CFA Institute

GAAP Arbitrage: Valuation Opportunities in International Accounting Standards

Author(s): Lawrence S. Speidell and Vinod B. Bavishi
Source: Financial Analysts Journal, Vol. 48, No. 6 (Nov. - Dec., 1992), pp. 58-66
Published by: CFA Institute
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in

GAAP Arbitrage: Valuation Opportunities

International Accounting Standards

have accounted for over $200 billion annually, stimulated by

changes in the European Community and the raising of the Iron
Curtain.

flow of cross-border equity investing, now over $1.2 trillion, is

expected to grow to $2.5 billion
by the mid-1990s and $13 trillion
Accounting standards diffler in 20 years. In the U.S. alone,
institutional investors are 6% ingreatly across countries.
vested abroad and will shortly be
But the differences can
moving to 10% and more.

Lawrence S. Speideli and

Vinod B. Bavishi

Governments have responded to

the economic imperative of capipresent opportunities for
talism and are scrapping the cenFigure A illustrates the current tral planning of communist and
those able and willing to
world of equity markets, repre- socialist regimes. They all want to
make the effort to underwill fulfill the dreams of their people
stand and adjust for them. sented by size. The map
change as equity capital markets and to become the next Japan,
grow in the newly capitalist coun- Korea or Taiwan. This cannot
In a recent project, the acand Asia. happen if capital is allocated simcounting statments of over tries of Eastern Europe
ply where financial reports are
100 companies in 12 devel- Corporations have historically clearest, rather than where costs
oped and emerging councared more about internal than are lowest or profit opportunities
external reporting. But as product highest.
tries were restated to apmarkets are becoming more gloproximate common
merger activityhas increased, The objective of an efficient global,
accounting standards.
bal capital market faces a major
combining
with companies
Companies in Sweden and
across country borders and obstacle in the labyrinth of comGermany showed the bigacross accounting borders. Cross- plex and obscure accounting
gest gains from restatement. border mergers and acquisitions practices prevalent around the

On average, these companies' net incomes increased

by 60% and 44%, respectively, while shareholders'
equity increased by 44%
and 41%.

Figure A

1990 Market Capitalizations of Developed and Emerging Markets

(millions of U.S. dollars)

Daen
LL

LU

"A good plan, violently executed right now is far better

than a perfect plan executed
next week."

States
Lnited

Tnda

General George Patton

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?17 Bbados

a
.

Shareholders, corporations and

depend more
governments
heavily now than ever before on
accurate and comparable global
financial data. Shareholders, the
traditional clients of financial reports, have become much more
numerous and widespread.

B..

PueVraela
XBSt~ &Tnbago<e

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Argentina

Kenya
Zimbabwee

lPhivjlpines
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& ii

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The global equity markets now

total over $12 trillion, compared
58 with $2.7 trillion in 1980. And the

0-5000

5001-25,000

25,001-100,000

100,001-200,000

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200,001-1,000,000
Over 1,000,000

Figure B

Nobes' Classification of Accounting Systems

Community have not produced

agreement on common accounting standards.

Financial Reporting
Practices

II
Micro-Based

Class

Subclass

Macro-Uniform

Business Practice,
Pragmatic, British
Origin

Business
Economics,
Theory

Continental
Government,Tax Legal

U.K. Influence

Family

Species

U.S. Influence

Tax-Based

7 4 7

rT

Government,
Economics

Law-Based

71L

Ca

~~.~~~

2.

~ ~ ~ ~

:2

i.

But the opportunities may outweigh the inadequacies of imperfect accounting data. Generally
Accepted Accounting Principles
(GAAP) may someday be the
same around the world; meanwhile, arbitrage opportunities
across accounting regimes can
lead to profitable investments.
Our adjustment and reconciliation techniques may not be perfect, but they are timely; and as
General Patton would agree, in
investing as in war, timeliness is
more important than perfection.

Source: C.W. Nobes 'International Classification of Accounting Systems` (April 1980), Table C.

Table I Cost Basis of Financial

Statements, 1990
world. While revolutionaries are
quick to change political, legal
and economic structures, they
rarely tackle the task of legislating
uniform accounting. Even at the
international level, the Interna-

Figure C

tional Accounting StandardsCom- Historical Cost Basis

mittee, the International FederaCanada
tion of Accountants,
the
United States
Austria
Organizationfor Economic CoopGermany
eration and Development, the
Switzerland
United Nations and the European

Timeliness of Publication of Annual Reports, Fiscal Year 1990

Pakistan

129

Italy

12(0

France

112
Ill

Belgium
India

1112

Germany

1(0

Hong Kong

99

Austria

99

Malaysia

98

Japan

92

United Kingdom

90

Mexico

89
86

Netherlands
811

Singapore

81

Finland
Spain

79

Australia

79

Switzerland

Averge

umber

Days Elapsed Between

Fiscal Year-End and
the Date of Auditor's
Report

Asia/Pacific

73
52

Thailand
United Staes

Europe

47

Brazil

North America

47

South Korea

45

Canad

South

45

Chile

34_

America

20

40

60

Source: InternationalAccountingand Auiditing Trends. 2nd edition.

80

100

120

140

South Africa
Japan
Pakistan
Thailand
Historical Cost with Price Level
Adjusted
Colombia
Chile
France
Netherlands
Norway
Portugal
Spain
Sweden
United Kingdom
Malaysia
Singapore
New Zealand
Historical Cost with Current Cost
Data
Mexico
Brazil
Current Cost Data
Argentina
Historical Cost with Revaluation
Belgium
Denmark
Finland
Italy
Hong Kong
India
Korea
Australia
Source:Cfarbase.

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LUL

m
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,.,

59

Table Im Long-Tern Investments sions of the internationalbodies.

(20%-50% owned), It is thus importantfor users of
Throughthe years,local practitio1990
globalfinancialstatementsto turn
ners have developed accounting

History of GAAP

standards primarily to fill the

needs of local commerce. Governmentshave steppedin to control accountingfor tax purposes.
The result is a patchworkof systems with differing theoretical
and conceptualfoundations.Figure B diagramsthese as a family
tree with two principalbranchesmicro-based, company-level accounting,fromwhichthe U.S.and
U.K. systems are derived, and
macro-based, government-imposed systems, often heavily influenced by tax policies, which
prevail throughout most of Europe.

Table II Consolidation Pracdces,

1990

LU

LU

UJ

LUJ

z
z
0

z
-J

No Consolidation
India
All Subsidiaries Consolidated
Canada
Mexico
United States
Argentina
Brazil
Chile
Venezuela
Austria
Belgium
Denmark
Finland
France
Germany
Italy
Netherlands
Norway
Spain
Sweden
Switzerland
United Kingdom
South Africa
Hong Kong
Malaysia
Singapore
Thailand
Australia
New Zealand
Domestic Consolidation, Others at
Cost
Japan
Korea
Domestic Consolidation, Others at
Equity
Taiwan

60 Source:Cfarbase.

Equity Method
Canada
United States
Brazil
France
Netherlands
United Kingdom
South Africa
Taiwan

New Zealand
Cost Method
Austria
Belgium
Germany
India
Pakistan
Thailand
Cost and/or Equity Method
Mexico
Chile
Venezuela
Denmark
Finland
Italy
Norway
Portugal
Spain

Sweden
Switzerland
Hong Kong
Japan
Korea
Malaysia
Singapore
Equity Method but Partially
Consolidated
Australia
Source: Cfarbase.

Both the U.S. and the U.K.systems

have spawned siblings in related
countries. U.S. GAAPhas a heavy
influence in Canada, Japan, the
Philippines and Mexico, while the
U.K.system has prevailed in many
of the Commonwealth countries.
Within these broad groups, however, there remain many differences resulting from strong national professional groups.
Despite our desire for comparability in global accounting, there
would be no net gain if comparability required undermining the
vitality of these national accounting organizations. Furthermore,
total comparabilitydoes not seem
likely in the near fulture,given the
vigorous debate at recent ses-

from complaintsto analysis,and

to view global accountingdifferences as an opportunityto profit
from carefulreconciliation.

Philosophical
Differences
Differencesin philosophyacross
accountingregimes are often intractable,because often there is
simply no right answer.Alternatives exist because different
points of view can be equally
valid.Globalcommercemayone
day producea consensus,but for
now thatoutcomeis as unlikelyas
havingautomobilesdrive on the
right side of every nation'shighways.Users must be made aware
of these differences and must
Table IV Inventory Valuation
Method, 1990
Mixed
Canada
United States
Chile
Austria
Belgium
France
Germany
Italy
Switzerland
Japan
Korea
Average Cost Method
Mexico
Brazil
Spain
Hong Kong
Malaysia
Pakistan
Singapore
Taiwan
First-In-First-Out Method (FIFO)
Denmark
Finland
Netherlands
Norway
Sweden
United Kingdom
South Africa
India
Thailand
Australia
New Zealand
Last-In-First-Out Method (LIFO)
Venezuela
Source: Cfarbase.

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Table V Depreciation Method, Figure D

Classification of Companies by Year-End Dates, Fiscal Year 1990

1990
Straight-Line Method
100

Canada
Mexico
United States
Argentina
Brazil
Chile
Venezuela
Belgium
Denmark
France
Italy
Netherlands
Portugal
Spain
Switzerland
United Kingdom
South Africa
Hong Kong
India
Malaysia
Pakistan
Singapore
Taiwan
Thailand
Australia
New Zealand

-1

Australia-138 Companies

79

80

Canada-315 Companies
72

Japan- 2,692 Companies

6
606o
2
40

United Kingdom- 549 Companies

~~~~~~~~~~~~~~~~~
47

States 2,919 Companies

_United
-

28

201

15

14

January - March

16

14 14

11

April - June

15t

July - September

October - December

X, of Companies with Year-End Dates Between

Source:Cfarbase.

Accelerated Method
Sweden
Japan
Korea

Straight-Line and/or Accelerated

Method
Finland
Germany
Norway

make their best effort to adjustfor Cost Basis of Financial Statethem. Major philosophical differ- ments: While historical cost was
ences include the following.
hardly questioned 20 years ago, it
Figure E

Business Segment Data

Source: Cfarbase.
Australia

76
82

59

Canada

r14
tN

63
82

Table VI Frequency of Interim

Financial Statements,

LL
0)

France

6
28

1990
Germany

Two Per Year

LU

Assets

cl
LU

Income
41

France
Germany
Spain
Switzerland
United Kingdom
Japan
South Korea

Sales
Japan

60
79

I,::
J

Singapore

93

zU

88

Three Per Year

13

Norway

U.K.

72

Four Per Year

80

Canada
Mexico
United States

20

40

60

80

% Disclosure

Source:International Accounting and Auditing Trends, 2nd ed.

Source:Cfarbase.

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U
100

z
z

61

Percentage of Companies Audited by Leading Accounting Firms

Figure F

Table VII Availabilityof EnglishLangugage Financial

Statements,1990

U.S.

98%

Italy

97%

Chile

96%

U.K.

94%

Japan

88%

Germany

87%
80

Spain
69%

Mexico

69%

Belgium

65%

Switzerland
58%

France
50%

Brazil
27%

India
Israel

ox

7~~~~~
0

20

40

60

j#I 'g
80

andAuditingTreds, 2nd edition.

Source:InternationalAccounting

is the sole basis today mainly in

the U.S.,Japan, Germany, Canada,
Switzerland, Austriaand South Africa. As Table I shows, adjustments for inflation are now common elsewhere.
Consolidation Practices: Significant corporate activities are often
missing from company reports
because of a failure to provide
consolidated statements. This is a
significant problem for financial

statement users in Japan,

and Taiwan (see Table lI).

India

Malaysia
Pakistan
Singapore
Australia
New Zealand
More than 40% Report in English
Chile
Venezuela
Belgium
Denmark
Finland
Netherlands
100
Norway
Portugal
Spain
Sweden
Switzerland
Japan
Taiwan
Thailand
Korea Less
than 40% Report in England

Mexico

Accountingfor Long-TermInvestments: The pattern of accounting

for investments of 20% to 50% of
equity is similar to that for consolidation of majority-owned subsidiaries, as Table ILLshows. Only
in a few countries, including the
U.S., the U.K., Canada, Singapore
and Australia, can one expect all
"tcontrol"interests to be fully re-

Figure G

Percentage of Analysts in Agreement on Last Year's EPS

LU

100

Canada

z
D

-J

z
-J

100%

U.K.

100%
100%

Germany
France
Spain
Italy
Switzerland

99%
96%
88%
84%
79%

z
6
0

62

japan
U.S.

Source:
1/BIE/S.

20

40

60

SO

Argentina
Brazil
Austria
France
Germany
Italy
Korea
Source: Cfarbase.

flected in the income stream.

Elsewhere (most notably in Germany), these positions are accounted for on a cost basis, with
only dividends recognized in income.

UJ
LLI

Report in English
AlU Conpanies
Canada
United States
United Kingdom
South Africa
Hong Kong

100

In Japan, where accounting for

both majority and minority interests varies widely, comparative
analysis of companies is extremely complex because of the
popularity of cross-holdings.
These are the foundation of the
powerful cooperative company
groups known as keiretsu. The
organization chart of the Tokyo
Group, for example, looks like
the web of a drunken spider and
includes 334 firms with interests
in railroads, hotels, construction,

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Figure H

Adjusted versus Reported Income

Sweden

______60_

Germany

in availability of annual reports,

when most U.S. and U.K. companies deliver them in three
months. Surprisingly, Germany,
France and Italy are among the
worst offenders in this regard
(see Figure C).

2
26~~~~~4
28

12

Japan
Italy
9

Belgium
6

France
r

Australia

Net Income

OperatingIncome

U.K.
Switzerland

-8

-10

10

20

30

50

40

60

70

Interim Statements: While quarterly reports are the standard in

the U.S., Canada and Mexico,
most companies in other countries provide only semiannual
data (Table VI). Comparisons
quickly lose validity when based
on old data. This problem becomes particularly important
when fiscal-year dates differ; this
is the case when comparing most
Japanese companies, which use a
Marchfiscal year, with those elsewhere (see Figure D).

% Change

Segment Disclosure: In the U.S.,

the Financial Accounting Standards Board mandated businessairlines and retail. This complex- not. High-quality accounting is segment disclosure with Stateity recently increased when the imperative, and anything less ment 16 in 1976. Elsewhere many
group established an antitakeover costs companies dearly in lower companies have voluntarily made
plan under which 35% of each stock prices and higher capital this disclosure. As Figure E
listed company would be held by costs. The world standard should shows, however, coverage is still
other group members.
be full, prompt and reliable dis- spotty.
closure, and in this respect, many
Inventory-Valuation Methods: As nations fall short.
Leading Accounting Firms:While
Table IVshows, these varywidely,
many small firms do excellent
with first-in, first-out used in the Timeliness: There is no justifica- work, their independence is
U.K. and Scandinavia,while aver- tion for a delay of over six months sometimes subject to question.
age cost is used nearly everywhere else. Recently, controversy
increased when the IASC indi- Figure I Adjusted versus Reported Book Value
cated its disapproval of last-in,
first-out accounting, a popular alternative in the U.S.
Sweden

Depreciation: Depreciation methods cause some of the most dramatic comparability problems for
global investors. While most U.S.
investors expect to see straightline depreciation, accelerated depreciation, which tends to understate earnings, is most popular in
Japan and Korea. Meanwhile, excess (often arbitrary) depreciation charges are sometimes used
to smooth earnings in continental
Europe (see Table V).

Quality Differences
While the many philosophical differences can be subject to endless
debate, quality differences can-

0)
LUl
m
LLU

44

Germany

41
CD
LU
UJ

Japan

14

Switzerland

Australia

U.K.

-14

Belgium

-14

France

-28

Italy

-28

-40

z
U

-30

-20

II
-10

z
0

10

% Change

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20

30

40

50

63

Figure J

Adjusted versus Reported Price/Earnings Ratio

Australia

124.1

ReportedP/E

12.6
11.4

France

Adjusted P/E
26.5

Germany
71.I

Japan
Switzerland

1(1.5|
9.5

10

20

30

The leading accounting firms uphold a high standard, but smaller

firms, particularly in emerging
markets (such as India) may be
heavily influenced by their clients. Figure F shows the percentage of various countries' firms
audited by large accounting firms.

Earnings Per Share: An example

of improvement in comparability
is shown in Figure G, which reflects the influence of I/B/E/S(the
Institutional Brokers Estimate
System) on financial analysts' behavior. I/B/E/S has been collecting Wall Street brokers' earnings
estimates for U.S. companies
since 1971, but it only began collecting abroad in 1986. At that
time, analysts often could not
agree on what companies had
earned in the prior year, let alone
their estimate for the future. Today, the situation is much improved, although it is still weak in
southern Europe.

After making our adjustments,we

calculated the net changes in the
income statement, balance sheet
and ratios such as P/E and price/
Thirty-six companies with
book.
Accounting Adjustments
changes were eliminated
extreme
In the art world, it is sometimes to produce summary data for 83
said that a piece is never com- companies.
pleted, the artist has simply
stopped working on it for a while. The changes of greatest signifiSo too in accounting. Financial cance for valuation may be those
statements are never complete or affecting the income statement.
perfect, they are simply a "best Figure H summarizes the direcguess" at a given point in time. tion and magnitude of changes in
History will judge them to have operating income and net income
been close or otherwise, but it by country (using the equalwill rarely find them perfect. This weighted average). When adsimplifies the task of adjustment; justed to a uniform global stanto achieve significant gains in glo- dard, Sweden and Germany show
bal comparability, we need not the greatest gains, with net instrive for absolute precision.
come increases of 60% and 44%,
respectively. Next come Japan, ItWe analyzed over 100 companies aly and Belgium with gains of
from 12 countries and five broad 12%, 11% and 4%. Only Switzerindustrygroups (consumer goods, land showed a decline.
capital goods, basic industries,
There were also significant
utilities and transportation).
These companies were selected changes on the balance sheet,
from the 900 largest global com- shown in Figure I. Again, Sweden
panies ranked by sales, assets and and Germany were big gainers,
with increases of 44% and 41% in
market capitalization.
40

Figure K

Language: While it may seem arrogant or lazy on the part of English-speaking people to expect
financial statements in English,
0:
our language has become a standard for business around the
world. Already, many companies
z
publish English language annual
reports (see Table VII). We hope
64 to see the percentage increase,
particularly in continental Europe. Users must be careful, however, because there is often more
detail in the local language reports.
LU

451

12.7

U.K.

L1J

Using a spreadsheet template, adjustments were make to standardize accounting for depreciation,
non-equity and discretionary reserves, goodwill, consolidation,
valuation of investment, asset revaluation, inventory adjustments,
intercompany transactions, foreign currency translation, extraordinary items and deferred
taxes. The appendix describes the
adjustments for one company,
Bayer AG.

50

60

80

70

Adjusted versus Reported Price/Book Value Ratio

16

Australia

2.(4

2.32
_3.25~~~~~~~~~~~~~~~~~~~~~~~~~~~~.

France
Germany

1.61

~~~~~~~~~~~~~~~~~~~~~~~~
Japan

1.1

_2.GI_3.18
P/BV

Switzerland

__Reported
2._17

1.9.3

Adjusted P/BV

2.2()0

U.K.

2.30_

0.0

1.0

2.0

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4.0

shareholders' equity. At the other

extreme, French and Italian companies had a 28% reduction in
equity.
Figures J and K show the changes
in P/E and price/book for these
markets when going from reported to adjusted bases.

Conclusion

Table AI Accounting Restatement for German Multinational

ChemicalCompanyBAYER
AGForFiscalYearendingon
December 31, 1990 (in millions of DM)
1. Operating Income
As Reported
3,551

+
+

Add back excess depreciation

1,341

Adjusted
4,892

Change
+38%

2. Shareholders' Equity
* Add back cumulative effect of excess depreciation after tax
* Add back special non-equity reserves

+
As Reported
Adjustments
We adjusted standardstoward the
15,545
6,795
U.S/U.K. conventions. This resulted in large changes in Ger- 3. Price/EarningsRatio
Will reduce from 7.2 to 5.6 (22% reduction)
man, Japanese, Swedish and Swiss
reported figures. Regardless of 4. Price/Book Ratio
Will reduce from 0.9 to 0.6 (32% reduction)
the norm chosen, however, those
countries appear to understate
values by amounts that are sometimes very significant.

Furthermore, there is evidence

that capital markets are not making a complete reconciliation for
these differences. Over time they
will, as analysts make more complete adjustments and as accountants make progress toward global standards. As this occurs,
capital markets will become more
efficient, and financial rewards
will accrue to those investors who
anticipate the direction of
changes in valuation. Meanwhile,
it is the responsibility of investors
and all other users of financial
statements to press for improved
global accounting, based on full
disclosure, so philosophical differences can be reconciled, and
on the standard of uniform high
quality around the world.

=
=

=
=

Adjusted
22,340

Change
44%

exceed three times the amount depreciation expenses on the

computed using the straight-line straight-linemethod (althoughits
method in any given year (i.e., size is about6%of Bayer's).Table
depreciationchargedduring the All compares Bayer and Wella.
year is limited to three times the After the adjustmentsto Bayer,
straight-linedepreciation,regard- accumulated depreciation as a
less of the method used).
percentageof adjustedtotalassets
is similar to Wella, at 28%, but
Basedon the rulesabove,an asset depreciation expense as a perwith a 30-yearlife will be fully centage of sales is still higher,at
depreciated in approximately 4%,comparedwith Wella's2.6%.
nine years. Because the majority
of assetsare depreciatedin sucha Alternatively,one can assume
shortperiod,the measurementof Bayer'soperatingstructureis simthe actuallife of assetsis difficult. ilar to thatof other multinational
corporationsin the same indusOne can use the averagedepreci- try.The averagedepreciationexation expense to sales or cost of pense for these major multinagoods sold of a similarcompany tional corporationscan then be
for estimation. For example, used as an approximationfor BayWella AG in Germanyprovides er's.TableAIIIillustratesthe pro-

(N

a,
a,

Table All Adjustment for Depreciation, Method 1 (fiscal year

Appendix

1990)

Bayer Restatement
Table AI shows the accounting
restatement for Bayer. The single Sales
most significant factor in the re- Total Operating Expenses
Assets
statement is depreciation ex- Total
Gross Fixed Assets
pense. This is true for many other Depreciation Unadjusted
German companies.
(% of Sales)
The method allowed by regulation is the declining-balance
method until the depreciation by
the straight-line method is
greater. The straight-line method
is used from that point. Also, depreciation computed using the
declining-balance method cannot

Depreciation Exp. Adjusted

(% of Sales)
Depreciation Method
Accumulated Dep. Unadj.
(% of Total Assets)
(% of Gross Fixed Asset)
Adjusted Total Assets
Accum. Dep. Adj.
(% of Adj. Total Assets)

LU

Bayer
41,643.000
38,092.002
37,947.000
43,800.000
3,034.000
7.29%
1693.000
4.00%
Tax Rules
29,841.000
78.64%
68.13%
53,013.000
14,775.000
27.87%

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LUS
Wella
2,562.000
2,435.000
1,728.000 z
762.000
67.000
2.62% z
67.000 D
2.62% 0
Straightline
394.000
22.80% -J
51.71% 65

Table AIII Adjustmentfor Depreciation,Method 2

Sales in U.S. Dollars
Pharmaceutical% Sales
Dep. Method
Unadj. Dep. Exp. % Sales
Adj. Dep. % Sales
Accum. Dep. % Assets Unadj.
Accum. Dep. % Assets Adj.

Bayer
27,900.810
19%
Tax Rules
7.30%
4.00%
78.60%
27.87

ICI
24,521.400
11%
SL Method
4.10%

Sandoz
9,650.000
46%
SL Method
5.80%

Ciba-Geigy
15,360.000
32%
Depr. CurrentValue
5.50%

43.00%

20.40%

N/A

cedure. One drawbackto this approach is that it raises cyclical

issues in evaluating companies
thatare exposed to differingeconomic conditions in different
countries.
Non-equity reserves are also a
problem in restating Bayer accounting figures. Some types of
reservesare clearlyspecifiedand
can be easily restated.However,
reservesare sometimesmixed together and not clearly specified.
At Bayer, for example, reserves
for futureuncertainbusiness risk
are mixed with reservesfor vacation and bonus.

an'
a:'
0)
uJ

Some estimatesmust be made to

restate these reserves. One approachis to estimatecertainparts
of operating reserves. Reserves
for vacation,for example,can be
estimated from companies in
neighboringcountrieswith similar cultures.These estimatedoperatingreserves can then be deducted from mixed provisions
and the remaindercan be added
back to income.

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