DIFFERENCES IN ACCOUNTING PRACTICES

Political, cultural, legal, and economic forces affect each country’s philosophy
and attitude toward its accounting system. They also affect the way a country’s
accountants treat different accounting issues. These different treatments in turn
impact a firm’s reported profits, the value of its assets, its tax bill, and its
decision to begin or continue operating in a country. International businesses that
rely on foreign accounting records but fail to recognize these differences may make
expensive, perhaps fatal, strategic errors and operating mistakes, as “Venturing
Abroad” suggests. Let U.S. look at some of the more important national accounting
differences that affect international business.

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VALUATION AND REVALUATION OF ASSETS
Most countries’ accounting systems begin with the assumption that a firm’s assets
should be valued on a historical cost basis. That is, an asset is carried on the
firm’s books according to the asset’s original cost, less depreciation. Because of
inflation, however, the market value of an asset is often higher than its
historical cost. The reso- lution of this problem differs among national accounting
systems. Dutch firms are permitted to raise the value of such assets on their
balance sheets to reflect the assets’ true replacement value. British accountants
may exercise their professional discretion and value assets on a historical cost
basis, a current cost basis, or a mixture of the two. Australia, an inheritor of
British account- ing philosophy, similarly grants a firm’s accountants a great
degree of professional discretion. Australian firms may alter the value of long-
term assets on their balance sheets to take into account inflation or improved
economic conditions. In the United States and Japan, however, such upward
revaluations are illegal. These differences in asset revaluation procedures suggest
the need for caution when comparing the strength of balance sheets of firms from
different countries.

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VALUATION OF INVENTORIES
Every introductory accounting course discusses the two principal methods for
valuing inventories: last in, first out (LIFO) and first in, first out (FIFO). In
times of inflation LIFO tends to raise the firm’s reported costs of goods sold,
lower the book value of its inventories, and reduce its reported profits (and,
presumably, its taxes) more than FIFO does, whereas FIFO produces a clearer
estimate of the value of the firm’s existing inventories than does LIFO. Thus, in
comparing the performance of two firms, one needs to know which tech- nique each
uses to value its inventories. There are significant international differences in
the use of the two methods. U.S. and Canadian firms may use either approach. In
China and India LIFO cannot be used, whereas in Japan LIFO is permitted. Firms in
Brazil and the United Kingdom normally use only FIFO.

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DEALING WITH THE TAX AUTHORITIES
A firm’s accounting records form the basis for assessing its income tax burden. In
Germany accounting procedures are detailed explicitly in the German Commercial Code
and follow the requirements of German tax laws. A German firm’s taxable income is
measured by the contents of the firm’s financial records. Normally no distinction
is made between financial statements reported to shareholders and finan- cial
statements reported to German tax authorities. The United States follows a
different approach. U.S. firms commonly report two different sets of financial
statements—one to the Internal Revenue Service (IRS) and one to shareholders. Such
conduct is authorized by U.S. law and allows firms to take advantage of special tax
code provisions to reduce their taxable income. For example, U.S. firms often use
accelerated depreciation for tax purposes but not for financial-reporting purposes.
A German firm normally does not have this option. If it wants to use accelerated
depreciation for tax-reporting purposes (to reduce its current-year taxes), the
firm also must use accelerated depreciation in reporting to its shareholders (which
reduces its reported income).
Forced to choose between higher taxes and lower reported income, most German firms
opt for the latter. Managers and investors need to recognize that the reported
profits of German firms are thus biased downward. The inflexibility of Germany’s
accounting system seems to put German firms at a disadvantage in raising capital.
However, German firms typically obtain most of their capital from large financial
intermediaries like banks and insurance firms. These inside investors have access
to more detailed information about the firm’s performance than is avail- able in
its public financial statements published in its annual report.

Tax laws also play a major role in French accounting practices, which follow well-
defined procedures detailed by the French government in the national uniform chart
of accounts. As in the German system, no deductions for tax purposes may be taken
unless they have been entered into the firm’s annual accounting records. Because of
the dominance of tax law in accounting judgments, French firms are likely to bias
their reported earnings and net assets downward to reduce their tax burdens.

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USE OF ACCOUNTING RESERVES
Another important difference in national accounting systems is in the use of
accounting reserves, which are accounts created in a firm’s financial reports to
record foreseeable future expenses that might affect its operations. An office
supplies whole- saler, for example, might establish a reserve account for bad debts
and for returned merchandise, knowing that when it ships merchandise, some
retailers will ship the goods back and some will fail to pay their bills. The use
of accounting reserves by U.S. firms is carefully monitored and limited by the IRS
and the SEC. The IRS dislikes accounting reserves because charges to them reduce a
firm’s taxable income. The SEC fears that firms might manipulate their accounting
reserves to provide misleading pictures of their financial performance.

In contrast to the restrictive U.S. system, the German Commercial Code liberally
permits German firms to establish accounting reserves for various potential future
expenses, such as deferred maintenance, future repairs, or exposure to
international risks. Because these reserves reduce reported income on which taxes
are based, most German firms use them aggressively. In the 1990s, for example,
Deutsche Bank admitted that its hidden reserves amounted to more than $14 billion.

The use of such reserves hampers outside investors’ ability to assess German firms’
perfor- mance. Often these firms use reserve accounts to smooth out fluctuations in
their earning flows by adding large sums to their reserves in good years and
dipping into their reserves in poor years. Because of their use of accounting
reserves, the reported earnings of German firms often fluctu- ate less than those
of comparable U.S. firms, giving the misleading appearance that the former are less
risky than the latter. These accounting differences complicate investors’ decision
making regarding how to diversify their portfolios internationally to reduce
overall investment risk.

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OTHER DIFFERENCES. Many other differences exist in the way countries treat
accounting issues. The following are a few examples:
● Capitalization of financial leases: U.S., British, and Canadian firms must
capitalize financial leases, whereas Swiss firms may do so but are not required to
do so.
● Capitalization of research and development (R&D) expenses: Most countries permit
firms to capitalize R&D expenses, but this practice is forbidden in the United
States except in limited circumstances.
● Treatment of goodwill: A firm that acquires a second firm often pays more than
the book value of the acquired firm’s stock. The excess payment is called goodwill.
In the Netherlands firms typically amortize goodwill over a 5-year period, although
they may write it off instantaneously or over a period of up to 20 years. UK firms
also are allowed to choose between immediately writing off goodwill or capitalizing
it on their balance sheets and amortizing it over a period of time. Japanese and
French firms may amortize goodwill as well.

Impact on Capital Markets

The various national differences in accounting practices would be little more than
a curiosity were it not for international businesspeople’s need for information to
make decisions. These differences can distort the measured performance of firms
incorporated in different countries. As already noted, the earnings of German and
French firms often are understated because of the con- gruency between financial
reporting and tax reporting. The price-to-earnings ratios of Japanese firms are
frequently higher than those of U.S. firms, primarily because Japanese accounting
prac- tices often substantially reduce reported profits. For example, Japanese
firms report depreciation expenses on an accelerated basis to their shareholders
and are allowed to create generous reserve funds for future pension liabilities.
The overall impact of these accounting differences is clear: Comparing the
financial reports of firms from different countries is exceedingly complex, making
it more difficult for international investors to assess the performance of the
world’s businesses.

These differences can affect the global capital market in other ways. The New York
Stock Exchange (NYSE), for example, is concerned about SEC-mandated accounting
rules that must be followed by publicly traded corporations under the SEC’s
jurisdiction. Those rules emphasize full and comprehensive disclosure of a firm’s
financial performance information, and the NYSE fears that the rules discourage
foreign firms from listing on the exchange, thereby threatening the exchange’s
global competitiveness. The Sarbanes-Oxley Act of 2002 has worsened this problem,
as “Bringing the World into Focus” on page 94 indicated; increasingly, foreign
firms are choosing to list their stocks on European or Asian stock exchanges,
rather than the NYSE.35 Consider the plight of Philips NV. As a Dutch company, it
must first comply with Dutch accounting standards. To list its stock on the NYSE,
Philips must then undergo the expense of reworking its financial statements to meet
SEC requirements as well as comply with the requirements of Sarbanes-Oxley.

The information-laden accounting practices used by U.S. firms do offer them certain
advantages, however. Many foreign bankers believe that the United States is the
easiest foreign locale in which to lend because of U.S. public disclosure policies.
Those policies result in reliable numbers for assessing the riskiness of potential
loans. In contrast, the German accounting system, which allows firms to lump
together various cost categories and establish a variety of reserves, is much less
helpful for a potential foreign lender. As one investment manager has noted, “The
poor quality of financial information available from many German companies makes it
difficult for investors to buy a stock with confidence, since valuations cannot be
clearly established.” In hopes of improving their standing with institutional
investors, many German MNCs adopted either U.S. GAAP or the International Financial
Reporting Standards (IFRS), an alternative transparent approach to financial
reporting issued by the International Accounting Standards Board (IASB). The FASB,
which establishes U.S. accounting standards, and the IASB have been negotiating to
standardize their treatment of accounting issues, but progress has been slow.