basis of the information collected in this survey.
178
Lible 9.4: Are accounting differences a significant hindrance to the
measurement of the criteria you use for the assessment of foreign
companies?
179
9,2.2 Do analysts restrict foreign investment to countries with more
The majority of respondents (86%)6 held that UK GAAP was the accounting
regime they were most familiar with, the other two respondents being more familiar
with US GAAP. Of the sample, 57% of the respondents held that investment in non-
UK companies was not avoided because of unfamiliarity with foreign accounting
practices (Table 9.2). This figure can be adjusted slightly to exclude the responses
from non-specialists analysts/fund managers who only analyse the financial
statements from one country. In this case the percentage of respondents who do not
restrict foreign investment to those countries with more familiar accounting practices
rises to 73%.
Conversely, 43 % indicated some avoidance of countries with unfamiliar

GAAP regimes (Table 9.2). Table 9.5 shows the results from cross-tabulating these
findings with profession, age and length of experience held in analysing non-UK
financial statements. It was found that analysts and fund managers with experience
greater than five years were unlikely to restrict foreign investment to those countries
with more familiar accounting practices (67%). It is evident from the information
presented later in this chapter that this is not due to an increased knowledge of relative
accounting regimes.
Country avoidance also occurred in most of the finance houses interviewed
due to several other reasons:
• The degree of regulation in a country. Countries with low regulation (for

example, India, Turkey, Greece and Vietnam) are avoided; and Austria, Portugal and
Eastern Europe are approached with caution. The degree of regulation can refer to
accounting regulation or to other forms of regulation, e.g. stock market regulation.
6 This data has been extracted directly from the interview summaries contained within Appendix B.
180
Table 9.5: Do you restrict foreign investment to countries with more
181
• Economically unimportant countries. Examples stated included Greece and
Portugal.
• Country risk. Examples stated included Spain and Italy.
Many respondents did express a lack of understanding and difficulty with accounting
practices throughout a range of countries. Avoidance was reported in the following

cases:
• China: Chinese accounting was considered on a "different wavelength" to that of
other accounting regimes.
• Eastern European countries, Austria and Italy. Poor disclosure was the main
reason cited for avoidance in these countries. Respondents found difficulties with
"large areas of unexplained items in the profit and loss account and in the
balance sheet ". Profit recognition was also problematic, for example, the
treatment of long term contracts in Italy.
Germany and Switzerland. Reserve and provision accounting leading to
misrepresented profit figures or even income smoothing.
A fund manager for Continental Europe avoided or only marginally invested
in Austria, Italy and Germany because of the secrecy involved in their respective
GAAP regimes. Later in the interview, he stated that the underlying value was
"...probably the highest in these countries but they try to minimise reported earnings ".
This remark, coupled with the earlier issue raised that these countries tend to have the
best economies, illustrates the possible extent of the effects of international
accounting diversity on asset allocation. The treatment of accounting numbers was
the exclusive reason for the avoidance of countries which, according to this fund
manager, had the best economies and whose companies generally had the highest
underlying values.
182
There is a strong disparity between the low level of difficulty reported by the
majority of respondents and the high level of difficulty that they experienced when
asked direct questions relating to specific accounting differences, later in the interview
process. This is discussed later in this section.
Where accounting difficulties were expressed, only 21% of respondents held
that this could deter them from investment (Tables 9.2 and 9.5). Most interviewees
did not consider difficulties in interpreting accounting information as a significant
reason for avoidance. Several methods adopted in order to cope were given. These
included:
• Scanning the statement of accounting principles.
• Undertaking company visits.
• Covering companies in "boom" sectors regardless of any difficulties experienced

in interpreting the accounting numbers.
Therefore, according to the data collected in this survey, Hypothesis H3: most
professional users of non-UK financial information restrict foreign investment to
countries with more familiar accounting practices, would be rejected. However, it is
held that for a significant minority (43%) country avoidance does occur because of a
lack of familiarity relating to foreign accounting regimes.
9.2.3 Do analysts restrict foreign investment to more familiar sectors?

Three respondents (21%) avoided certain sectors because of a lack of
understanding of the accounting practices used. The financial services sector,

especially insurance companies, was the most frequently stated example.
One analyst for Japan stated that, although some sectors were avoided due to
the lack of transparency in accounting regimes, this was not deemed to be problematic
as a portfolio with the desired risk/return parameters could still be maintained using
183
investments in other sectors. The repercussions of such practice could be important
for the distribution of wealth, with such sectors experiencing problems when trying to
raise capital overseas. Further comment on this is outside the realms of this research,
but the results suggest that it is an important issue. If an adjustment was made in
order to exclude all specialists from the results, being 29% of the sample, the
percentage of respondents who undertake sector avoidance rises to 30% (from 2 1%).
Table 9.6 illustrates this: no specialists restrict investment to more familiar sectors.
This result was expected.
The evidence of this survey is not concordant with hypothesis 114: most
professional users of non-UK financial information restrict foreign investment to more
familiar sectors. However, from the survey results an inference can be made that
restricting investment to more familiar sectors is seen to have an influence on a
significant minority (2 1%).
9.2.4 Do analysts restrict investment to more familiar companies
Only one respondent stated that particular companies, in this case within the
oil and gas sector, were avoided because of difficulties experienced in understanding
the financial statements. This case is distinct from analysts who focus upon reputable
companies for research and ultimately investment, because of their reputation. Due to
this distinction only the former case has been recorded in the results. The
characteristics of this oil and gas analyst be found in table 9.7.
Thus, hypothesis H5: most professional users of non-UK financial

information restrict foreign investment to more familiar companies, would be rejected
on the basis of this data.
184
Table 9.6: Do you restrict foreign investment to more familiar sectors?
185
9.2.5 Techniques adopted in international investment: How analysts cope
with international accounting diversity?
a) Reliance upon information less sensitive to corporate reporting, e.g.
macroeconomic data.
79% of respondents utilise macroeconomic data to some extent during asset
allocation (see Table 9.2). Reasons stated for the importance given to macroeconomic
data included:
• To establish growth areas within the economy. This is the starting point of
analysis for many of the respondents.

• To check that sales and profit forecasts are in line with economic forecasts.
Background knowledge.
• To check the past performance of a company, for example, how well a company
operated during a recession.
• To check cyclical factors such as inflation.

. To establish political policies that may have repercussions for investment. For
example, American health care policy adopted in some states has had
repercussions upon the pharmaceutical industry.
The principal source of macroeconomic data utilised are monthly economic
reports covering the basic economic issues such as inflation, interest rates, GNP and
exchange rates. One analyst held the use of macroeconomic data to be the single most
important part of the analysis process, stating:

"80% of getting performance right is interpreting macroeconomic
information correctly."
186

Table 9.7: Do you restrict foreign investment to more familiar companies?
Yes Slightly No
PROFESSION % % %
Analyst-specialised - - 21
Analyst non- - - 14
specialised___________________ ___________________ ___________________
Fund Manager non- 7 - 29

specialised___________________ ___________________ ___________________
Both specialised - - 7
EXPERIENCE____________ ____________ ____________
Long> 5 years 7 - 57
Short < 5 years - - 36

1 -
AGE____________ ___________ ___________
25-30 - - 14
30-35 - - 36
35-40 7 - 7
40-45 - - 21
45-50 - - 7
50-55 - - 7
7 - 93
187
Reasons stated for not utilising macroeconomic information when undertaking
foreign investment (21% of the sample) included:
Adopting a bottom-up approach to asset allocation. Focus is placed upon
individual companies in the early stages of investment, thus there is little call for
looking at the macroeconomic data affecting a country.
Investing in global sectors. A fund manager for the chemical sector stated that
"as the sector sells globally, there is no need for macroeconomic data relating to
spec j/lc countries" However, he failed to see that macroeconomic factors would
affect the cost of production, through the input prices of the country of
manufacture. If the factors of production are expensive, profits will be eroded if
the company is selling on a competitive basis with concerns operating in low cost
environments.
Macroeconomic information is not personally used by some fund managers but
they correctly expressed expectations that analysts use macroeconomic data when
undertaking initial analysis and in preparing brokers' reports.
With reference to table 9.8, it is evident that 90% of non-specialists utilise
macroeconomic data, whereas only 50% of sector specialists rely upon such
information when undertaking analysis.
On the basis of the data collected in this survey, hypothesis H6: most
professional users of non-UK financial information cope with international accounting
differences partly by reliance on other information that is less sensitive to corporate

reporting such as macroeconomic data, would be accepted (79%).
188

Table 9.8: To what extent do you cope with international accounting

differences by reliance on other information such as macroeconomic data?
Yes Slightly No
PROFESSION% % ___________
Analyst-specialised 7 - 14
Analyst non- 7 7 -
specialised___________________ ___________________ ___________________
Fund Manager non- 21 7 7

specialised___________________ ___________________ ___________________
Bothspecialised - 7 _________________
Both non-specialised 14 7 -
50 29 21
EXPERIENCE_____________ _____________ ____________
Long>5 years 29 14 21
Short<Syears 21 14 -
50 29 21
AGE____________ ____________ ___________
25-30 7 7 -
30-35 7 7 14
35-40 14 7 -
40-45 14 - 7
45-50 - 7 -
50-55 7 - -
50 29 21
189
b) Reliance upon trend analysis using published financial information
All respondents utilised published financial statements, systematically
working through them in order to establish trends in the activities of the company
under examination. Fund managers undertook this fundamental analysis in addition
to the analysis contained within the brokers' reports used. Trends relating to share
price, sales and profit margins and capital structure were examined over a variety of
periods. 50% of respondents looked at companies retrospectively over a period of two
to four years, sometimes depending upon existing knowledge of a company, i.e. two
years for a familiar company, three to four for a newly targeted company7.
The other half of interviewees preferred to conduct trend analysis over a much
longer time span of five to ten years. It was considered desirable to go back as far as
possible in order to follow a company through its business cycle. However, this was
deemed almost impossible in most cases, depending upon the availability of data and
the stability of accounting regimes. China was cited as a problem area due to the lack
of accounting data available even over relatively short periods, such as two or three
years. Difficulty was also expressed when countries implemented new accounting
standards, amended existing ones or, within Europe, adopted the 4th and 7th
directives. Comparisons of accounting information prior to and after changes in
accounting policy were problematic, even if the accounts had been restated for the
previous year. One respondent held that it was not worthwhile to conduct trend
analysis on German companies before 1989 because the effect of the 7th directive had
been so great, rendering post-1989 figures incomparable to pre-1989 figures.
Hypothesis, H7: most professional users of non-UK financial information
cope with international accounting differences partly by trend analysis using

published accounting data, would be accepted on the basis of this data.
7 This data has been extracted directly from the interview summaries contained within Appendix B.
190
c) Reliance upon ratio analysis using published financial information
Ratio analysis was undertaken by all the respondents although the extent and
methods varied quite significantly. At one extreme, very comprehensive ratio
analysis was undertaken after restatement to a hybrid of UKIUS GAAP and, at the
other extreme, ratios were employed, without restatement, only to check for clear
anomalies between brokers' reports. lASs did not play any significant role for
restatement purposes. Analysts interviewed were not clearly aware of lASs as very
few companies analysed voluntarily produced lAS reconciliations, whereas all foreign
companies listed on the NYSE produced US GAAP reconciliated accounts to comply

with the SEC listing requirements. Although analysts were not aware, lASs were
vague until 1995 and would therefore offer limited assistance for comparability
purposes.
Many respondents use a standard spreadsheet to calculate ratios, market
measures and valuations based upon cash flow, earnings, price and book value. The
same ratios would not necessarily be calculated for every company. Brokers' reports
are generally the source of information for these spreadsheets for analysts. Ratios
calculated that were frequently mentioned include:
• Return on capital employed
• Return on net assets

• Return on equity
• Profit and loss margins

• Earnings per share
• Price/Earnings
• Price/Cash flow
• Gearing
• Debt levels and interest cover
191
Some respondents were aware of the problems inherent in using profit based
ratios, due to the subjectivity involved in establishing profit. For this reason, cash
flow based ratios were preferred by these interviewees. Unfortunately, the definitions
advocated for cash flow were all derived from profit, for example profit plus
depreciation or net profit plus depreciation less ongoing activities plus/minus changes
in working capital. The relative differences between PIE ratios for different countries,
notably Japan, were recognised by two respondents, who adopted price/cash if
companies seemed expensive when using PIE. Price to cash was not, however,
generally considered to supplant PIE . One respondent did not use cash flow based
ratios but was aware of the disadvantages of profit based ratios, resulting in him using
these ratios sparingly.
Restatement is rarely carried out (7% of respondents) prior to ratio analysis
(see Table 9.2 and the subsequent part of this section). This has significant
consequences for analysis, as the ratios calculated will not be comparable, as
previously highlighted in chapter 5 section 5.4.3. A worrying issue raised throughout

the interview process is that many fund managers do not undertake restatement
because they assume that analysts perform this prior to producing brokers' reports.
There is a consensus among fund managers that the information contained within
these reports is comparable for different countries, therefore the ratios included and
those further calculated are comparable between companies. An illustration of a

possible consequence can be seen in one finance house using a benchmark for gearing
of 40%. Any company exceeding this was considered too risky for investment.
Without restatement, most Japanese companies, for example, would surpass this cut
off point and would not be considered for asset allocation purposes (Aron, 1992).
192
The hypothesis H8: most professional users of non-UK financial information
cope with international accounting differences partly by ratio analysis using published
accounting data, is confirmed with respect to the information presented here.
d) Restatement of financial statements to more familiar accounting rules,
followed by analysis.
As previously mentioned, restatement is not a common technique employed by
analysts or fund managers. No respondent carried out a comprehensive restatement of
foreign financial statements. Only 7% of the sample undertook .'full' restatement

according to UK GAAP, a further 14% undertaking partial restatement (refer to
Tables 9.2 and 9.9). However, this was carried out to check for anomalies in the
accounts or between brokers' reports for the same company. Examples of the
adjustments made included altering the accounts for the effects of different accounting
rules relating to goodwill and restructuring charges. A further 7% of the respondents

carried out adjustments on the financial statements prior to analysis. The adjustments
involved stripping items from the accounts, so as to exclude them from analysis.
Goodwill, depreciation of fixed assets and provisions were some of the items adjusted
for. The use of US GAAP adjusted data and the adjustments made by the DVFA in
Germany were utilised by 14% of the sample (21% including one of the analysts also
undertook partial restatement).
There was a dichotomy of thought surrounding the usefulness of such
information, those utilising it considered that adjusted data enhanced their analysis,
but were unable to undertake full restatement due to time constraints. The supporters
of an opposing school of thought ignored US GAAP information, even when provided

with the US GAAP financial statements, unless these were the only statements the
company produced. This was held to be the case in many oil and gas companies, as
193
the sector is highly influenced by the US. Reasons stated for not utilising adjusted
data included:
• Investment should be from a domestic perspective. Analysts/fund managers
should use domestic figures as the majority of shareholders use domestic figures.
It is these investors that drive the share price not the foreign investors.
Accounting is not a very important consideration when undertaking
investment, therefore it is not worth wasting resources to adjust.
For single country portfolios, adjusted information does not enhance
investment decisions because all the companies are following the same GAAP
regime.
• Cultural differences cannot be accounted for through restatement or
adjustments, therefore it is not intrinsically useful.
Most of the above arguments are worthy of comment. Firstly, it is not
necessarily the case that share price is set through the activities of domestic investors.
This is especially doubtful for companies listed on foreign stock exchanges which
have a high percentage of foreign shareholders, i.e. a typical company which the
finance houses invest in. Secondly, because two companies prepare their financial
statements according to the same GAAP regime, does not render them comparable.
For example, the treatment of goodwill can vary dramatically between one French
company and another, depending upon the amortisation period chosen, between four
and thirty years, which can easily cause a 10% difference in reported profits.
194

differences by restatement of accounts to more familiar accounting rules?
Restatement Restatement Adjustment US GAAP No

_________________ _____________ (slight) ___________ only ______
PROFESSION % % ________ % %
Analyst-specialised 7 7 - - 7
Analyst non- - - - - 14
specialised______________ ______________ _____________ ____________ _______
Fund Manager non- - - 7 29

specialised _______________ _______________ _____________ _______
Both specialised - - 7 - -
Bothnon- - 7 - 7 7
specialised______________ ______________ _____________ ____________ _______
7 14 7 14 57
EXPERIENCE__________ __________ _________ ________ _____
Long>5years 7 7 - 14 36
Short<5 years - 7 7 - 21
7 14 7 14 57
AGE__________ _________ ________ ________ ____
25-30 - 7 - - 7
30-35 7 7 7 7 7
35-40 - - - 7 14
40-45 - 7 - - 14
45 -50 - - - - 7
50-55 - - - - 7
7 14 7 14 57
195
Incidentally, it is a good sign that some international investors are aware of the
effect of cultural differences upon accounting. Furthermore, accounting does not
purport to report on qualitative issues, this is outside the realms of the traditional
accounting model. Restatement is a technique which can help remove the diversity
inherent in accounting systems that have developed under widely different cultural
arenas. It cannot make accounting numbers from different regimes 100% comparable,
but it can greatly assist in the interpretation of quantitative information, thus leading
to superior, better informed investment decisions
From the information presented here, hypothesis I-I 9: most professional users
of non-UK financial information cope with international accounting differences partly
by restatement of accounts to more familiar accounting rules, followed by analysis,
would be rejected.
e) Other techniques
The majority of respondents did not employ any other techniques to those
aforementioned to cope with international accounting diversity. However, 14% of the
sample undertook company visits. All the interviewees who employed this technique
did so to enhance other methods, for example, ratio and trend analysis. The reasons
stated for undertaking company visits varied: one respondent stated that this was "to
gain a better understanding of the company and an insight into the quality of
management"; a US analyst/fund manager advocated the use of company visits as a
crucial part of asset allocation, "helping to build a picture of the company from the
bottom up", making over two hundred visits per annum. Finally, one respondent only
carried out a company visit when the company targeted for investment was looked
upon favourably but used unfamiliar accounting rules. Only one respondent, included
196
in the 14%, further supported the use of technical analysis, using n-coefficients to
predict share price (refer to Tables 9.2 and 9.10).
As the use of techniques other than those described earlier within this section
are not commonly employed, according to the information presented in this survey,
the hypothesis H 10: most professional users of non-UK financial information cope
with international accounting differences partly through the adoption of other
techniques, would be rejected.
9.2.6 Are analysts aware of the existence of international accounting
differences that affect/distort reported earnings?
In examining how professional users of financial information perceive the
'bottom line', respondents were asked to rank a number of countries in order of
diminishing reported profit levels, ranking the least conservative accounting regime
first. According to academic doctrine (e.g. Radebaugh and Gray, 1993, p3908), the
generally accepted ranking is UK, US, France, Germany and lastly Japan. The choice
of these countries is merely illustrative. Other countries were substituted in the
interviews, where appropriate, according to the accounting systems with which the
respondent deals in the ordinary course of work.
The majority of analysts and fund managers interviewed (69%) were aware of
the relative levels of reported profits of the GAAP regimes in the countries personally
examined for investment. Thus, these respondents correctly perceived the
comparative lack of conservatism in UK and US GAAP. It was expected that this
should be the case as the whole population purported to be most familiar with either
UK or US GAAP. Apart from US and Canada analysts or fund managers, those
8 Referto Table 4.1.
197
representing the Far East were also aware of UK and US perceived profit levels, as
many former colonial countries have adopted the accounting practices of their former
governors. Some respondents offered reasons as to why they considered particular
accounting systems to be conservative or not.
For example the following points were raised:
US GAAP is very structured. UK profits would be higher than US profits

because of the greater scope to 'Iddle and create fictitious earnings" as compared
to the US which is more structured. Also another respondent stated: "I would be
more likely to believe a USprofitfigure than a German profit figure because US
disclosure is tight and German disclosure is not."
Japanese accounting is very conservative. There is a close link between

accounting for financial reporting purposes and accounting for taxation, therefore,
reported earnings are generally understated.
Income smoothing in Germany. The long established practice of provision and
reserve accounting in Germany was held to seriously affect underlying earnings
levels, often resulting in the lowest reported profits, with respect to Europe, but
the highest fundamental levels.
Several interviewees did not consider the question raised to be a sensible one.
Firstly, the comparability of international profits was thought to be distorted by
inflation, exchange rates and the treatment of exceptional and extraordinary items,
thus rendering the comparison of international accounting statements extremely
difficult. This last issue, i.e. the treatment of exceptional and extraordinary items, is
actually an example of a possible cause of the distortions that the interviewee was
198

differences by using other techniques?
_________________________ Yes Slightly No
PROFESSION % % %
Analyst non-specialised - 14
Fund manager non- 7 - 29

specialised___________________ __________________ __________________
Both non-specialised 7 - 14
14 - 86
EXPERIENCE_____________ _____________ _____________
Short<5years - 36
_______________________ 14 - 86
AGE___________ ___________ ___________
25-30 - - 14
30-35 - - 36
35-40 7 - 7
40-45 7 - 14
45-50 - - 7
50-55 - - 7.14
14 - 86
199
being asked about. Secondly, several respondents stated that the relative level of
reported earnings a company disclosed was dependent more upon which phase the
company had reached in its business cycle, than which GAAP regime it was
following. Finally, a respondent held that profit was so subjective and open to
manipulation that it was not useful as a decision tool. Therefore, it was deemed that
this exercise, to rank international profits, was not a useful one. Nevertheless, this
respondent alternatively used cash flow as the basis for all valuations, despite the fact
that cash flow is merely an adjusted version of profit (e.g. with depreciation added
back)
From the results obtained in this interview, there appears to be a general
understanding of the apparent overall differences between different accounting

systems. Therefore, hypothesis H 11: most professional users of non-UK fmancial
information are aware of the existence of international accounting differences that
effectJdistort reported earnings, must be accepted.
9.2.7 Are analysts aware of the international diversity between specific

generally accepted practices in GAAP regimes?
) The treatment of goodwill
An area of accounting that significantly influences the level of reported
earnings is goodwill. For an account of the possible distortions created by the

diversity of treatment in goodwill practices across different GAAP regimes refer to
section 4.3.
All respondents were asked which practice, relating to the treatment of
goodwill, they would expect to see in the countries for which investment and I or
analysis is undertaken. Although the range of countries under examination was wide,
200
interest has been focused upon the major financial reporting countries, i.e. UK, US,
France, Germany and Japan. The results are summarised in table 9.11.
Firstly, with reference to the generally accepted practice in the UK, which is to
write goodwill off immediately to reserves (or unusually amortise over useful life)
(SSAP 22, paras 39 and 41), 46% of respondents recognised this (see Table 9.12a).
However, even though knowledge of this rule was evident, the majority of
respondents failed to interpret the consequences of its application for international
comparisons: asset values are reduced through the immediate write off of goodwill to
the reserves compared to capitalisation; reported earnings are maintained through
immediate write off compared to amortisation which reduces profits.
A similar number of respondents (46%) recognised some aspects of the

accounting treatment for goodwill in the US, i.e. capitalise and amortise over a period
not exceeding forty years through the profit and loss account (APB Opinion 17).
However, half of these respondents did not know how long the maximum period of
amortisation is. With reference to Table 9.1 2b, 46% of respondents held that
goodwill was not an important consideration in the US and, therefore, were not
concerned with either knowing the specific accounting rules or making any
adjustments for goodwill. Comments relating to this included relying upon brokers'
reports which were deemed comparable, thus personal knowledge of specific
accounting policies was not required. Some respondents felt that the amount of
goodwill in the accounts was immaterial and did not warrant further adjustment or
consideration. Furthermore, the accounting rules can be found in the notes to the
accounts, so there was not any necessity to know them by heart.
201
Table 9,11: Survey results: generally accepted goodwill practices in major
financial reporting countries, as perceived by respondents
Correct Incorrect Country not Goodwill is not

treatment of treatment of relevant to the importantl don't
goodwill goodwill stated respondent know
_____________ recognised __________________ __________________ ___________________
% % %
UK 46 - 54
US 46 8 46
France 8 - 46 46
Germany 15 8 54 23
Japan - - 77 23
Knowledge of goodwill practices in any other GAAP regime appeared poor.
There was an apparent unwillingness to state specific practices relating to Japan,
Germany and France. Conversely, it was stated by the majority of relevant
respondents that goodwill was not an important consideration and, therefore, this type
of knowledge was not deemed necessary. Even after adjusting the results in Table
9.11 to accommodate respondents who did not deal with particular countries and
therefore did not require any specific knowledge relating to them, only 14 % (one
respondent out of seven) were aware of French GAAP and 29% (two respondents out
of seven) were aware of German GAAP relating to the treatment of goodwill.
p 23% of sample recognised capitalisation but not the amortisation period.
202

Table 9.12(a) Generally accepted goodwill practices in major financial
reporting countries, as perceived by respondents: UK°
Correct Incorrect Country not Goodwill is

treatment of treatment of relevant to the not important
goodwill goodwill respondent / don't know
______________________ recognised stated _________________ ________________
PROFESSION % % % _________
Analyst-specialised 23 - -
Analyst non- - - - 15
specialised_______________ _______________ _______________ _______________
Fund Manager non- 15 - - 15
specialised________________ ________________ ________________ _______________
Both specialised - - - 8
Both non-specialised 8 - - 15
__________________ 46 - ______________ 54
EXPERIENCE__________ __________ __________ __________
Long> 5 years 38 _____________ _____________ 23
Short<5 years 8 ___________ - 31
___________________ 46 - 54
AGE_________ _________ _________ _________
25-30 8 _______________ - 8
30-35 15 - - 15
35-40 - - - 15
40-45 15 - - 8
45-50 - - 8
50-55 8 - - -
46 - - 54
10 The following results relating to the perceived international accounting treatment of specific areas
reported within the financial statements are based upon thirteen, not fourteen, respondents. This is due
to the exclusion of the group interview that was undertaken as a piloting exercise. No specific
comments relating to this were extracted from this interview that are capable of formal analysis.
203

Table 9.12(b): Generally accepted goodwill practices in major financial

reporting countries, as perceived by respondents: US

______________________ recognised stated
PROFESSION _________ _________ % %
Analyst-specialised 15 - 8 -
specialised_______________ _______________ _______________ _______________
specialised_______________ _______________ _______________ _______________
Both specialised - - - 8
Both non-specialised 15 - - 8
___________________ 46 - 8 46
EXPERIENCE__________ __________ __________ _________

Long>5 years 31 - 8 23
Short<5 years 15 - - 23
46 - 8 46
AGE__________ __________ __________ _________

25-30 8 - - 8
30-35 - - - 23
35-40 15 - - 8
40-45 15 - 8 -
45-50 - - - 8
50-55 8 - - -
46 8 46
204
Table 9.12(c): Generally accepted goodwill practices in major financial
reporting countries, as perceived by respondents: Germany
205
Table 9.12(d); Generally accepted goodwilJ practices in major financial
reporting countries, as perceived by respondents: France
206

Table 9.12(e). Generally accepted goodwill practices in major financial

reporting countries, as perceived by respondents: Japan

______________________ recognised stated
PROFESSION % % % %
Analyst-specialised - - 23 _______________
Analyst non- - - 15 -
specialised ________________ ________________ ________________ _______________
specialised________________ ________________ ________________ _______________
Both specialised - - 8 -
Both non-specialised - - 8 15
- 77 23
EXPERIENCE__________ __________ __________ __________

Long> 5 years - - 46 15
Short<Syears - - 31 8
- 77 23
AGE__________ _________ _________ _________

25-30 - - 8 8
30-35 - - 23 -
35-40 - - 15 8
40-45 - - 23 -
45-50 - - - 8
50-55 - - 8 -
- - 77 23
207
Goodwill was not considered an important issue in Germany by 15% of the
sample (see Table 9.1 7c). One respondent stated that this was because it only occurred
in consolidated accounts and was therefore not a tax issue. Although this may mean
that goodwill is not affected by taxation rules, international variation is still important
for comparative purposes, because the analysts u consolidated accounts.
Additionally, German companies were not perceived to be very acquisitive.
An analyst focusing solely on France did not consider goodwill as an
important issue as all French companies account for goodwill according to French
GAAP. Thus, no problems were experienced when undertaking comparative analysis.
This should not be so, as French GAAP permits capitalisation and amortisation over
the estimated life and in exceptional cases goodwill may be written off against
reserves. Thus, various practices are adopted with respect to the period of
amortisation, commonly ranging between four and thirty years. Such intra-country
variation should be adjusted for, where differences are material, when undertaking
comparative analysis. The cross-tabulated results relating to the perceived French
practice are contained within Table 9.12(d).
Take-overs were not deemed evident in Japan because of cultural factors.
Consequently, there is very little accounting for goodwill in Japanese accounts. This
is reflected in the results (see Tables 9.11 and 9.12e) with all respondents who analyse
Japanese financial statements as part of their work, representing 23% of the entire
sample, alleging that goodwill was not a significant issue in Japanese financial
statements. This is not correctly perceived as many large Japanese companies have
bought overseas subsidiaries. Moreover, it is this type of Japanese company that UK

analysts/brokers deal with.
208
There was little evidence of any adjustments made relating to goodwill. One
of the two respondents who undertook restatement as an analytical tool failed to
recognise goodwill as an important issue and, thus, did not make any adjustments for
this between foreign financial statements. The other respondent utilising restatement
also did not adjust for goodwill. This respondent deals principally with US
companies, which are characterised by amortisation over up to a forty year period. It
was held that a fortieth of goodwill was not a material amount with respect to profit
levels. Hence, adjustment was not deemed worthwhile. There was some evidence
among other interviewees of adjustment, but not on a restatement basis, for example,
clearing goodwill out from the accounts altogether, and thus excluding goodwill from
the calculation of ratios. Several reasons were given by different respondents
justifying this practice. Firstly, goodwill was considered "too technical" and excluded
on this basis. Secondly, being an intangible asset, the basis of valuation for goodwill
is not reliable and adjustments are required "in order to gain reasonable net asset
values and gearing levels ". Finally, one respondent stated that:
"An adjustment is only deemed worthwhile If it influences profit and can be
seen to do so for a number ofyears, If this is so I'd rely on a broker to make the
adjustment rather than do so personally."
Such assumptions may presume too much, especially in the light of the results
of this survey which suggest that analysts do not restate financial statements to a
common foundation.
Another respondent, an analyst for the chemical sector, stated that he did not
adjust for goodwill as this was not an issue, i.e. not of material concern, in the
chemical sector. However, this is not true. For example, it is apparent in the 1993
accounts of the Roche Group, that goodwill is an important consideration in the
209

Table 9.13: The effects of alternative goodwill treatment using the
chemical sector as an illustration: The Roche Group (Switzerland).
TREATMENT OF GOODWILL
Write off to Amortise over Amortise over Amortise over
reserves (a)'' 4 years (b)' 2 10 years (c)' 3 40 years (d)'4
PROFIT AND mn Sw Fr mn Sw Fr mn Sw Fr mn Sw Fr
LOSS
Depreciation charge 700 280 70

Net profit before 2,478 1,778 2,198 2,480
taxation
BALANCE SHEET mn Sw Fr mn Sw Fr mn Sw Fr mn Sw Fr

26,460
Net assets 27,560 28,980 29,190

Equity 17,754 20,554 20,554 20,544
% % %
Effect on profit ..i 28 . II
Effect on net assets t8 10 1' 10
Effect on equity t 16 t 16 1 16
11 The actual treatment adopted by the Roche Group (Switzerland) is presented under column (a). This
is also a common practice in the UK and the Netherlands.
12The figures contained within columns (b) to (d) are illustrative of the resultant figures that would be
disclosed under various accounting rules. The basis of adjustment refers to the 2.8 billion Swiss Francs
that have been written off to equity in the Roche Groups consolidated accounts over the three years to
1993. Column (b) represents the adjustments that would be required if goodwill was amortised over a
period of four years, a common practice in Germany. In Japan and Spain the arnortisation period is
commonly five years.
t3CoIumn (c) represents the effect of amortisation over 10 years.
14Column (d) represents the effect showing goodwill as an asset and amortising over 40 years, the
practice frequently adopted in the US of and amortisation over forty years.
210
chemical sector. Since 1990 a total amount of 2.8 billion Swiss Francs has been
charged directly to equity, with the 1993 amount being 382 million Swiss Francs.
The 1993 balance on equity is 17.8 billion Swiss Francs, indicating that this write off
to reserves has reduced equity levels to 84% of the value that would be evident if an
alternative accounting treatment was adopted. Table 9.13 illustrates this, showing the
effect of adjustments required for different GAAP regimes on profit, asset and equity
levels for the Roche Group. The results are definitely material, goodwill reducing
profit by 28% if amortisation over four years was adopted rather than a write off to
reserves. Equity is increased by 16% if the goodwill is written back and net assets
would rise accordingly by 8%. This has significant implications for analysis,
especially for techniques such as ratio and trend analysis, which are heavily dependent
upon accounting numbers. This illustration is not an extreme one, similar results can
be obtained by examining other concerns, for example, Roberts Pharmaceutical

Corporation (USA).
The accounting policy adopted in Roberts Pharmaceutical Corporation is to
amortise goodwill and write it off through the profit and loss account over twenty-five
to forty years. Looking at the 1993 consolidated financial statements, to restate to UK

GAAP and write goodwill off immediately to reserves, equity would decrease by
10%, net assets by 5.2% and profit would increase by a staggering 62%. This is based
upon the following information for the year to 31.12.93:
• Net profit $7,228,000
• Total goodwill at fair value $21,693,000
• Depreciation charge for goodwill for the year $4,484,000
• Net assets $285,444,000
• Equity $217,306,000
211
Hypothesis H12: most professional users of non-UK financial statements are
aware of the differences existing between major corporate financial reporting
countries, with respect to the treatment of goodwill, would be rejected on the basis of
this data.
b) The determination of cost for stock
A further significant area of international accounting diversity that can have
material consequences on reported earnings levels and asset valuations is that of the
determination of cost for the valuation of stock. For a full account of the possible
effects and the specific accounting treatments advocated by various GAAP regimes,
refer to section 4.3.
There was an apparent lack of specific knowledge relating to the treatment of
stock valuation among respondents. The results are contained within Tabk 9.14.
Only 15 % of interviewees exhibited any precise knowledge of accounting treatment
for stock valuation in the countries for which analysis and investment occurred. The
majority of respondents, in all cases, were not aware of the flow assumptions involved
in this area. Consequently, it was stated that stock valuation methods were not an
important consideration when undertaking international comparisons. The following
justifications for this action were put forward:
. Low inflation. This reduces the differential produced between the various
methods, thus lessening the need for any adjustments. 7 e caee te. a(v4
i.icjEaec 4 9eea14 me44wed 4 tk 'e pieeee icdev, c,ccia'.
74&(
c omoa wcr4 dea&e 4e4 ft'ue4. One respondent declared that in
times of high inflation he would prefer to see LIFO in the financial statements in
212
order to "gel more sense out of the accounts 7 woaéd o eaa'4e led to te modt
e.ed4e ecao# 6ec9 e49ed to ftc44e4 c t.(e ftwjct ad to
deea&e9 ftwj4 aeo'do91q. at (e4 t.(e tocá at o6dotete fte4 jg (e 6z(4.'tee
(eet. w4c maáed a ø4e.'e4e o6 aoaet ea€ae4. A further respondent independently
supported this on the basis of preferring conservative accounting policies which
understate rather than overstate reported earnings.
• The effects of the different methods cancel out over time. Trend analysis can
be carried out retrospectively on financial statements over a ten year period. Over
this time span it was deemed that the flow of stocks was irrelevant to the
investment decision. 4voeDe. wd 'rejoxeiee to 4ede 9.2.5 (6). 5Of o (e
damft(e coicdaded t'eicd aa4dc o mac4 4ote't ftethdd. t4 10 to - çi€ai4. 41Wze4
aamett wodd modt eeu(q scot LOU.
• Reliance upon brokers' reports to adjust or highlight any anomalies. 7i iae

u 6eot eoed ut t(e ,eveciioa dethoc 'te€ati to 9oodwc1. 7i(e dame 49ameitt4
aft,ft4 áee. e. e. t4at 6eo do ot cac jt adft
• Low stock levels. It was not deemed worthwhile knowing the accounting
treatment or adjusting for any differences in asset values when companies that had
little stock, compared to the size of net assets. 7 e a deadci(e aftfto4e.
dome .te4fto.caeict4 aftfteaed to we t$ 44 a.c er4ade 4ti( t4(4.c a ea4oc
scot 'ze4tat4 7 c4 eeat josc (ooc9 at tAe deeto'r4 eocie'ed. jo's eramé(e.
t5T4ic4ftot and aucatc. eJid io scot c4aaetozced 4 dm411 dtocá (ad.
• High stock turnover. Stoes twueoe doea .cot (4ee 4N ejct *3&oc (4(0 cam6e'4
'r.eaeed 44(e,c c4&cc9 4eoes o.c 49O iuc. '?e4 toe tacoee ae(aaE4 04404
213
((e d'jeeceed 6eeaeeit 4T asd 7& eot 6e aeeeftted cu a
O eeaa, 4ieaja
'zea4 j4# *4áec9 adft(4tmote c awa cac (we *ateia1 ejjed4 o 4i 444et
d4e4 4d eft ftwj
No adjustments took place with respect to the treatment of stocks, even for the
11.8 % of respondents who undertook restatement as an analysis technique (see Table
9.1). Several respondents did express concern as to the distortions that different stock
valuation methods manifest when undertaking comparative financial statement
analysis. One respondent expected the differences to be signiftcat, esptc(y iii
"upstream companies" but ignored this area because ". .you can't get back to the raw
data from the accounts." A further respondent declared that "an adjustment should
take place where companies have understated their stocks. However, I have never
come up against this." '7e a e eteait ahu' ei(hi eom#ueat *eaad. 6at cr de4 wt aftfte4/ (
t(e ado.fttiot o oe aeeoa e o acotAe i. e. 9O
The results obtained relating to the determination of cost for the valuation of
stock have been cross-tabulated in Tables 9.1 5(a-e). No obvious correlations were
found. In light of the result obtained from this survey, hypothesis H12 (most
professional users of non-UK financial information are aware of the differences in the
treatment of determination of cost for the valuation of stock between major GAAP
regimes) would be rejected.
214
Table 9.14: Survey results: generally accepted practices relating to the
determination of cost for the valuation of stock, as perceived by
respondents
c) Deferred Taxation
The treatment of deferred taxation is a significant area of international
accounting diversity which can affect the level of reported earnings in the profit and
loss account and liabilities within the balance sheet. International variation ranges
from the requirement to provide fully in the US, partially in the UK and, due to the
close relationship between accounting and taxation numbers in most of Continental

Europe, the method of how to account for deferred taxation is not an issue in the
accounts of individual companies. However, the need to account for deferred taxation
can arise in preparing group accounts and it is these consolidated statements that
analysts and fund managers use. Therefore, knowledge of international variation is
important to facilitate adjustments when undertaking comparative analysis.
15 The shaded areas within the table represent the most commonly used method within these countries,
even though other methods are allowable for stock valuation.
215

Table 9.15(a): Generally accepted practices relating to the determination

of cost for the valuation of stock, as perceived b y respondents: UK
FIFO LIFO Country not Not important!

relevant to the don't know
____________________ _____________ _____________ respondent _______________
PROFESSION _________ % % %
Analyst-specialised - - - 23
specialised______________ ______________ _________________ _________________
specialised______________ _____________ ________________ ________________
Both specialised - 8
Both non-specialised 8 - 15
___________________ 15 - 85
EXPERIENCE_________ _________ ___________ ___________

Short < 5 years - - 38
___________________ 15 - - 85
AGE________ ________ __________ __________

25-30 - - 15
30-35 - - - 31
35 -40 - - - 13
40-45 - - - 15
45-50 8 - - 8
50-55 8 - -
15 - - 85
216

Table 9.15(b): Generally accepted practices relating to the determination

of cost for the valuation of stock, as perceived by respondents: US
FIFO LIFO Country not Not important /

_______________________ _____________ _____________ respondent ________________
PROFESSION ________ % % %
Analyst non-specialised - - - 15
Fund Manager non- - 8 - 23

specialised_____________ _____________ _________________ ________________
Both non-specialised - 8 8 8
- 15 8 77
EXPERIENCE_________ _________ ___________ ___________

Long >5 years - 15 8 38
Short <5 years - - 38
15 8 85
AGE________ ________ __________ __________

25-30 ____________ ___________ ______________ 15
ju-jJ -
3
35-40 - 8 8
40-45 - 8 - 15
45-50 - 8
50-55 - 8
15 8 77
217

Table 9.15(c): Generally accepted practices relating to the determination

of cost for the valuation of stock, as perceived by respondents: France
FIFO LIFO Country not Not important!

______________________ _____________ _____________ respondent ________________
PROFESSION % % __________ %
Analyst-specialised - 23 ________________
Analyst non-specialised - 15 ______________
specialised______________ ______________ _________________ _________________
Bothspecialised _____________ _____________ 8 _______________
- - 54 46
EXPERIENCE_________ _________ ____________ ___________

Long> 5 years - 23 38
Short < 5 years - 31 8
- - 54 46
AGE________ ________ __________ __________

25-30 - - 8 8
30-35 - 23 8
35-40 - 8 8
40-45 ___________ ___________ 15 8
45-50 - 8
50-55 - 8
54 46
218

Table 9.15(d): Generally accepted practices relating to the determination

of cost for the valuation of stock, as perceived by respondents: Germany

_____________________ ____________ ____________ respondent _______________
PROFESSION % % % %
Analyst-specialised - 23
Analyst non-specialised - - 8 8
Fund Manager non- - 23 8
specialised_____________ _____________ ________________ ________________
Both non-specialised - 23
- - 54 46
EXPERIENCE_________ _________ ___________ ___________

Long> 5 years - - 38 23
Short <5 years - - 15 23
- 54 46
AGE________ ________ __________ _________

25-30 - 8 8
30-35 - 15 15
35-40 - - 8 8
40-45 ___________ ___________ 8 15
45 - 50 ____________ ____________ 8 -
50-55 - 8
- 54 46
219

Table 9.15(e) : Generally accepted practices relating to the determination

of cost for the valuation of stock, as perceived by respondents: Japan

______________________ ____________ ____________ respondent ________________
PROFESSION % % % %
Analyst-specialised - 23 ________________
Analyst nori-specialised - 15
specialised______________ ______________ _________________ _________________
Both specialised - 8 15
Both non-specialised - 8
_7_7
II
EXPERIENCE_________ _________ ___________ ___________

Long>5 years - 46 15
Short<5 years - - 31 8
77 23
AGE________ ________ __________ __________

25 - 30 ____________ ____________ 8 8
-
35-40 - 8 8
40-45 - 23
45-50 - 8
50-55 - 8 -
II
220
Table 9.16: Survey results: generally accepted deferred taxation practices in
major financial reporting countries, as perceived by respondents
The results of the survey with respect to the perceived accounting treatment of
deferred taxation are represented in Table 9.16 and these are cross-tabulated for each
country in Tables 9.17(a-e). These results illustrate an overwhelming example of
ignorance with regards to this area of accounting diversity.
No respondents recognised the UK treatment of accounting for deferred tax,
being on a partial basis. However, one respondent stated that she would expect to see
deferred tax numbers in UK accounts, but ou1d not expect them to be as big as those
found in French companies! This is not true, as deferred taxation generally only
arises in French group accounts by virtue of foreign subsidiaries and consolidation
procedures and thus the figures obtained would not be expected to exceed UK
numbers, which are based upon a partial provision. This does not present a clear
understanding of the divergence of policies between different accounting regimes.
' 6 The shaded areas within the table represent the prevalent treatment for deferred tax within the stated
countries.
221
Similarly, the respondent who correctly identified German GAAP in this area,
believed that the largest deferred taxation numbers would be found in UK accounts.
This was the most common misconception related to UK versus US practices. 31 %
of respondents incorrectly considered the UK to disclose the larger deferred tax
figures, in relation to the US. This is generally not true, because there are more
causes of deferred tax in the US and US GAAP requires full allocation.
The majority of respondents did not know the variations that exist between
various GAAP regimes and did not purport to know either. Table 9.16 illustrates that
this is so: 69 % of respondents were unaware of treatment in the UK and the US.
Excluding the percentage of respondents for whom the country in question was not
relevant, the percentage ignorance was 100% for France and Japan and 83% for
Germany. One respondent remarked that this area was "too technical" resulting in no
adjustment occurring because of a lack of understanding. This can have a large
repercussion upon ratio analysis when comparing retained profit and net assets
between different accounting regimes. 23% of the sample explicitly stated they would
also not expect their colleagues to know specific accounting policies relating to this
area. One respondent observed that:
"I don't know as much as Ishould...there is little discussion among analysts of

deferred tax as an issue... it should be the analyst's job to highlight such problems but
too little occurs in practice."
The overall ignorance is apparent from the responses recorded. A further 23

% of respondents confused deferred taxation with corporate tax actually paid, showing
a lack of understanding of the basic principles involved. Deferred tax arises because
of the reversible timing differences between tax and accounting revenues. Possible
222
causes of reversible timing differences include depreciation and stock valuation
methods. Thus, it is not sensible to state that deferred tax is not a problem because
projections are based upon standard tax rates rather than trying to make more realistic
predictions, or that as standard tax rates are used within certain countries the need to
adjust is not required. The two issues are quite separate!
The two respondents who utilise restatement as an investment technique do
not restate for differences in deferred tax. This is the third instance of a significant
area of accounting diversity which is not adjusted for, the others being goodwill and
stock valuation methods.
Some adjustment, as opposed to restatement, did occur. One respondent
regarded deferred taxation as pseudo-shareholders' funds, rather than a pseudo-
liability. Depending upon the circumstances (which were not specified) adjustments
were carried out for this by deducting the provision for deferred tax from the long-
term liabilities section in the balance sheet and including it with shareholders' funds.
Subsequently, ratio analysis occurred using the adjusted figures. This treatment
appears to be inappropriate for some countries. For example deferred tax is only
recognised in UK accounts if there is a foreseeable liability. SSAP 15 states that "tax
deferred or accelerated by the effect of timing dfferences should be accountedfor to
the extent that it is probable that a liability or asset will crystallise ". There was also
some indication of pulling the deferred tax figure out of the balance sheet for further
analysis without excluding it from long-term liabilities for ratio analysis. One
respondent also removed deferred tax balances, when material, excluding them from
certain ratios calculated in analysis, e.g. interest cover and equity : total assets, but not
others, such as gearing! The conclusions drawn from such analysis would be highly
inconsistent.
223
One respondent did not restate accounts for differences in the treatment of
deferred tax because companies were generally considered to have more conservative
policies for depreciation than the tax authorities have. This is not true: tax
depreciation is normally faster than accounting depreciation. It is not clear that he
analyst's reasoning would be relevant even if it were factual.
In the light of the result obtained in this survey, hypothesis H14: most
professional users of non-UK financial statements are aware of the differences in the
treatment of deferred taxation between major GAAP regimes, would be rejected.
d) Other accounting differences
Other areas that some respondents expressed concern about included the
capitalisation of leases, accounting for pensions, the treatment of foreign exchange
losses and gains, consolidation and transfer pricing. An overview of international
differences that exist in the first four cases can be found in section 4.3. These areas of
accounting diversity were viewed as being problematic and the cause of difficulties
when undertaking international investment analysis. It is not known whether these
items are adjusted for, although it is probable that no restatement or adjustment occurs
in the majority of cases. This inference has been made based upon the low level of
adjustment that is evident from the results presented in section 9.2.5.(d), i.e. no
respondent undertook full restatement and only 12% of the sample undertook partial
restatement. The issues of accounting for pensions and the treatment of leases were
addressed in more detail during some of the interviews and therefore require further
discussion.
224

Table 9.17 (a): Generally accepted practices relating to deferred taxation
in major financial reporting countries, as perceived by respondents: UK
Correct Incorrect Country not Not important!

Treatment Treatment relevant to the don't know
___________________ _____________ ________________ respondent ________________
PROFESSION % % % %
Analyst-specialised ____________ 15 _______________ 8
Analyst non- - 8 - 8
specialised______________ ________________ _________________ _________________
Fund Manager non- 8 23
specialised______________ ________________ _________________ _________________
Both non- - 23
specialised______________ ________________ _________________ _________________
_______________ 31 - 69
EXPERIENCE_________ ___________ ___________ ___________

Long>5 years _________ 23 ____________ 31
Short<5years _________ 8 - 38
n
AGE________ __________ __________ __________

25-30 - 15
30-35 ____________ 8 - 23
35-40 - - - 15
40-45 ___________ 15 ______________ 8
45-50 - 8
50-55 - 8 -
31 - 69
225
Table 9.17 (b): Generally accepted practices relating to deferred taxation
in major financial reporting countries, as perceived by respondents: US
226

Table 9.17 (c): Generally accepted practices relating to deferred taxation

in major financial reporting countries, as perceived by respondents:
France
Correct Incorrect Country not Not important I

___________________ _____________ _______________ respondent _______________
PROFESSION ________ 0/ % %
Analyst non- - - 8 8
specialised______________ ________________ _________________ _________________
specialised______________ ________________ _________________ _________________
Both non-specialised - 23 -
- 54 46
EXPERIENCE_________ ___________ ___________ ___________

Long > 5 years - - 38 23
Short<5 years - - 15 23
54 46
AGE________ __________ __________ __________

25-30 - 8 8
30-35 - - 15 15
35-40 - 8 8
40-45 - 8 15
45 - 50 ____________ ______________ 8 ______________
50-55 - 8
54 46
227

Table 9.17 (d): Generally accepted practices relating to deferred taxation

Germany
Correct Incorrect Country not Not important /

___________________ _____________ _______________ respondent _______________
PROFESSION % % % %
Analyst-specialised 8 - 15
Analyst non- - - 8 8
specialised______________ _______________ ________________ ________________
specialised______________ ________________ _________________ _________________
Both non- - - 23
specialised______________ ________________ _________________ ________________
8 - 54 38
EXPERIENCE_________ ___________ ___________ ___________

Long> 5 years 8 - 38 15
Short < 5 years - 15 23
___________________ 8 - 54 38
ACE________ __________ __________ __________

25-30 - 8 8
30-35 _____________ ______________ 15 15
35-40 - 8 8
40-45 8 - 8 8
45-50 _____________ ______________ 8 _______________
50-55 - -
8 54 38
228

Table 9.17 (e): Generally accepted practices relating to deferred taxation

Japan
Correct Incorrect Country not Not important /

___________________ ______________ ______________ respondent _______________
PROFESSION% _________ __________ __________
Analyst-specialised - 23
Analyst lion- - - 15
specialised_______________ ________________ _________________ _________________
specialised_______________ ________________ _________________ _________________
Both specialised - - 8 15
Bothnon- - - 8
specialised_______________ _______________ ________________ ________________
- - 77 23
EXPERIENCE__________ __________ ___________ __________

Long>5 years - 46 15
Short<5 years ___________ ____________ 31 8
- 77 23
ACE_________ _________ __________ __________

25-30 - 8 8
30-35 ____________ _____________ 31 -
35-40 - 8 8
40-45 _____________ ______________ 23 _______________
45-50 _____________ ______________ _______________ 8
50-55 8 -
- - 77 23
229
i) Accounting for Pensions.
There was little knowledge of accounting for pension costs and the effect of
the range of treatments on asset and reported profit levels. Two fund managers for
Asia independently stated that this was not a current issue because of the demographic
structure of the population.
"For countries with a generally much younger population, such as is the case
for most ofAsia, pensions are not seen to be an issue yet; perhaps in twenty to thirty
years time."
"... (furthermore) salaries are still very low and the concept ofpension
provision is a relatively new idea within the accounting systems analysed"
However, one fund manager for Japan acknowledged the existence of a problem with
pension accounting:
"Pensions have a large effect upon the way profits are reported in Japan,
especially f a company has to set aside large amounts due to a lack ofprovisioning in
the past
Generally it was considered that analysts would not adjust for pensions and brokers
would not include them in their reports.
The international differences between accounting treatments for pensions can
create large impacts upon the results of the company and asset values. For example,
according to UK GA.AP, SSAP 24 'Accounting for Pension Costs', pension

obligations should be accounted for on a full accrual basis. Comparing this treatment
with German GAAP, which did not require any provisioning for pensions until 1987,
larger pension expense levels are expected in the UK. This is further manifested by
the lack of provisioning in Germany for workers under thirty years of age and failure
to provide for pay rises, although pensions are set at the final level of pay. These
accounting policies stem from German tax rules. Thus, a material amount of future
230
liabilities that will crystallise are not represented in the balance sheet. Furthermore, a
lack of provisioning and suitably funded schemes will have severe future
consequences for cash flow.
(ii) Leases
The capitalisation, or not, of leases can have material effects upon the reported
level of earnings and thus earnings-related financial indicators such as EPS, PIE,
ROCE etc. Furthermore, asset levels are directly influenced by this choice of
accounting policy. International practice differs depending upon whether the
economic substance is taken over legal form or vice versa. The former is the case in
the UK, with companies capitalising finance leases. There are no individual company
rules in France governing this area but finance leases can be capitalised in
consolidated accounts. In the more conservative, tax based countries such as
Germany and Japan, the legal form is accounted for. This results in the exclusion of
the lease at cost from the asset section of the balance sheet and the treatment of the
lease payments as a rental expenditure.
It is of concern that, despite some awareness of the international differences,
the treatment of leases was not adjusted for and was only considered an issue by one
analyst in the transport and aviation area. This respondent exhibited confusion with
regards to this area, citing British Airways as a company who have large amounts of
leased aircraft which is not disclosed in the balance sheet" making it incomparable to
companies operating in other countries where disclosure is a requirement under
GAAP" As previously stated, the UK is an example of one country that & require
disclosure. However, the point is that neither UK nor US rules (nor those of any other
country) would require capital isation of British Airways' type of leases.
One respondent stated that leasing was not an area of concern when dealing
with securities in SE Asia, as the origins of the accounting systems are fundamentally
231
Anglo-American, many being former colonies of the UK and US. Moreover, these
countries were perceived to have adopted lAS and thus achieved harmonisation,
removing the necessity to adjust. f7 c. a eammot meeoee,eeo. '7e ado.ftzt oL
e'utatio.ea aeco dtdd4 doed tot 4eomaeiea14 'eft'tedeøtt dadi44ti4 o6
fraetee4 zkoa9/to€t a1 adoftt coamzee dae to t'Ae ofttoø a'i&14&e we eae

dt4cd4'U€, fta'eeda4 6ejo'e f'5. 7, eomft&4ee T4S doe4 .øt 4
eosa'4&&4 44 44 fteeebied. 7(emo'te o4 dome 4/eomftase4 adøftt
9.3 CONCLUDING REMARKS AND SUMMARY OF FINDINGS.
The following hypotheses would be acceptable on the basis of the results of this
survey:
• Hi: accounting diversity has some effect on capital market decisions;
• H2: accounting differences are a significant hindrance to the measurement criteria
• H6: most professional users of non-UK fmancial information cope with
international accounting differences partly by reliance on other information that is
less sensitive to corporate reporting such as macroeconomic data;
• H7: most professional users of non-UK financial information cope with
international accounting differences partly by trend analysis using published

accounting data;
232
international accounting differences partly by ratio analysis using published
accounting data;
The remaining hypotheses would be rejected on the basis of the information collected
through this survey:
• 113: most professional users of non-UK financial information restrict foreign
investment to countries with more familiar accounting practices;
• H4: most professional users of non-UK financial information restrict foreign
investment to more familiar sectors;
investment to more familiar companies;
. H9: most professional users of non-UK fmancial information cope with
international accounting differences partly by restatement of accounts to more
familiar accounting rules, followed by analysis;
• HiO: most professional users of non-UK financial information cope with
international accounting differences partly through the adoption of other
techniques;
• Hi!: most professional users of non-UK financial information are aware of the
existence of international accounting differences that effectldistort reported
earnings;
• Hi2: most professional users of non-UK fmancial statements are aware of the
differences existing between major corporate financial reporting countries, with
respect to the treatment of goodwill;
233
• H13: most professional users of non-UK financial statements are aware of the
differences in the treatment of the determination of cost for stock valuation
between major GAAP regimes;
• 1114: most professional users of non-UK financial statements are aware of the
differences in the treatment of deferred taxation between major GAAP regimes.
These conclusions are interesting and informative but not statistically proven
as the sample of this survey may not be representative of the entire population
addressed. This is due to two reasons: firstly the small sample size, being 17
respondents from five finance houses, classified as 13 or 14 where appropriate.
Secondly, the sample was not randomly chosen and thus does not purport to represent
a normal distribution. However, the firms interviewed were sufficiently diverse in
interest and size to represent a reasonable cross-section of the processes involved in
appraising international securities.
The analysis of these results together with the results from the questionnaire
are presented in the final chapter ( Chapter 10) of this thesis.
234
CHAPTER TEN
CONCLUSIONS AND IMPLICATIONS
jQ,1 INTRODUCTION
This is the concluding chapter of this research. Its purpose is firstly to
summarise: the objectives of this work, the methodologies adopted, and the results
obtained from the questionnaire and interview surveys. Secondly the overall
conclusions and inferences drawn from this research will be discussed and examined
in the light of any limitations involved. The implications arising from the results are
then examined and, finally, further research ideas, relating to the field of enquiry but
outside the objectives expressed within this particular work, will be addressed.
10.2 SUMMARY OF OBJECTIVES

The principal objective of this research was to establish how important
differences in international accounting are to the investment community, whether
GAAP differences are recognised and if so what implications this has for the analyst
or fund manager researching foreign securities. The following issues were directly
addressed in both the questionnaire and interview surveys:
• Does accounting diversity affect capital market decisions?

• Is accounting diversity a significant hindrance to the measurement criteria
professional investors use to evaluate non-UK securities?
• Is investment at all restricted because of international accounting differences?

How do professional investors cope with international accounting diversity?
Are professional investors aware of the extent to which different GAAP regimes
can distort profit and asset values? For example can professional investors 'see
through' international accounting policy choices relating to goodwill, deferred
taxation, stock valuation or pensions?
234 P
This field of accounting is still at its infancy with liftie evidence documented
relating to the behavioural aspects of professional investors in foreign securities.
Heading the empirical work to date are Choi and Levich (1991). Their market based
study concluded that:
"a major implication of our findings is that accounting dfferences are important and
affect the capital market decisions of a signI cant number of market participants we
surveyed, regardless of nationality, size, experience, scope of international activity
and organisational structure. "(Page 11)
Choi and Levich interviewed a range of international fmancial statement users
(regulators, exchange officials, rating agencies, data services, underwriters etc.) in
New York, London, Zurich, Tokyo and Frankfurt. Thus, some evidence exists
suggesting that accounting diversity is a problem for US, UK, Swiss, German and
Japanese professional investors.
Unlike Choi and Levich, this research was intended to focus on professional
investors situated in the UK but using non-UK fmancial statements as part of their
work. International accounting diversity is potentially a far bigger issue in London
than for any other stock exchange. Cochrane (1994) shows that as a percentage of
average daily turnover, foreign turnover in 1992 was 43.2% for London, representing
$l,128m, compared to 6.8% ($461m) for New York, 1.5% ($27m) for Germany, 8.5%
($29m) for Zurich and 0.3% ($58m) for Tokyo. Emphasis in the present research
was put on analysts and fund managers, as it was held that these two user groups have
more influence on driving share prices than any other group, for example the range of
users interviewed by Choi and Levich. However, many similarities between this
research and that of Choi and Levich should be highlighted. Firstly, the two
investigations have an overlap of interests: prevalent lines of enquiry included
"whether international accounting diversity affected capital market decisions ", and
"how users cope with international accounting diversity" These fundamental
235
questions were addressed to establish support for, or evidence against, existing
empirical work. However, the characteristics of the sample used here, and indeed the
population examined, are distinctly different from Choi and Levich's and the extent of
enquiry here is deeper.
10.3 METHODOLOGIES
Any research that seeks to establish a framework to explain the behaviour of
individuals, as intended here, cannot be served by traditional market based research
techniques, as outlined in chapter 6. The remaining research methods available to the
social scientist are principally questionnaires and interviews. Both were undertaken to
supplement each other.
The questionnaire format, see Appendix A, was used for both the postal
questionnaire and interviews. The design of the questionnaire was based around the
following fourteen hypotheses formulated with the intention of addressing the
aforementioned issues:
Hi: accounting diversity has some effect on capital market decisions;
H2: accounting differences are a significant hindrance to the measurement criteria
• H3: most professional users of non-UK fmancial information restrict foreign
investment to countries with more familiar accounting practices;
• H4: most professional users of non-UK fmancial information restrict foreign
investment to more familiar sectors;
investment to more familiar companies;
236
• 116: most professional users of non-UK financial information cope with
international accounting differences partly by reliance on other information that is
less sensitive to corporate reporting such as macroeconomic data;
international accounting differences partly by trend analysis using published
accounting data;
international accounting differences partly by ratio analysis using, published.
accounting data;
• 119: most professional users of non-UK financial information cope with
international accounting differences partly by restatement of accounts to more
familiar accounting rules, followed by analysis;
• 1110: most professional users of non-UK fmancial information cope with
international accounting differences partly through the adoption of other
techniques;
• 1111: most professional users of non-UK fmancial information are aware of the
existence of international accounting differences that effect/distort reported
earnings;
differences existing between major corporate financial reporting countries, with
respect to the treatment of goodwill;
• 1113: most professional users of non-UK financial statements are aware of the
differences in the treatment of the determination of cost for stock valuation
between major GAAP regimes;
237
differences in the treatment of deferred taxation between major GAAP regimes.
For the postal survey, the questionnaire was made as short as possible , it was
contained within two sides of A4 and had many closed ended questions. This was
done in order to maximise response rates. Albeit, the response rate was low, (see
chapter 8). Circulation was via the September 1993 edition of the IIMR's monthly
journal "Professional Investor". However, not all recipients of the questionnaire

would have fallen into the population under examination, i.e. members of the IIMR
who use non-UK financial statements as part of their work, so the exact response rate
cannot be determined, but was not good. However, the information collected and
results obtained are still interesting even though no attempts can be made to 'prove'
hypotheses or state without reservation how the investment community behave with
respect to international accounting diversity. Further limitations of the questionnaire
will be considered in the penultimate section of this chapter.
For the interview part of the research, a total of seventeen independent
interviews were undertaken at major finance houses based in London. An adequate
distribution of analysts and fund managers covering all major investment areas (UK,
US, Continental Europe, Japan, Asia, SE. Asia, Canada, Scandinavia) and major
sectors (consumer goods, food and beverages, media, pharmaceuticals, mining,
tobacco, chemicals, paper, capital goods, oil and gas and transport and aviation) was
achieved. It was regarded as paramount that such diversity of activity was considered
in order to establish whether, and then explain why, international accounting diversity
was a problem for one specific type of user and not another, the variety of techniques
adopted to cope and so forth.
238
10.4 SUMMARY OF RESULTS
Information collected from both the interview and questionnaire surveys
strongly suggested that international accounting diversity is a major problem for
international traders of securities and consequently affects the capital market decisions
made. When examining the results it is important to focus for some purposes on those
professional investors who directly use international accounting information, thus
excluding the following respondents from the sample:
• Non-specialist (i.e. several sectors but single country) analysts, as international
comparisons do not occur if investment and analysis is restricted to one nation and
hence one GAAP regime.

• Fund managers. The majority of fund managers rely on reports prepared by analysts
and assume that the analyst has dealt comprehensively with all accounting diversity
problems.
Of the remaining 'relevant' interview respondents, 67% of all specialised
analysts and 100% of specialised joint analystlfund managers interviewed regarded
international accounting diversity as a problem affecting capital market decisions,
when undertaking international analysis and investment (for the questionnaire this
was 74% of analysts). These results were regardless of age and length of experience
in working with non-UK financial statements.
Based on the responses received from active market participants it can be
stated that international accounting diversity is perceived to exist and is a problem for
professional investors, albeit not an insuperable one. 50% of the sample interviewed
compared to 87% of questionnaire respondents recognised international accounting
differences to be a sign flcant hindrance to the criteria used to assess foreign
companies, see Table 10.1. This includes 100% of specialised analysts interviewed
and 100% of analysts responding to the questionnaire.
239
The barriers caused by international accounting differences are thus significant
and a cause of concern for market participants. However, these barriers are not
insurmountable and, due to coping mechanisms adopted, do not greatly restrict
investment to countries with more familiar accounting practices (42% for interview,
13% for questionnaire'), to more familiar sectors (21% and 13%) or more familiar
companies (7% and 27%). The principal category of interviewees that restricted
investment were non-specialised fund managers.
Table 10.1: Comparison of interview and questionnaire results.
INTERVIEWS QUESTIONNAIRE
YES NO YES NO N/A

_____________ % % % % %
Do accounting differences affect your capital market 33 64 74 26 -
decisions?
Are accounting differences a significant hindrance to the
measurement criteria used for assessment of non-UK 50 50 87 13 -
company accounts?
Is foreign investment restricted to:
• countries with more familiar accounting practice? 42 58 13 74 13
• more familiar sectors? 21 79 13 74 13
• more familiar companies? 7 93 27 60 13
To what extent do you cope with international
accountingdifferences by: _______ _________ _______ _______ ________
• reliance on other information, e.g. macroeconomic 79 21 73 27 -
data? _______ _________ _______ _______ ________
• trend analysis? 100 - 67 33 -
• ratio analysis? 100 - 73 27 -
• restatement to a more familiar accounting regime? 21 79 87 13
• other techniques? 14 86 33 67
It could be suggested that the responses to the questionnaire are biased as the
respondents were self selecting i.e. only those analysts who have a personal interest in
t Results are recorded in this order for the remainder of the chapter, i.e. interview results followed by
questionnaire results.
240
international accounting differences responded. Thus one would expect a higher
percentage of respondents to the questionnaire (compared to the interviews) to
recognise international accounting diversity as a significant hindrance to analysis or
that it affects capital market decisions.
A number of coping mechanisms were highlighted throughout the survey. The most
popular techniques appeared to be the traditional analysis tools such as trend analysis
(100% and 67%),and ratio analysis (100% and 73%). These results may be biased
towards the questionnaire responses for the aforementioned reasons: anyone who has
an interest in international accounting diversity should be aware of the potenta]

shortcomings of using ratio and trend analysis, especially without prior restatement.
Likewise a higher proportion of respondents that restate accounts prior to any analysis
would be expected in the questionnaire survey. The results relating to the extent of
trend and ratio anlysis are somewhat worrying in that only 21% of respondents
interviewed undertook any type of restatement (87% of questionnaire respondents).
Taking the questionnaire data to be biased (also see limitations section 10.6), there is
a distinct lack of evidence supporting restatement. Furthermore, upon further enquiry
it materialised that only 7% of respondents actually tried to adjust the accounts back
to a benchmark, the other 14% merely adjusted the fmancial statements for large or
erroneous items. As evidenced in chapter five, applying traditional analysis
techniques to companies from countries with inherently different accounting systems
and institutional frameworks is potentially dangerous as the results will not even be
slightly comparable, see Aron (1991) and Choi et al (1983). Furthermore, those
respondents who did utilise restatement as a coping mechanism still stated that
accounting diversity was a problem and a significant hindrance to the measurement

criteria used to assess foreign companies.
This is in accordance with the findings of Cboi and Levich (1991, pp 1 1-12).
Their findings suggested the following:
241
• existing restatement algorithms are still at a very crude stage of development,
• existing algorithms are not being applied effectively,
• no algorithm is capable ofproducing a proper and meaningful restatement.
At present little research has been done to establish what constitutes restatement for
analysts (see section 10.7). It is important to establish this as, if restatement is
insufficient as a coping mechanism due to the first two reasons, further effort
expended on restatement would be worthwhile, however if the third reason prevails
other coping mechanisms would have to be used or developed. The ambiguity
surrounding what constitutes restatement could suggest reasons why the two surveys
produced substantially differing results (21% compared to 87%). Any adjustment to
the accounts prior to further analysis could have been interpreted as restatement by the
questionnaire respondents, but clearly does not constitute restatement for the purposes
of this research.
A further, highly popular coping mechanism involved the reliance on other
information less sensitive to corporate reporting, e.g. macroeconomic data (79% and
73%). This involves employing a top down approach to investment, firstly selecting
the country for investment on the basis of GNP, expectations etc. and then selecting
attractive sectors within that country, and finally under-priced securities withài thai
sector. This approach reduces the need for inter-country comparisons and therefore
alleviates the problems associated with international accounting diversity. An
important coping mechanism whereby the investor associates him/herself with the
local environment in which investment is to take place by positioning themselves in
that environment (multiple principle capabilities ) has been excluded from this
research, as the sample consisted of professional users of non-UK financial statements
working from London. Therefore the extent of MPC as a coping mechanism cannot
be commented on. However, many of the finance houses interviewed had employed
foreign citizens to undertake analysis and investment in their native countries but
242
based in London, e.g. US analyst covering the US. This has distinct competitive
advantages as the analyst should be more familiar with the accounting regime and
institutional frameworks prevalent in his or her native country than any foreign
counterpart.
Moving on to further issues raised in the surveys, the overall perception of
relative profit levels of major corporate reporting countries was fairly high, with 69%
of interviewees recognising the relative conservatism (or lack of it) for the countries
in which investment was undertaken. This illustrates an awareness that international
accounting diversity can lead to widely differing profit figures. However, there was
no logical connection made by respondents between this recognition and the
perceived consequences of it. For example a respondent may state that Germany has
far more conservative accounting practices than the UK and thus lead to lower
reported profits, but continue to compare unadjusted PB's or ROCE's for companies
from the two countries. An awareness of how accounting policy choices affect asset
values was not greatly recognised by the sample. Specific accounting treatments for
stock valuation, deferred tax and goodwill were not generally known or deemed
important. There were large discrepancies in the results between the questionnaire
and interview surveys. In all the three aforementioned examples, respondents to the
questionnaire appeared better informed (see Table 10.1) which suggests one or more
of three things:
• the questionnaire sample was self selective and only those interested in
international accounting diversity responded,

• the respondents to the questionnaire only returned the completed version if they
were confident in their responses,

• the respondents of the questionnaire 'looked up' the answers.
Due to the potentially biased questionnaire sample , the interview results should be
given more weighting when drawing any inferences or conclusions.
243
Table 10.2 Knowledge of the correct accounting treatment for goodwill,
deferred tax and stock valuation in UK, US and Germany. Interview and
questionnaire survey results compared.
_______________ _______ INTERVIEWS QUESTIONNAIRE
% of respondents % of respondents
recognising the correct recognising the correct
_______________________ ___________ accounting treatment accounting treatment
GOODWILL UK 46 66
_____________________ US 46 25
___________________ Germany 15 23
DEFERREDTAX _______ ________________ _______________
______________ UK - 53
___________________ US - 53
___________________ Germany 8 31
STOCKVALUATION _______ ________________ ______________
__________________ UK 15 47
__________________ US 15 47
_______________ Germany - 33
The three examples of international accounting differences were chosen
because of the potentially material effect they can have on asset/liability and profit
levels. This is supported by empirical evidence, for example Simmonds and Aziéres
(1989) and Natwest markets (1993). Several points of interest arising from the lack of
knowledge, as evidenced in Table 10.1, are worthy of comment. Firstly, the majority
of the 2100 of the interview sample who undertake restatement to some degree 2 failed
to recognise the differences in the treatment for stock valuation and deferred taxation
2See Table 9.2.
244
between the UK, US and Germany. Half of those restating recognised the correct
treatment for accounting for goodwill in the US and UK, but only a quarter for
Germany. It is therefore not surprising that international accounting diversity is still a
problem and a significant hindrance even to those market participants who undertake
restatement.
10.5 LIMITATIONS
As outlined in chapter six, the limitations of questionnaires and interviews are
widespread. The interview and questionnaire surveys need to be addressed
individually due to the differences in limitations identified.
10.5.1 Limitations of the questionnaire survey
A major limitation of the questionnaire survey was the low response rate, the
exact response percentage is not precisely known (see section 10.3). Due to this poor
response rate the results obtained cannot be conclusive or deemed representative of
the population examined. Thus, the information collected through this research
method can only be 'suggestive' in explaining investors' behaviour rather than

statistically proving their actions.
The distribution of the sample responding is not normal, but biased towards
qualified accountants. The percentage of qualified accountants working in analysis
and fund management is approximately 5%3, whereas the percentage of respondents
qualified was 13%. Qualified accountants have a better understanding of accounting

techniques and policy choices than their unqualified counterparts. Thus, it is expected
that professional investors qualified as accountants would experience less of a
3 The percentage of qualified accountants to the total of interviewees was 5.8%. This was considered
the approximate percentage of qualified colleagues by the majority of respondents.
245
problem with international accounting differences, or at least should have a better
perception of them.
Further bias is present in the sample as the respondents to the questionnaire are
self-selective. Only those recipients who are interested in international accounting
differences would consider responding. Therefore, all recipients who are not even
aware that accounting diversity is an issue are excluded from the questionnaire results.
Furthermore, the questionnaire design could be criticised for the biased sample. The
questions examining specific acco\mtrng policy choices v..'iThin a range of countries
suggest that there is a right and a wrong answer, as respondents are asked to match
selected policies with particular countries. Therefore, one of two things could happen:
respondents not knowing which accounting policies were prevalent in which country
either gave up and did not return the questionnaire, or looked up the answer.
Therefore, it is expected that a higher percentage of the questionnaire respondents
would appear to recognise specific accounting practices within major fmancial
reporting countries, compared to the interview sample (see Table 10.1). This is
consistent with the results, for example 47% of respondents recognised the most
commonly used stock valuation method employed in UK and US in the questionnaire,
but only 15% of interviewees recognised this. Similar results were obtained for
deferred tax, (53%, 0%).
It is very important to be able to classify respondents into specialist and non-
specialist and fund managers and brokers. This was only partially achieved for the
questionnaire survey. The importance is due to the fact that country specialists do not
tend to undertake direct inter-country accounting comparison as they only ever
compare financial statements prepared in accordance with the same GAAP. For this
reason international accounting diversity will not pose a major problem, if one at all,
for such users. Furthermore fund managers tend to rely on reports prepared by
analysts, which they deem entirely comparable, as the analyst is perceived to have
246
coped sufficiently with the problem of international accounting diversity as part of his
or her job. Although the distinction between analyst and fund manager was raised for
the questionnaire, the specialist/non-specialist issue was not recognised. For this
reason detailed analysis could not be performed on the questionnaire data and
therefore results are less informative than they may suggest.
10.5.2 Limitations of the interview survey
Some problems were also experienced with the interview. Firstly there is a
danger that interviewees will respond in the way that they think the interviewer wants
to hear, rather than to state what problems are met and what techniques are adopted in
practice. Some evidence of this did arise, for example, one interviewee originally
stated that US adjusted accounts were ignored, even if readily available, because
"analysts should use domestic figures as the majority of shareholders are coming
from a domestic perspective and it is these investors that drive the share price, not
foreign investors" However, after some general discussion on the benefits of
restatement, the respondent contradicted himself, stating that "US GAAP adjusted
accounts are usedfor the basis of certain adjustments, for example, pensions and
provision accounting" However, under interview conditions it is relatively easy to
identif' such discrepancies and to investigate further. Furthermore, the reaction of the
interviewee can be monitored unlike the case with a postal questionnaire.
10.6 CONCLUSIONS AND IMPLICATIONS
Perhaps the most important implication of this research is that concerning
market efficiency. However, the results are only suggestive, and statistically valid
conclusions can therefore not be drawn. The results do shed some light upon how the
investment community behaves and possibly how share prices are affected by their
actions.
247
It has been shown in the summary of results (section 10.4) that market
participants are not knowledgeable with respect to international accounting diversity
and the potential effects which accounting differences have on reported profit and
asset levels. This evidence coupled with strict adherence to traditional investment
techniques, such as trend analysis and ratio analysis, without prior restatement, would
suggest that analysts are not as sophisticated as the efficient market hypothesis
suggests. On the contrary, the evidence collected here indicated that UK professional
investors in non-UK securities are fixated with certain accounting numbers and ratios
and do not see through international cosmetic accounting choices, i.e. this lends
support to the functional fixation hypothesis (see chapter two).
This conclusion is further exemplified by the responses of a few interviewees.
One respondent stated that he took advantage of the Ycnowledge gap' between his
personal knowledge of international accounting differences and the knowledge
expressed by the market (deemed negligible) to formulate trading strategies.
Ironically, this respondent did not restate and was not able to identify any of the major
international differences raised in the interview. A further respondent stated that
knowledge of specific accounting differences in GAAP regimes, together with
sufficient local knowledge of the environment from which an annual report originated,
would most definitely give the analyst a competitive advantage. However, this
advantage was only deemed to be of benefit in the long run, as short term market
prices were driven by the 'ignorant' investors who could not see through international
accounting differences but instead traded from a functionally fixated position.
Unfortunately, not enough is known about how international markets work and
how share prices are driven if a company is listed on more than one exchange.
Research to date has focused on how a domestic market reacts to information releases
on domestic securities. This is an area where further empirical work is required.
248
Several questions need to be addressed in order to provide evidence against
EMH. EMH in the semi-strong form (as widely acknowledged empirically to exist on
all major exchanges) purports that all available information is compounded efficiently
and instantaneously into the share price. As a result anyone trading on past or
publicly available information, cannot consistently beat the market after transaction
costs are considered. Firstly, therefore, are international accounting differences public
information? Numerous texts exist which highlight the major differences in GAAP
regimes (Nobes and Parker ,1995; Choi and Mueller, 1984; Hoizer, 1984). Moreover,
many finance houses have commissioned their own reports focusing upon adjusting
financial statements for international accounting diversity (Touche Ross: Simmonds
and Azières, 1989; Natwest Securities, 1993; Baring: Nobes, 1991 etc.). This
information is 'publicly available', although, the exact differences that exist for
specific companies are not readily available unless a company increases the disclosure
to incorporate GAAP adjusted statements or a detailed restatement is carried out. If a
sophisticated investor group existed it would adopt coping mechanisms that deal
effectively with international accounting diversity and therefore would be able to
distinguish between real and cosmetic accounting differences between GAAP
regimes, and compound this into share prices. If this state of efficiency exists on an
international level, it is very difficult to explain the behaviour of the active market
participants that were interviewed for this research.
The second issue arises from the importance placed upon published financial
statements as source documents for information when undertaking analysis or

investment. It is well documented that professional investors rely strongly on
financial statements for investment purposes (Chang and Most, 1985; Winfleld, 1978;
Day, 1986) and that non-professional investors rely strongly on the advice of their
stockbroker for investment purposes (Epstein and Anderson, 1994). Therefore the
249
implications arising from the potential misuse and misinterpretation of foreign
financial statements cannot be ignored.
Further implications for the efficient distribution of wealth arise from the
techniques adopted by professional users of foreign financial statements in order to
cope with international accounting diversity. For example, by adopting a top down
approach to investment, the need to compare financial statements at an international
level is removed. However, under-priced, and therefore attractive, securities will be
missed if the country in which the company is situated is not considered for
investment because, for example, it has a low GNP weighting. This not only leads to
the inefficient distribution of wealth but could also have serious implications for the
company when trying to raise funds overseas.
10.7 SUGGESTIONS FOR FURTHER RESEARCH
There are many questions that have been raised by this research but not
answered within the scope of objectives stated. Firstly, with reference to restatement,
the following issues are of interest:
• How useful are the restated financial statements that analysts produce?
• Do analysts who restate financial statements to more familiar accounting regimes
outperform those who rely only on the original annual reports?
• Does the release of restated information, e.g. US GAAP adjusted accounts for
foreign companies listed on the NYSE, have any impact on share price?
• Do companies that voluntarily produce restated information have access to
cheaper funds when trying to raise them overseas?
Following from the above, numerous issues concerning the 'capital market effect' of
international accounting differences arise, for example:
250
Are Japanese companies penalised for apparently high levels of gearing and
expensive P/B ratios when trying to raise capital overseas?
• How does the domestic stock market assimilate information concerning foreign
listed companies, i.e. are stock markets sophisticated enough to establish the
differences between real and cosmetic international accounting differences?

Do international accounting differences affect the size of merger premia in
international deals?
251
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APPENDIX A
Score "5" for "Very Much" to
"1" for "Not at All"
5 4 3 2 1

1. Do international accounting differences affect your capital market UUUUU
decisions? If you scored 3 or more, please briefly explain.
2. Are accounting differences a significant hindrance to the measurement

of the criteria you use for assessment of foreign companies? If you scored
3 or more, please briefly explain. U U U U U
3. Do you restrict foreign investment to:

- countries with more familiar accounting practices?

UU U U U
- more familiar sectors?

UU U U U
- more familiar companies? UU U U U
4. To what extent do you cope with international accounting differences by:

(a) Reliance on other information such as macroeconomic data U UUUU
(b) Trend analysis using published accounting data U UUUD
(c) Ratio analysis using published accounting data U UUUU
(d) Restatement of accounts to a more familiar accounting rules,
followed by analysis U UUUU
(e) Other techniques. U UUUU
If you scored 3 or more for (e), please give brief details.
5. How do you allocate funds between domestic and foreign markets?

Please give brief details.
6. How do you select specific securities once you have chosen a country?
Please give brief details.
APPENDIX A.l
7. Given identical economic facts relating to a company, which country's
rules would lead to the largest reported profit?
Please insert a rank from 1 to 5 in each box, 1 being the highest.
Japan UK US France Germany

U U U U U
8. Generally accepted practices relating to the treatment of goodwill include:
(a) immediate write-off against reserves;

(b) shown as an asset without amortisation;
(c) shown as an asset and amortised over 15 years or less;
(d) shown as an asset and amortised over more than 15 years.
Which practice do you find most commonly in the following countries?

Please insert one letter in each box.'
UK US Germany
U U U
9. Generally accepted methods relating to the determination of "cost" for the

valuation of stocks include:
(a) LIFO
(b) FIFO
(c) Average cost
Which method would you thy is the most common in the following countries?
Please insert one letter in each box.
UK US Germany
U U U
10. Which of the following is the best description of the treatment of deferred tax
in the following countries:
(a) accounted for on a full basis
(b) accounted for on a partial basis (i.e. only when it is expected to be paid)
(c) deferred tax does not generally arise.
Please insert one letter in each box.

UK US Germany
U U 0
1Foc the inteivicw the choice of country was adapted to reflect countries relevant to the interviewees targeted investment area.
Ibiswasthecase foiquestions 8- 10.
APPENDIX A.2
APPENDIX B
INTERVIEWS: SUMMARISED NOTES TAKEN
B.! ORGANISATION 1: FIRST INTERVIEW 29 MARCH 1994
Interview with four fund managers, organised by geographic area. Portfolios chosen
by fund managers are based upon equities and bonds (government bonds for institutional
investors and Eurobonds for private investors). The fund manager is for private clients.
Details of interviewees:
• UK and Continental Europe Fund Manager, 10 years experience, not qualified as an
accountant. Age 30 - 35.
• North American and Far East Fund Manager, 15 years experience, not qualified as an
accountant. Age 40-45.
Continental Europe Fund Manager, 4 years experience, not qualified as an accountant.
Age 25-30.
• Manager, 34 years experience, not qualified as an accountant. Age 55-60.
APPENDIX B. I
As fund managers the interviewees do not undertake financial statement analysis of
any kind. Conversely, financial statements are utilised to gain an overall impression of the
company, how it presents itself etc., rather than as a source of financial infonnation.
However, it is assumed that financial statements are used indirectly through the appropriation
of analysis gained from a consortium of firms employed to research stocks. There are
approximately a hundred firms of analysts which undertake analysis work for this
organisation in a variety of countries. On average three firms will be requested to provide
reports for any one particular line of enquiry so that the figures gained can be checked against
each other and any anomalies investigated.
Thus, accounting diversity is not a direct problem for these respondents as they do not
undertake their own accounting analyses. This is further exemplified by the organisational
structure of the company, as fund managers are trained with a focus upon distinct
geographical areas. Thus, focus for investment will be upon certain sectors within a certain
chosen countries, rather than basing investment decisions upon a sector across country, for
example researching General Motors, Ford, and Chrysler within the US as opposed to
comparing BMW (Germany), Honda(Japan), General Motors (US), Rover(UK),

Mercedes(Germany), Fiat(Italy) etc. Thus accounting diversity is not a problem per se as the
comparison of one country's accounting with anothers does not arise.
Accounting diversity was however recognised, a fund manager specialising in
German stocks, noting the vast difference between the DVFA (the German professional
association of financial analysts and investment advisors) adjusted figures and the figures
disclosed on the face of the published financial statements. Such adjustments are advocated
by the DVFA to enhance the comparability of US/UK and German accounts. (See Chapter 3
for details of this adjustment.)
APPENDIX B.2
Thus accounting diversity is perceived to exist but is not a significant hindrance to
investment criteria used for investment decisions. On the contrary other matters, such as
economic factors like the degree of regulation in a country were cited as possible reasons for
investing in, or for avoiding a country. For example, countries with low regulation such as
India, Turkey, Greece and Vietnam are avoided and countries such as Austria, Portugal and
Eastern European countries are approached with caution. Thus, as one analyst stated:
"there is a tendency to stay clear of low regulation as opposed to countries with
incomprehensible accounting".
Individual securities are selected from listed companies that have good reputations
and have been well researched, principally using local analysts in the way aforementioned.
One strategy adopted is to analyse securities that are "unfashionable" but where the
underlying fundamentals remain positive. The analysis based upon the information received
from local analysts varied; a quantitative approach was adopted by the Continental Europe
fund manager, focusing upon 13-coefficients and technical analysis as decision tools; valuation
approach looking at P/E ratios on a comparable basis, trends in margins (e.g. Sales margin,
profit margin etc.) future projections of cash flow/profit and an analysis of ratios. Gearing
was viewed as an important consideration with a bench-mark of 40% being quoted across the
board as the cut-off point for investment as higher levels of debt were viewed as risky.
Restructuring of a company was also cited as an important consideration, e.g. Woolworth in

the US.
APPENDIX B.3
B.2 ORGANISATION 2: SECOND INTERVIEW 29 APRIL 1994
Analysts/fund managers are arranged primarily on a geographical basis. However, if
a particular region is highly covered further segmentation occurs by sector, e.g. few analysts
cover the US and Japan and therefore they look at all sectors, whereas the rest of the Far East
and Europe have a high presence of analysts assigned thus permitting individual analysts to
focus upon industrial sectors. This structure has implications for the questions asked, as a
wider knowledge of accounting diversity is expected from a sector analyst as opposed to a
country analyst. The details of the four analysts/fund managers interviewed are as follows:
Analyst and fund manager specialising in the Far East (Australia, New Zealand,
Malaysia, Philippines, Indonesia) and the following sectors: mining, tobacco and food
and beverages. 4 years experience in international investing, not qualified as an
accountant. Age 25 - 30.
Analyst and fund manager for the US and Canada; as only one of two analysts for this
region, all sectors are covered. 12 years experience in international investing, not
qualified as an accountant but graduated in finance in America, thus coming from a US
perspective. Age 40-45.
European analyst/fund manager for the following sectors: chemicals; oil;
pharmaceuticals; and paper. 4 years experience in international investing, not qualified
as an accountant. Age 30-35.
• Japanese fund manager covering all sectors. 10 years experience in international
investing, not qualified as an accountant. Age 35-40.
APPENDD( B.4
B.2.1 Far East analyst! fund manager
The process of asset allocation starts with deciding which region should be focused
upon for investment, this is achieved through the use of macroeconomic data. Once the
region has been chosen securities are selected using several techniques. Firstly, reports
containing financial information such as ratios, EPS etc. are requested from brokers (original
analysis not generally undertaken due to time constraints and work load). Financial accounts
are used to check both the feasibility of the cash flow/earnings forecasts and for any
erroneous items or anomalies apparent between requested brokers' reports, in which case
restatement to UK GAAP is undertaken, e.g. capitalised interest is taken out of the balance
sheet where it occurs. Company visits are used to gain a "understanding of the
business". Further to this trend analysis is employed, tracing the company back three to four
years to piece together how the company is doing, as a separate exercise carried out from
published data/brokers report. Other information which is considered useful if provided is
the cash flow statement and US adjusted data.
In general countries are not avoided because of accounting practices:
'1am aware of certain things in certain countries but can cope OK scanning the statement of
accounting principles helps."
In saying this the respondent does avoid China, because:
"their accounting really is on a d/Jerent wavelength.., with such countries I lookfor the stage
that they are at in the "boom/bust" cycle before investing."
APPENDIX B.5
A clear perception of the existence of differences in reported profit was visible,
ranking UK, US and Japan according to academic doctrine. As the respondent deals with UK
and US accounting this was expected, as was the respondent not knowing the respective
'academic' levels of profit in Germany and France. Japanese accounting was perceived as
very conservative because of the basis of accounting being for tax purposes and the existence
of high P/E ratios. The majority of Far East accounting systems have their origins with
either Anglo-Saxon accounting or American accounting depending upon the strongest
influences present during colonisation.
Turning to specific accounting differences the respondent was aware of the UK and
US treatment for goodwill but did not know of the treatment in Germany. For restatement
purposes:
"an adjustment is only deemed worthwhile ?f it influences profit and can be seen to do so for
a number ofyears, f this is so I'd rely on a broker to make the adjustments rather than do so
personally."
dtatemoct woa€d 4a9et eIe ad ad/aaemet woatd 4 teita(€eat4 eaeed oat j4
4 cO4lt9 4*oté4€t9 4 *4teu41 amoa4 o6 oda'd€, il.tá'ôa9s (ic 044 4ee 44
iome eoa.tzie eoeed (e.g. 41i) amtuaoc woa& 6 i'Ae co 'atA tAat
e%eeftto.c; e.. ,1S70l3. ii(e da'd j aeeoa jo 9oodai&. eabe4
4ngoti4atthe o 20 9e&)
The flow assumptions for valuing stocks at cost in UK, US and German GAAP were
not known. This was not however seen to be a problem as:
APPENDIX B.6

"it would only be investigated ffocusing upon a sector/company which holds consistently
high levels of stock or has a low level of stock turnover.., otherwise it is not deemed to
be important."
The treatment of deferred taxation was not known and it was expected that the
majority of colleagues would not know either. However, this was not viewed as a problem
because:
"it would only be relevant f apparent, material and a one off"
i4 i - a l49e dijjeecee 6eeaieei jo tzw€e, W ad ea1t t4e j4nmm
dtâua(e4tead4t4
"aftft4ote asd maee'Ual d4jeeee4" qet ae wt adft.edted jo 6eeaade oo t'Ae (4eá o ø4e
B.2.2 European analyst/fund manager
Asset allocation was described as a very bottom up process, focusing upon a
particular company early in the process rather than looking at the country, then sector and
finally choosing specific securities. Thus, there is little call for macroeconomic data, apart
from to check that sales and profit forecasts provided by the director are in line with
economic forecasts. The financial statements are referred to in the early stages of analysis,
systematically working through the accounts to extract interesting information on sales, price,
capital structure and various accounting policies, e.g. depreciation policy for fixed assets,
depreciation of capital expenditure, provisioning levels, and goodwill, which all may be
adjusted to some extent. Such analysis is performed for companies over the past four to five
years to establish trends. Brokers' reports are also utilised in most sectors. The exception is
oil, since this is a predominantly American industry so that US GAAP information is
APPENDIX B.7
generally provided with financial statements, decreasing the need and usefulness of
restatement by an independent analyst. Where brokers' reports are used the respondent
expects that accounting differences will be highlighted.
Difficulties are, however, experienced with accounting diversity, resulting in the
respondent restricting capital market investment to countries with more familiar accounting
policies:
"If a company has large areas of unexplained items in the profit and loss account or balance
sheet it will be avoided and I will buy more in a country with more familiar accounting
practices."
Eastern European countries were cited as examples, and also Austria. However, not
understanding the accounting within a company's financial statements is not inevitably
followed by avoidance. If the company is looked upon favourably but uses unfamiliar
GAAP, a company visit will be undertaken prior to the investment decision.
Focusing upon reported bottom line figures, the respondent had a clear idea of
perceived relative profits as recognised academically. However:
"...things are changing, especially in Germany with the writing back ofprovisions. . . depressed
profits in past years, sales have now decreased but profit remains unchanged ..income
smoothing."
eom*eice aie'e à.de- &, made im.ftôzeaae j4atcea€ ew ec4a €q
a9zeed (o d4ie&,e e(ee "cdaoe e4ewei" joit &ae ft4fto4e4 o#t z4e /5 - eàt eà'a1e.ct t'.e
- oj a44eLi. 4 *aác eee, aø4e 'e4eu'e aecoa(âc9, eJie4
deem 44' e 6eea well eeo964e4)
APPENDIX B.8
The respondent was not aware of specific accounting policies relating to goodwill,
stock or deferred tax in UK, US and Germany. As this analyst invests in sectors across
Europe, with the oil sector being highly influenced by US GAAP, this seems worrying as this
respondent adjusted the financial statements prior to analysis, and it has been shown that
these aforementioned areas are examples of the major adjustments that are required for
comprehensive restatement (see chapter 3, e.g. Simmonds and Aziêres, 1993). Explanations
were given for the lack of interest shown in each of the three examples: goodwill, stock
valuation and deferred taxation. Goodwill was not important in Germany because:
"it only occurs in consolidated accounts which are not a tax issue"
eA *ae meae z'Adt 9aoduci e4 coi auIede ' 6 x de4, ec4ti4*€ câttioc i4 dtdt
iscfttt4scLç7
Furthermore, the analyst stated that:
"When you read through the accounts they tell you what method is employed so you do not
need to know what to expect as it is in the notes."
The method of valuing stock at cost was only deemed important in the sectors that
have large inventories by virtue of their industry, for example the oil industry. In this case all
oil companies provide US adjusted accounts and thus disclose the difference between FIFO
and LIFO figures. Furthermore, if relying upon brokers' reports, it is expected they would
highlight the difference and provide comparable figures. Deferred tax was not viewed as a
'priority" as:
"over time it does not matter too much, it can be big in one year but Jam notjust looking at
one year."
APPENDIX B.9
B.2.3 Japanese analyst
International accounting differences do not directly affect this analyst's capital market
decisions as he only analyses Japanese companies. However, even though differences

between UK and Japanese accounting are recognised, and allowances made, there are certain
sectors that are approached cautiously due to a lack of transparency in accounting. This is not
perceived to have important repercussions upon investment as a widespread portfolio of
limited securities can still be obtained within the desired risk parameters.
Asset allocation starts with a view of macroeconomic data to establish where the
growth areas lie within the economy. However, the use of macroeconomic data is minimal
and less than for most fmance houses. Ultimately, the choice of which sectors to invest in
and the amount of funds available for investment is made by higher level management.
Companies are selected using fundamental analysis, which is viewed as being the most
important technique, looking at trends of past published accounts to establish if the company
represents good value, and using ratios, mainly based on cash flow rather than earnings, as
Japanese earnings are seen to be highly conservative. Restatement to a more familiar GAAP,
i.e. UK GAAP, does not occur due to time constraints. Some US GAAP information is
utilised when provided and found to be interesting but only approximately 30 companies of
those followed provide this. Brokers' reports are utilised.
With reference to which country's rules would lead to the largest reported profit, the
respondent recognised Japan as the most conservative and the UK as the least, but stated with
reference to Daimler-Benz that it depended upon the phase in the economic cycle.
APPENDIX B.1O
Goodwill was not recognised to be a problem as:
"there are very few take-overs in Japan and therefore very little accounting for goodwill."
Stock valuation methods were also not viewed as causing problems due to low inflation in
Japan making this less of a concern. Finally, the respondent also did not know of the
differences in deferred tax accounting between Japan, UK and US:
"I don't know as much as I should.. there is very little discussion among analysts of deferred
tax as an issue... it should be the analyst's job to highlight such problems but too little occurs
in practice."
B.2.4 US/Canada analyst
The respondent only focuses upon US and Canadian stocks, so accounting diversity is
not a problem per se and US and Canadian GAAP is very similar if not identical.
Furthermore, this analyst is American and so US GAAP is the bench-mark used in investing.
Comparisons between UK and US GAAP are only carried out when specifically requested by
the in-house UK analysts.
The amount to be invested in these markets is decided upon by higher level
management, thus we gained no insight as to how this initial allocation process takes place
from this interview. Investment is restricted to listed companies and over-the-counter stocks,
although the analyst interviewed had a personal bias towards private placements.
Asset allocation within the US market is viewed as a three step process. Firstly,
macroeconomic information is used, the US is looked upon as a number of economic regions
APPENDIX B. 11
rather than as one country, so this data assists in the decision as to which state should receive
attention. This is quite important, for example the health care policies adopted in certain
states have had drastic repercussions upon the pharmaceutical industry. Macroeconomic data
also helps build up a picture of the nature of the business. The second stage is to examine the
quality of the management; company visits are highly important, the analyst making over two
hundred per annum, helping to build up a picture from the bottom up. Thirdly, but of equal
importance, are the financial considerations. Trend analysis is used, usually over a ten year
period if possible, it is thought desirable to go back even further, for example to trace a
company throughout the entire business cycle in order to pick out the highs, lows and
averages, but this is practically impossible in most cases. A very comprehensive standard
report is produced containing ratios, market measures, valuation based upon cash flow,
earnings, price, book values and so forth. Restatement never occurs due to the analyst being
most familiar with US GAAP and thus coming from a US perspective. Securities are
ultimately chosen with a view to outperforming the market, as such the basis of portfolio
diversification is to start with a model of the actual market and adjust for intended risk. Ideal
investment opportunities exist when stocks have slumped, as valuation is deemed paramount.
Extremely sophisticated techniques such as co-variance analysis are considered useless in the
US due to the volatility of earnings, e.g. because of restructuring costs.
The respondent was aware of the relative levels of UK and US reported profits, as
academically recognised. UK profits were thought to be higher due to the greater scope in
UK GAAP to 'flddle and create fictitious earnings" as compared to the US which "is more
structured".
Goodwill in US accounts was thought to be shown as an asset and amortised over up

to 40 years, which is correct according to US GAAP. However, this was not deemed as
APPENDIX B.12
important because a fortieth of the value of goodwill was not seen to have a large effect upon
profit. It was held more important that the value of intangibles in the balance sheet seemed
reasonable. The valuation of tangible assets was not held as important because the
respondent always views prospective companies as going concerns and thus the valuation of
assets would not drive an investment decision.
LIFO was recognised as the most popular adopted practice in the US and FIFO in the
UK. However, adjustments are rarely made when comparing companies using different
methods in the States because the effect of low inflation has caused the differences no longer
to be material. Also, it was suggested that the effects are cancelled out over time, and as ten
years are usually taken into account adjustment is not deemed necessary.
The accounting practice relating to deferred tax was seen to have recently altered in
the US, although he was not aware of the details. Nevertheless, the analyst was watching out
for those industries which would suffer the greatest impact of the change, deferred tax would
not drive an investment decision.
APPENDIX B. 13
B.3 ORGANISATION 3: THIRD INTERVIEW 5 MAY 1994
The three analysts interviewed provide reports to fund managers and analysts in house
but principally to other finance houses:
Capital goods sector analyst covering France, Germany, Luxembourg, Sweden, UK,
US, Switzerland and Italy. Five years experience in analysing non-UK accounts, his
domestic accounting actually being US. Not qualified as an accountant but did
accounting in business school. Age 40-45.
European chemical sector analyst, covering all countries with listed chemical concerns:
Austria, Belgium, Switzerland, Germany, France, UK, the Netherlands and Sweden. Six
years experience in analysing non-UK accounts. Not qualified as an accountant. Age 40-
45.
. Transport and aviation sectors analyst, concentrating in Europe (excluding
Luxembourg), but also US and Japan. Fourteen years experience in analysing non-UK
accounts. Not qualified as an accountant. Age 30-35.
APPENDIX B. 14
B.3.1 Capital goods analyst
International accounting diversity is seen to be a problem because they look at raw
data only, but not an insurmountable one. Comparability is seen to be improving. For
example, with the adoption of the 7th Directive in Germany, consolidated accounts are more
consistent and the DVFA adjustments do not appear to be as great as they used to be
(although DVFA adjustments are not designed to enable international comparison). A major
persistent problem cited was that of reserve/provision accounting on the continent, especially
in Germany and Switzerland where income smoothing is apparent. Countries that have
devalued, e.g. Sweden and Finland, were also seen as problematic. Italy was cited as the only
country about which reluctance was expressed with regards to investment because of
difficult accounting, the treatment of the recognition of profits on long term contracts was
singled out as a problematic area.
The capital goods sector is characterised by cyclical companies, so using
macroeconomic data is important for factors such as inflation. Analysis is based upon
fundamental analysis, looking at each company over the past five, or ten if possible, years.
Numerous ratios are calculated from this data and trends in margins noted. Restatement
occurs to check for clear anomalies, for example, restructuring charges and goodwill are
adjusted for, but a complete, comprehensive restatement does not occur prior to the
calculation of ratios.
The UK was viewed as having accounting practices that would lead to the largest
reported profit, followed by the US, with Germany as the most conservative. The respondent
did not know of French and Japanese levels, but stated that he expected Scandinavian
countries to report even higher profits than the UK%4 e ote'za€4 .toe øveJ.
APPENDIX B.15
The practice of writing goodwill off to reserves was recognised correctly for the UK,
but also for Germany where although this practice is permitted, amortisation (over a four year
period or longer) is also common. Amortisation was recognised as the US and French
practice, but the length of amortisation was not known. /Ye deem4 a aeat i(4t t4e
4d99oeoeaoa444€4ei4aaea(4#c9i&ea44et. 4*tkl4
t(e C'41e oc4 Øee&4&e, 44 oftftodedto ad/44tâq d4jt9i4e9aiie4 eeoa4ctj4
t(e ejjeet oa 'xeftoited ftwj2) This was emphasised when he stated that:
"i.. also no adjustment for depreciation of tangible fixed assets would be made as these are
subject to natural depreciation anyway."
/ea a4 COmft4ae4 ad.afte e4 dijjeect fr4diee4 o Quata4eoa øel€ as ftee

deeiae me(fodefJ
Stock valuation methods were not taken into account for restatement purposes due to
the present low general levels of inflation, furthermore it is considered to balance out over
time. However, in times of high inflation the respondent would prefer to see LIFO in order to
get more sense out of the accounts. f7ti woed o6 eoae tead i'o t4e me fteaâie ed4Wt4
es(49ed (ofte44e4 ia t'4(e ftwj aMd ëos aeeôce. dwea&a frwj4 aecodae94. lat lea'iia
z'Ae 4tde at o64olete fte4 cit (Ae talaicce 4'eet. Wa( c4e4 a coa4ea4e o 444et calae4.)
Specific deferred tax practices were not known. This was not seen to be a problem as
the projections made in analysis are based upon standard tax rates rather than trying to make
more realistic predictions. The US deferred tax was thought to be lower than the UK, but not
significantly. 7 c 1éae(iee ((e we'4e ecødd 4 mae. a4 uS eom.ftasAes jat4 aeeoa#ct jo d4ewd
eax cea4 oic4 fta/4 aeoaatisc9 4 'eace cit t'Ae cait lead (4 4cceaat
d4jeeceea. ø woald altmatel ate a lae éaet afto.c 'catios a*I aita4dio eax'cied oat)
APPENDIX B.16
B.3.2 European chemical sector analyst
International accounting diversity was perceived to be a big problem for this analyst,
consequently the respondent tried to avoid any comparison of accounting figures between
countries and relied upon information less sensitive to corporate reporting such as industry
reports. Financial statements are thus only utilised to any degree when examining chemical
concerns within the same country. The extent of diversity was viewed to surpass the figures
themselves and to be rooted within the different cultures of the countries examined, thus
causing difficulties in interpreting accounts. h174 c ezae e*amaEe 4 €'i'r2ae o e .taea'e o
eftoe4 %c4ft4'a1ë# 9madW
e4e ewd 4oa1d ot #eee4 6e aaaeiaeed w4 éeodd Ofr 'ic:44& 44 it woald i 4âuci4
eeue1 ei4te wit4(âe W eoCet4. Sad ut inteietati,.t wëiea tat aa aaee44 o t.4e eal(aa1
dijje'ocee4 ajjeetica co'r,&nate ttc.) As a result of this the respondent felt that he could
"make qualitative decisions but not quantitative ones" (based on accounting information from
unfamiliar GAAP regimes), and thus chose not to undertake "cross cultural comparisons".
Fundamental analysis was the principle technique employed for determining asset
allocation. However, the companies chosen for analysis depended initially upon current
market capitalisation:
"Ifeel obliged to cover the largest company in my sector and go as far down the list (of
chemical concerns ranked according to market capitalisation) as time permits".
The extent of trend analysis depended upon the stability of the accounting regime, for
example trend analysis was not deemed worthwhile for accounting periods prior to the
adoption of the Seventh Directive in Germany, as they are not comparable to current
practices. The UK was also cited as problematic:
APPENDIX B.17
"the constantly changing accounting practices (in the UK) mean itis not worthwhile going
back more than a couple ofyears."
Thus although the respondent felt he would like to trace companies over a longer period, such
as ten years, it is not practically possible. Ratios are also utilised in assessing companies for
investment, although the extent depends upon data availability. Some ratios, e.g. return on
capital employed, return on net assets and return on equity were used sparingly even if data
was accessible, as these were thought of as "pretty meaningless". Apart from the basic
disadvantages of such ratios relying upon earnings rather than cash flow, their usefulness
would diminish if calculated without carrying out comprehensive restatement first, which was
never undertaken by the respondent.
Where US GAAP was provided by companies, it was not held to be intrinsically useful as:
"you cannot account for cultural d(fferences through restatement."
It is, however, used to a degree in noting the differences highlighted. Reliance upon other
data was utilised as aforementioned, although there was not thought to be much use for
macroeconomic data as:
"in the chemical sector companies sell globally".
e c mae'weeo*im44 do g L 'e a (mftaet fto# "tie *ad' i w4 dad eomé

(4c
detl.
eosftac Whd eo(dd ajjece c4 comft€eraee44 a.d z(a ja(ae jiateci1 e4a(4f)
Focusing upon perceived levels of reported profit, the respondent's opinions for the
UK, US and Germany were in line with those commonly accepted by academics. No
Japanese companies and only two French companies were followed by the analyst, with one
of the French companies reporting in US GAAP. As such, the relative profits for these two
APPENDIX B. 18
countries were not known. In addition it was stated that there are circumstances in which this
would not fit, e.g. Daimler-Benz.
The respondent was aware of the current popular treatment of writing off goodwill to
reserves in the UK, and that there was some form of amortisation in the US but thought that
there was no goodwill to consider in Germany. Goodwill was never adjusted for as it is not a
significant issue in the chemical sector. f7id e o eae.d7 Variations in the method
for valuing stock at cost were also ignored because:
"you can't get back to the raw data from the accounts":
Specific differences in policies between countries were not known but it was thought
to have significant effects on results, especially in upstream companies. The treatment of
deferred tax was also unknown and it was thought that colleagues would not be aware of
specific country GAAP either. When prompted to state what the analyst usually came across
in financial statements with regards to deferred tax, the rejoinder was that there might be
large deferred tax numbers in the UK and Switzerland but manageable numbers or none in
Germany. W(tIoa4 e4e &ue e e€e ad &ttt4'e dejeivze t'4z au4e4 ce4cde' 9e'zmae 1ae
' a4e4 aodd 9eteat4 oe 4 j4a#cd ea z'A€ Z ad 44 adeioe&e4 oa4 ft4ilftwica.J
Furthermore, the analyst regarded deferred tax in the accounts as pseudo-shareholders' funds
rather than a pseudo-liability, and depending upon the circumstances would adjust for this by
deducting the provision for deferred tax from the long term liabilities section of the balance
sheet and include them with shareholders' funds upon which ratio analysis would be based.
a jøe4eea&e &iq. 7o améte. 5$, /5 4te4 e(4e "z'ax dejeed o acee&ated 6
4eeoateedjeo zeetieteeaa
taihiaq aet wcii cta&ae"f)
APPENDIX B.19
B.3.3 Transport and aviation analyst
This analyst provides information to in-house fund managers and to those of other
finance houses on companies within the transport and aviation sectors. Activity is currently
high within Europe, excluding Luxembourg, and in Japan and the US but has reached much
further afield in the past.
Accounting diversity was perceived to exist, with the respondent stating that he did
not hold much confidence in any one accounting system, although specific reasons for this
were not given. For this reason the respondent had created a personal bench-mark, being a
hybrid between UK and US GAAP, for comparing other accounting systems with. However,
accounting differences were not held to affect any capital market decisions because the
accounts are only one of numerous sources of information that can be utilised.
Macroeconomic information was not personally used by the respondent in the process
of asset allocation, although indirectly, through outside sources, checks were made that future
forecasts for profits, earnings, dividends etc. were in line with economic forecasts for the
relevant economies. Trend analysis was generally employed over a period often years to
gain personal knowledge relating to the business cycle of the company under analysis, but
only for three years for research purposes and also forecasting for three years. Ratio analysis
was carried out on published financial data for the same period, with restatement to a hybrid
of US/UK GAAP.
When asked to rank the relative expected profits which would be given using the
different accounting policies of five countries, inflation, currency exchange and the treatment
of exceptional and extraordinary items were given as reasons as to why this question was not
sensible. Any attempt to address the issue in question was vague, stating only that German
APPENDIX B.20
profits would probably be low due to reporting for tax purposes. Thus, excluding Germany,
it may be deduced that the respondent did not know which of the remaining countries were
expected to produce high or low levels of reported earnings. The specific practice of
goodwill was recognised for UK and US GAAP, although the period of amortisation in the
US was not known. The most common practice in Germany was thought to be to write
goodwill immediately off to reserves. However, although this practice is permitted,
amortisation over four years or more is also common. Goodwill was stripped out of the
accounts altogether, rather than restating practice to any particular GAAP regime, in order to
gain "reasonable net asset values and gearing calculations ". The different methods of stock
valuation were not known and held not to be of interest in the aviation sector which is
characterised by low stock levels. Finally, the respondent appeared highly confused over the
issue of deferred tax, stating that he was not interested in it and left the accounts as they stand
for analysis purposes as it is too difficult to understand. Thus, deferred tax would remain
under long term liabilities for the purpose of ratio analysis, thus having large repercussions
upon the figures obtained for companies operating under different rules! This is worrying,
especially as the analyst viewed the UK to have larger provisions than the US when in reality
it is the reverse, with the former requiring partial accounting for deferred tax and the later
making a full provision. This practice was justified on a cash flow basis, stating that:
"deferred tax works itself out over the years ".
Further confusion was exhibited with regards to accounting for leases, citing British Airways
as a company who have large amounts of leased aircraft which is not disclosed in the balance
sheet, making it incomparable to companies operating in other countries where disclosure is a
requirement under GAAP! t7 ' 4*1 1S ae eam.ft(e4 o t4(e ew eoactueo ew(ia do
4dooeaee dee44ce.)
APPENDIX B.21
B.4 ORGANISATION 4: FOURTH INTERVIEW 17 MAY 1994
Two analysts were interviewed who principally provide reports for in-house
purposes. The details of the interviewees are as follows:
• French analyst. Specialising in France, but restricted to the top 50 listed companies
which have a Canadian link, for example a French MNC which has a Canadian
subsidiary. Four years experience in analysing non-UK accounts. Not qualified as an
accountant. Age 30-35.
Switzerland and Belgium analyst and marketer. Specialising in Switzerland and
Belgium but also in the food and oil and gas sectors within the UK. Two years
experience in analysing non-UK accounts. Not qualified as an accountant. Age 25-30.
B.4.1 French analyst
This analyst initially worked in Canada and was more familiar with Canadian
accounts than with any other GAAP regime. However, currently a stronger familiarity with
UK GAAP is perceived to exist by the analyst. Accounting diversity was not recognised to
be a problem and it was considered that there is nothing of importance disclosed in a set of
accounts that would stop the analyst from looking at a company.
The company organisation divides Europe into geographic regions and the UK into
sectors, delegating the responsibility of these divisions to separate analysts. Thus,

international comparison does not directly take place.
APPENDIX B.22
This organisation is Canadian in origin and thus due to the majority of clients being
Canadian, investment is restricted to those companies with a Canadian connection. This
explains why the analyst in question was interested in French companies with a Canadian
link, for example the French forest products sector. Overall Organisation D is not dissuaded
from investing in companies with unfamiliar accounting practice, although some countries
were avoided due to country risk, for example Spain and Italy, where it was considered that
there was not a lot of "value added" because of this factor. Organisation D has only had a
presence in Europe over the last two and a half years, thus investment to date is somewhat
exploratory, only recently entering the securities market, prior to which only sovereign risk
was considered, for example government bonds.
Financial statements are utilised for trend analysis, looking at two consecutive years
of data for familiar companies and three or four for newly targeted companies. Other
information such as macroeconomic data is used to gain background knowledge.

Restatement is not considered a worthwhile undertaking because comparison is restricted to
French companies only. A standard spreadsheet has been designed as an analysis tool,
calculating several ratios of interest from a banker's standpoint, such as debt levels, gearing,
cash flow etc.
An overall perception of the existence of differences in reported profit was visible,
stating that French accounting is more conservative than UK or US GAAP, although the
respondent could not say anything very clear about this.
The generally accepted practices relating to the treatment of goodwill were not
known, and it was considered by the analyst that knowledge of this nature was not needed.
APPENDIX B.23
No adjustments were made concerning goodwill as the figures involved were not deemed
material enough to be of concern. ('oweom. i frzaae t'teatme.tt C4f C4 da 4tamé4 lwm
oe 7ete comfta' aitotAe', defte.d4i ,éoc e.4e amotae fteiod e4oiet 7e d4jewee i
wcc oil 9oodad€ i tAe ,éw asd ott aeeoa4tt oe a 4e'iod 6e('ee 4 cued 30 qea'4 cac
aeeoee a dijjøtece i.e 'eftoed eaei.e94 44 9te4t 44
The respondent was also not interested in the diversity in practices relating to the
determination of 'cost' for the valuation of stocks and was unaware of the varying practices
between France, UK and US. No adjustments were made for this area in the process of
analysis and interest only extended to:
"whether it [the differences relating to stock valuation] affected working capital."
Defte.ede9 eao.e i'Ae deet.o4 dtaded, eoe4 ea.e aeeoa.et jø' a e fteee.tta9e ci
aad e4(44 caic a 14't9e imftact cfto.e woe9 eaftcral edea14tio#t defte.icdâc9 aóo.c w444 meWcod
ci % 7.ce4 eomft4.c Sai.Ct- 9Jai.c w4 s(a
jâie w(oE4 ow#ce ea.ea&as a64idia ( aa.cda.ee ,14ae4 Tce.; fo(ô.e T.cc.;
1f4t4.e ea.ead4 Tcc. .• 1%,ta.c eeamiei ci ?aieada Ttc.; DtiE4 Iima'ed) dadc4e4
deOeá (e 'e4 aeeoa#ct4c jc mcze thue 30% ci eita€ ee.et uet.J
With reference to the treatment of deferred tax, the respondent was unclear of current
practices in the UK, US and France, but would expect French companies to report the biggest
numbers. f7ei c .co (4'e eade, 44 e.cea14. dejeed iaz dce .cot aue i.e iadâü(aa€ 7're.te4
eomftascied ci iaxatiom ftaftcded• 'owee'e. ie *a 4 aeca i.e
- 4eeoact4 6eeatae /4.eCe4 i.e joei9.e 4a64cdie4 4eeomi4 &4e eh id evfteeted i's
*edeci6a1a.eee4
dejeved earat.e.J
APPENDIX B.24
B.4.2 Switzerland and Belgium analyst also UK analyst for oil and gas and food
Asset allocation is chiefly based upon those companies with a Canadian connection as
aforementioned. Due to the inexperience of this particular analyst, an allotment of thirty
accounts are overseen leaving "...little time to look elsewhere".
Accounting diversity was not perceived to be a problem as this analyst was not
aware of the differences between different GAAP regimes:
".. treating foreign accounting numbers as f they were UK numbers.
Therefore no adjustments were made within analysis to cope with accounting diversity. The
financial services sector and some companies within the oil and gas sector were the only
areas which investment was not made because of a lack of understanding of the fmancial
statements.
The principal technique employed in analysing companies targeted for investment
was fundamental analysis using published accounting data relating to the past three years to
discover trends in performance. Some difficulty was expressed when undertaking trend
analysis relating to the adoption of FRS 3, Reporting financial performance, in UK
companies' 1993/94 accounts. The respondent experienced problems in the comparison of
past years' figures, prior to the new standard, where restated comparable figures had not been
included in the accounts. This suggested that the respondent does not understand the changes
in UK GAAP brought about through FRS3, and was unable to restate the figures himself.
Ratios were employed to a limited degree, particularly cash flow based ratios and changes in
working capital. Macroeconomic data was not heavily relied upon for future predictions,
although certain information was considered retrospectively, for example how well a
company had performed during a recession.
APPENDIX B.25
When questioned as to which country's accounting regime would the respondent be
most impressed by a reported profit of £100,000,000, the response was uncertain but he stated
that he was aware there would be differences. However, the respondent stated that:
"I would be more likely to believe a USprofitfigure than a German profit figure because US
disclosure is tight and German disclosure isn't."
Focusing upon specific accounting differences the respondent was not clear as to the
practices relating to goodwill, inventory valuation or deferred taxation. Goodwill was stated
as being "too technical" but was taken out of the standard spreadsheet used by the company
as an item of singular importance. With reference to the varying methods of 'cost'
determination for stock valuation, the interviewee was not concerned at the possibility of
differences existing between methods because:
"...stocks do not tend to be large and therefore there is no need to worry. Any company that
has understated it's stocks amendment should take place, but I have never come up against
this."
The concept of deferred taxation was confusing for the respondent: he appeared
unsure of what deferred taxation was and seemed to confuse it with basic corporation tax.
Albeit, part of the standard spreadsheet used by the company deducted deferred taxation from
general provisions to study it more closely rather than to exclude this item from analysis.
APPENDIX B.26
B.5 ORGANISATION 5: FIFTH INTERVIEW 28 JUNE 1994
The organisational structure is to assign regions rather than sectors to each fund manager.
The details of the two interviewees are as follows:
• Continental European fund manager. Three and a half years experience in
analysing non-UK financial statements, not qualified as an accountant. Age 35-40.
• Asian fund manager. Twenty five years experience in analysing non-UK accounts.
Partly qualified as an accountant, but to what degree was not specified. Age 45-50.
B.5.1 Continental European fund manager
All countries within Continental Europe are considered for asset allocation with the
exception of Greece and Portugal, being deemed economically unimportant. International
accounting differences were stated as affecting capital market decisions to a high degree. For
example, the Austrian economy was considered, by the respondent, to be one of the strongest
throughout the community, yet investment in Austrian companies is marginal principally
because of the lack of comprehension held by the respondent relating to Austrian accounting
and published figures. This respondent exhibited a strong tendency towards investing in
countries where accounting principles and practices were easier to grasp. Preference was
given to Switzerland, the Netherlands and Nordic countries. On the contrary, Germany, for
not reporting earnings as they should be, and Austria and Italy, for poor level of disclosure,
experienced marginal investment only. With respect to the restriction of investment to
particular sectors due to problematic accounting practices, the insurance sector was avoided
throughout all countries as deemed to be too complex.
APPENDIX B.27
The extent to which the fund manager coped with international accounting differences
by focusing upon information less sensitive to corporate reporting is reflected in the
following quote:
"80% of getting performance right is interpreting macroeconomic information correctly, for
example, GNP, interest rates, inflation."
Trend analysis was carried out utilising brokers' reports from 7-8 different sources.
This involved tracing a company back over a 2 to 3 year period. The inconsistencies and
consequential drawbacks of using profit as a key indicator were recognised and a cash flow
approach was adopted. However, the respondent's definition of cash flow is a derivative of
profit:
Nt. r + I)Kp RI*:I.iIoN + o\c;i u; ± 'tl.M;t s i

/ - i.vi: F1ENi I- \%(
Restatement was not used at all and US GAAP figures were ignored if given, "unless
the company only reported in US GAAP". The reason for this treatment was stated as:
". . . should use domestic figures as I assume the market uses domestic figures... you can't have
half the shareholders focusing upon one set of accounts and the other haiffocusing upon
another. /oa1eie, g eat iáe i%a#re/o1deu wd€ ot al€ 6e dome4tie and t4
doe4 'ø€ dt'4cd. '2e 4eemed aftftaeict ic t(e cctewiew t 'eiftode.ste jd4 4et2
eftt9 i'%e pjmacee o dame eôsa eo4€4ó9. edfteeial4 w.4ee te doe'&eq
APPENDIX B.28

Funds are allocated between countries firstly on the basis of macroeconomic
information, allowing for the aforementioned avoidance of certain countries. Country risk is
high because of this, i.e. investment bias in a number of limited countries (Switzerland, the
Netherlands and Nordic countries) could lead to a majority of shares within the respondent's
portfolio crashing if any one of these countries experienced a large politicalleconomic
problem which would affect its financial markets.
Turning to the interviewee's perception of the general expected profit levels and
specific examples of common accounting practice throughout Europe, Sweden was seen to be
the least conservative accounting regime followed by Norway, the UK, Belgium and France,
with the most secretive accounting regimes to be Germany, Austria and Italy. This would
explain the avoidance/marginal investment in these countries. However, the interviewee
proceeded to state that:
"the underlying profit was probably the highest in these countries but they try to minimise
reported earnings."
ea 6iteet€e *e# dedq eomft4 e4tia (/€4eeoaie4
't&4c eo.t4c'ez4&e COCC 44 (t ejjed4 o 4eeoa9 dâiew4 fto.e 444ee 4El4C4#t, . e.
dedeed eAae ca 4e ed eeo,ømie icd de4c a1e /ee 4et
'4 m49€441 4aa4e e( 4ecot frz4et4e4 ae teo fteAet4cf1e. ,4€do, it dogtd 4 #toted ttat
$c'edem'4 otea€4 e t'Ae moat oewatae coaie4.J
With reference to the treatment of goodwill, the most common practice in the US was
recognised. However, practices common to the UK, Germany and France were not known.
It was not considered important in German companies because:
APPENDIX B.29
"... they tend not to be acquisitive, for example there was not much goodwill in the
BMW/Rover deal."
Generally specific knowledge was not deemed necessary as the information relied upon
comes from brokers' reports which are expected to be both consistent and correct!
The LIFO/FIFO adjustment was considered to be less of an issue because of low
inflation, stated at an average of 2% throughout Europe. It was generally considered
favourable if a company had consistently chosen conservative accounting policies, being
rewarded with a higher rating being granted.
The respondent did not understand deferred taxation nor knew what to do with it.
However, if large deferred tax balances were present in a set of accounts being examined, the
interviewee systematically removed this item from the figures when looking at ratios such as
interest cover and equity to total assets (total assets being perceived easier to deal with than
net assets). However, deferred taxation was not adjusted for if examining gearing ratios
leading to incomparable results.
Finally, with respect to accounting for pension funds, knowledge of specific treatment
and the effects on assets and profit figures was not held:
"Brokers'reports generally do not comment on pension funds but some analysts include them
with interest bearing liabilities, most analysts would not adj ust for pensions."
1 ea4cee4 ddt'A4e. e,c 9 *ace, aaa,ea,ede-

ftwe jd 44 9e1m44 94,4' d 'eqa6e ftwc j fteeiios mtd l9'7. fkmo'e.
APPENDIX B.30
dae eo eaz cde4 9euscat eomfta.ie4 e4dtot ftwiede jo coo'r4e cmde 30 ea' o ae ad jo fzu
e4, a€eh fte#&ogd a'e 644ed aftot j4ral ftae 7i& *4tei41 *O 6€tae &Jddee
t%at atd€ ta&e ae scot #ee4ewjed e t%e lalaee f€et a* attmate4 iYie'e ae deuee
cocde.4e#tce4 j4 ja(a'e ea j1oe4J
B.5.2 Asian fund manager
Accounting diversity was not deemed top be a problem as markets are viewed from a
domestic viewpoint, i.e. it is believed that the price sefters within a market are the domestic
investors, not foreign investors. 1'ees(e e cie o t wocdd dejem€ fto.t 4 eoøçta. jø'
eamftfe dome 44a#c eOmft4ie4 are m4/o4 eU 4 115/Wz ewedt44.J
There was also less of a requirement to focus upon international comparison for the
respondent, as companies are compared against other companies from the same country
rather than across countries. Asset allocation begins with country weighting within the Asian
portfolio. Some countries were avoided but accounting was not given as the sole reason, and
would not alone deter the respondent from investment. No sectors were avoided.
The process of analysis involved trend and ratio analysis. Trend analysis was
conducted with company accounts retrospectively over a period of five years if possible,
although in some countries, for example China, five years of accounting information is not
available. Basic ratio analysis was undertaken for each company, although not always the
same ratios were employed in each instance. Brokers' reports were utilised to source this
information. Restatement was not carried out by the analyst, nor was it expected in the
brokers' reports as it was thought not to be practical or useful! Furthermore, group accounts
APPENDIX B.3 I
published according to UK or US GAAP were not considered useful unless they were the sole
accounts of the company.
With reference to the perceived levels of profiticonservatism within major fmancial
reporting countries, the respondent was in accordance to that generally recognised by
academic doctrine for the UK, US and Japan. Goodwill was not considered important in the
East, as take-overs are not evident, especially in Japan. The differences that arise from the
choice of valuation method for the determination of the valuation of the cost of stock was
only deemed relevant if a company was in risk of having to write-off a lot of unsold/obsolete
inventory. There was a lack of understanding of the concept of deferred taxation and its
effects in the accounts by the respondent:
"Deferred tax is not a problem in South East Asia as a standard rate of tax is used"
The treatment of pensions was considered to be a worrying issue by the interviewee, who
stated that:
".. pensions have a large effect upon the way profits are stated in Japan, especially f a
company has to set aside large amounts due to a lack ofprovisioning in the past.
Demographically, for countries with a generally much younger population, as such is the
case for most ofAsia, pensions are not seen to be an issue yet, but perhaps they will be in 20-
30 years time."
APPENDIX B.32
B.6 ORGANISATION 6: SIXTH INTERVIEW 13 JULY 1994
The organisational structure is to assign regions rather than sectors to each fund
manager. Details of the interviewees are as follows:
South East Asian fund manager, principally Hong Kong, Singapore, Malaysia,
Thailand and the Philippines. Six and a half years experience in analysing non-UK fmancial
statements, not qualified as an accountant. Aged 30-35.
UK fund manager (formerly the US). Although no sectors are assigned for analysis
the interviewee is biased towards consumer companies, beverages, media, publishing,
television and pharmaceutical sectors. Twelve years experience in fund management.
Qualified as an accountant. Aged 50-55.
B.6.1 South East Asia fund manager
International accounting diversity was not viewed as a problem for this respondent
who relied upon brokers' reports to point out the major items of importance and irregularities
within foreign financial statements. However, he was aware of problems inherent within this
area, stating that:
".. there is a great scope for dubious accounting".
Financial statements are viewed as important documents to be referenced when
undertaking analysis but incomprehensible accounting practices resulting in financial
statements that were not easily understood, would not deter the respondent from further
analysis/investment:
"It is more important f a sector is booming to cover this even f the accounting is not
understandable "
APPENDIX B.33
Asset allocation between markets was based on the Morgan Stanley free index, the
notion of the index being 'free" was considered very important as this excludes all companies
whose shares are not fully tradable. Once country targets are decided upon analysis of
individual companies commences.
Trend and ratio analysis were the two most important techniques employed when
undertaking specific asset allocation, trend analysis being performed retrospectively for two
years for each company. Numerous basic ratios were utilised, including profit and loss
margins (sales margin, gross and net profit margin etc.), return on capital employed and cash
flow based ratios. The respondent was aware of the diversity prevalent in PIE ratios between
countries/companies and preferred to use Price/Cash, especially when companies "looked
expensive on the PIE's". Cash flow was, however, based upon a derivative of profit, basically
profit plus depreciation. f7i& t(e ee ftfw&em4 z(e wifta#cdect c to oue'come, C. e. t%e
oj eAe eomeftt o ftwj 444j4c€ Ctdi4t4't i4 i4ewct a ftwftoed dobd#.)
Cash flow statements were considered extremely important and utilised where
available. Although restatement was not carried out, due to time constraints, US GAAP
adjusted accounts were used in preference to domestic accounts when available.
With respect to the degree of conservatism, in the reporting of profits across major
countries examined within the questionnaire, the respondent stated that:
"I have no feeling whatsoever for this, Jam more interested in cash flow and therefore this is
not important"
'4 oj eoceeeo.t4ài'e'uc9 t44 LC.cL'ewCea'ee4
-I
APPENDIX B.34
Goodwill was not considered to be an issue as it was thought to be a rare occurrence
in Asia, as most companies are family owned.thia4 e #ua lie zae, ee jaee ze táe
eift,.edectade4 aoee e.cde 44 a øoddãft4 (/4tee
eaeeae9 j4duc4 camed 4ee4 jo wedtmet Ieeaa4e tQe't 44e4 do wt (eid t'o lie jd4
tada&e. 7a4 e je44 14 ftteed aéo lae acd ma(tiatosaé eftaøu t.4e'ce dtoald lie a
deee o 9oda'& w (4e ae&'at(d aa4e 7(e eodeit ald lie awae o
co#edeecee4 o &jje'tene oodeu& ft4dCe4 uftoc 444et i4€aed ad eftu'ed ftwj4 jaed.)
The respondent was aware of the practice most commonly found within the UK, and
Malaysia was considered to show goodwill as an asset which was amortised over more than
fifteen years.
The issue of a variety of stock valuation methods being adopted in practice was not
considered of importance due to the current low levels of inflation in Asia, although the
respondent considered that this area deserved attention, even though he had never given it.
No adjustments were made either for deferred taxation. This was justified as most far east
countries have a standard rate of taxation and do not make allowances for deferred taxation.
f7 d.oe4 c&e4øate a dea acdi o (Ae eoeeeftt o d4eed (arato. .eo'c c ejjed4
ftoc eftoted ftwj 6a€aiee .4eet ea1ae4]
Pensions were not perceived to be a problem for the next ten to twenty years due to
reasons such as salaries still being very low and the concept of pension provision still being a
relatively new idea within the accounting regimes examined. Whenever pensions provisions
were discovered during analysis, the respondent would adjust "(f relevant", adding back the
provision to cash flow.
APPENDIX B.35
Other areas that the respondent expressed concern about were consolidation, the
capitalisation of interest, treatment of foreign exchange loss/gain, transfer pricing and holiday
taxes, the former UK/US colonies representing less of a problem due to the origins of their
accounting systems and the adoption of International Accounting Standards. f7e adofa!eo oj
'i/IS diie 4e4'4m44llq 'tefre4oet dt4dadi4a(i4c oj ft'aet4e tfwtoat tke coa.ttde dae
eAe &e aada&e w& eae4 atacd, 7e'teje comá€iaeee 4 com.fta*4 wi%á 'i/IS
'xeemeKt4 d.oe4 eaq ad eomftaJ&q ad ti4 'e4fto.tdefft fteeebie4j
B.6.2 UK fund manager
This fund manager currently deals with certain sectors within the UK fmancial
market, therefore he does not currently deal directly with any international fmancial
statement analysis, but has in the past. The following is therefore retrospective where dealing
specifically with this area.
International accounting diversity was considered a barrier to country investment

would could deter investment in an individual company.
Asset allocation is carried out by senior management. The process involves
comparing in-house forecasts with forecasts available from outside sources. These forecasts
are based upon economic data. The resulting weightings form the targets for individual fund
managers.
Individual companies are chosen using a bench-mark, for example the US S&P 500
index. Valuations are then undertaken, principally through fundamental analysis (described
APPENDIX B.36
below)and compared to the valuation given via the index. If the former exceeds the index
valuation, investment takes place.
Part of the aforementioned fundamental analysis undertaken is trend analysis, tracing
the financial reports of a company back over a period of five to ten years. On screen
information is used to extract standard formulae from the financial statements. Around six
basic ratios are extracted, including EPS, PIE and Price/Cash flow. Price to cash flow was
considered a useful tool as it strips out problems inherent in accounting policies. However,
this was not considered to supplant the P/E ratio. The definition of cash flow used was not
obtained. Other information less sensitive to corporate reporting, such as macroeconomic
data, was utilised, for example, monthly economic reports covering basic issues such as
inflation, exchange rates and interest rates. Restatement was not carried out, but when asked
if US GAAP information would be used, the respondent initially agreed and stated:
"This would be the basis for certain adjustments, for example provision accounting for
pensions."
However, later in the interview the respondent contradicted himself stating that:
"US GAAP is ignored unless the bulk of the shareholders are US investors, as I prefer to
adopt a domestic perspective."
The respondent had a relatively clear idea as to the degree of conservatism, as
generally recognised by academic doctrine, in reported profit figures of different GAAP

regimes.
Turning to specific accounting differences, the interviewee correctly identified the

most commonly found practices for the treatment of goodwill in the UK and US. The effects
of different methods being adopted for the valuation of stock were thought to be less of an
APPENDIX B.37
issue due to falling inflation and an increase in stock turnover. fSeocá t iøee' daed stat 4cte
acejjeee cfto ede m44 Qaeed %e cdd dto o eede T7O. ,1O 4TO, eda4
edi4 #øt a eaE4' w4o.c j4 te9éeetâi9 ed ae4 o aecoeat diedie ah4 C4.t ae'e *ate'ë4€
ejjed oc 6t4 ebted ftwj4' leud4 4* 444et eIdta4tio#j
Confusion was evident when questioning the fund manager with respect to the
treatment of deferred taxation. Firstly, the respondent expected the largest deferred taxation
balances to be present in UK rather than US financial statements. t 7 c&ee e e
eoeet.
ftwaeaio#e jo d4eed eata4a#c da.J Secondly, reasons stated for the large balances
found in the UK were:
"Companies tend to have far more conservative policies for depreciation than the Inland
Revenue (capital allowances)."
ede cftfto4eee id
"I would distinguish between deferred tax in the UK and US as in the US it becomes an
eventual liability, whereas in the UK it could go on forever."
fOcce aa e4e euede id *oe eoeet' 44 ft4€ ftoco# ea4e4 ede ',eeô * # o ed44e 9
djj.eiee4 9c9 'ti4e eO dejeed tax w4 ae eeded e 'ee e je4ee4&e jaea'e e. e.
evftecte4' to c$ta&4e 4004Pc.J
jTVo
APPENDIX B.38

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THE UNIVERSITY OF READING

Thesis for Doctor of Philosophy Degree

International Financial Statement Analysis:

15th January 1996

Globalisation of securities markets has caused many members of the investment

is used by London-based participants in the market. Hypotheses are established after

the small amount of published research in an international context. Seventeen market

If this sample is representative, the findings suggest that most market

participants are inexpert in accounting; sector experts see international accounting

and there is very little knowledge of international accounting differences.

2. ACCOUNTING THEORY; PERCEPTIONS AND CAPITAL

2.1 Domestic accounting choice from a domestic stock market

2.2 The role of analysts in equity valuation 8

3. ACCOUNTING CHOICE AND THE BEHAVIOUR OF THJ

4.3.5 Fixed asset valuation 57

4.3.7 Reserves and provisions 60

5. INTERNATIONAL FINANCIAL STATEMENT ANALYSIS

(a) Depreciation of tangible fixed assets 80

(h) Pension costs 85

(j) Revaluation of fixed assets 86

(n) Disposal of a subsidiary 88

(q) Foreign currency translation 89

(r) Debt/share issue costs 89

(u) Restructuring provisions 90

6.3.1 Statistical measures of dispersion 110

(b) The co-efficient of variation 111

(a) Least squares method 112

(b) The coefficient of determination 113

(c) Testing for significance 114

(d) The Wilcoxon test 114

(e) Pearson product moment correlation coefficient 115

(f) Spearman rank correlation coefficient 115

6.3.6 Previous research employing market based research techniques 115

6.4 Summary 117

7. PROPOSAL FOR STUDY, HYPOTHESES, METHODOLOGY

7.1 Introduction and purpose of study 119

9. INTERVIEW SURVEY RESULTS

9.2.2 Do analysts restrict foreign investment to countries with more

(e) Other techniques 196

9.2.6 Are analysts aware of the existence of international 197

accounting differences that effectldistort reported earnings?

9.2.7 Are analysts aware of the international diversity between 200

specific generally accepted practices?

(b) The determination of cost for stocks 212

(c) Deferred taxation 215

(d) Other differences: 224

(i) Accounting for pensions 230

(ii) Leases 231

9.3 Concluding remarks and summary of findings 232

APPENDIX B: SUMMARISED NOTES TAKEN FROM I]NTERVIEWS

INTRODUCTION, PURPOSE AND REVIEW OF CONTENTS

in an attempt to establish the following:

users of this information cope?

1.2 GLOBALISATION OF FINANCIAL MARKETS

Scott-Quinn, 1991 and Smith, 1991).

1991, p2). Further examples are given in Table 1.1.

1.3 THE NEED FOR FOREIGN CORPORATE FiNANCIAL INFORMATION

of the world's major exchanges.'

"Continued reduction in national trade barriers, the emergence of Europe as a unified

market, the convergence of consumer tastes and preferences, as well as growing

sophistication of business firms in penetrating foreign markets, directly or indirectly through

competitive context of multinational business" (Bartlett and Ghoshal, 1989).

1 Derived from J. Cochrane (1994, p13).