International accounting standards and practices

International Accounting

The Dupont analysis identifies three key equity value drivers. These are operating efficiency, asset use efficiency, and financial leverage. Operating efficiency is measured by the (net) profit margin, asset use efficiency by total asset turnover and financial leverage by the equity multiplier (Investopedia, 2013). Operating efficiency is clearly one path to healthy returns, because firms with higher margins are more likely to earn profit. They can withstand price shocks in their industries as well, allowing them to earn profit even under adverse circumstances. The total asset turnover represents the degree to which the company's assets contribute to profits. While the first two are good for the value of the firm as a whole, the equity multiplier reflects how much of the firm is actually owned by the shareholders. Thus, the equity multiplier is critical to the Dupont formula in order to determine how the company's performance drives equity value as opposed to firm value.

All dimensions of global operations can affect the stock price of parent companies. We will assume for the purposes of this discussion that all stock prices are based on rational analysis and reflect the true intrinsic value of the firm. Global operations contribute sales to the company, and profits that appear on the income statement. Assets and liabilities from foreign operations will appear on the balance sheet. Foreign operations, whether wholly- or partially-owned, will reflect on the financial statements of the parent company. Beyond that, foreign operations also introduce risk to the parent company. This risk can be operational, political, economic or simply just foreign exchange risk. The latter can actually be important when a company becomes highly dependent on a single foreign market, where fluctuations in the foreign exchange rate can expose the company to significant translation risk.

GAAP covers foreign currency adjustments under FAS 52. Companies must translate the results of foreign subsidiaries into U.S. dollars, when those results are in foreign currency. Assets and liabilities are recorded at the exchange rate at the time of the translation; equity accounts at historical rates; and income statement items are recorded at the weighted-average rate for the period (Douglass, 2010). There are times when the company must determine the functional currency -- for example would a subsidiary in a small country like Fiji actually conduct most of its functional business is FJD or does it use Australian dollars, which are common for major transactions in that part of the world.

Equity valuation of investments in the European Union and Russia would be based on historic averages. There are a few interesting challenges here. First, is the Euro the functional currency in the EU, or is most of that EU business in the UK, such that sterling would be the functional currency? Is the functional currency for the Russian investments the ruble, or are they in dollars or euros? These are the sorts of questions that would need to be asked, in addition to finding historical values, in order to understand how best to value these corporate equity investments.

As notes, GAAP covers foreign currency adjustments and valuation under FAS 52. If the company is operating under IFRS or producing statements to report in IFRS, it would use IAS 21. Other systems, like GAAP in the UK or Canada, would have their own policies and the company would need to take those into account if publishing statements in those countries under those systems.

Part II. Equity valuation is done at historical translation rates. This is perhaps strange because the value of the equity in the functional currency would reflect the equity drivers, which are current conditions. If the equity drivers are the current total asset turnover, net margin and equity multiplier, then using historical exchange rates to translate this value back to the home currency seems clumsy and imprecise. However, one must follow GAAP so it does not matter whether the technique is elegant or not.

Operations and financing activities are unlikely to derive from different types of financial statements. Such transactions may be recorded differently, but there is not likely to be a causal relationship where the type of accounting system results in different operating or financing decisions. The idea has been floated about merger & acquisition activity and international investment analysis. However, firms have a variety of techniques at their disposal, and are certainly not beholden to one valuation technique just because it is prescribed in their accounting standards. M&A activity almost always uses internal, sometimes proprietary, measures, to determine the value of the target firm.