Tuesday, March 31, 2009

International Investors Beware

Today's investor is encouraged to diversify his portfolio not only by industry but also by geography. But when comparing companies across international boundaries, investors must be cognizant of the existence of varied accounting rules by country GAAP. That is, identical companies will show different results depending on which country's GAAP each is following.

For the average investor who is not privy to the internal accounting discussions of a company under study, comparing results by taking country GAAP into account is a tall order. Certain adjustments may be made related to depreciation methods (e.g. straight line vs accelerated) or useful life assumptions, but in general many investors may simply ignore the differences which they cannot quantify.

Sidney Gray and Lee Radebaugh offer some help to our investor. In their research, they have attempted to normalize accounting results by measuring the conservative accounting levels of various country GAAPs into consideration. The following table illustrates their results:

According to the study, companies in the UK are the most optimistic, and not by a slight margin. In general, this would require reducing earnings from a UK company by almost 25% for it to be comparable to an American company. At the other end of the spectrum, Japan uses the most conservative accounting methods, showing profits almost 40% lower than what would be shown by an American peer. 

It should be noted, however, that this study was published in 1997, and since then there has been a progressive movement towards IFRS as a standard rather than individual country GAAPs. Therefore, the study will no longer be relevant for several of the countries surveyed. Nevertheless, when comparing companies, the prudent investor will adjust for the fact that different accounting principles will yield different results.

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