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Accounting for Differences

While generally accepted accounting principles go a long way to standardize accounting practice in the United States, accountants still have some leeway in reporting earnings and book values. Financial analysts have even more leeway in how to use those reports; for example, some analysts will include profits or losses from extraordinary or nonrecurring events when they report net income, but others will not.

Similarly, accountants have discretion concerning the treatment of intangible assets such as patents, trademarks, or franchises. Some believe that including these intangibles on the balance sheet provides the best measure of the company`s value as an ongoing concern. Others take a more conservative approach, and they exclude intangible assets. This approach is better suited for measuring the liquidation value of the firm.

Another source of imprecision arises from the fact that firms are not required to include all their liabilities on the balance sheet. For example, firms are not always required to include as liabilities on the balance sheet the value of their lease obligations.5 They likewise are not required to include the value of several potential obligations such as warrants6 sold to investors or issued to employees.

Even bigger differences can arise in international comparisons. Accounting practices can vary greatly from one country to another. For example, in the United States firms generally maintain one set of accounts that is sent to investors and a different set of accounts that is used to calculate their tax bill.7 That would not be allowed in most countries. On the other hand, United States standards are more stringent in most other regards. For example, German firms have far greater leeway than United States firms to tuck money away in hidden reserve accounts.

When Daimler-Benz AG, producer of the Mercedes-Benz automobile, decided to list its shares on the New York Stock Exchange in 1993, it was required to revise its accounting practices to conform to United States standards. While it reported a modest profit in the first half of 1993 using German accounting rules, it reported a loss of $592 million under the much more revealing United States rules, primarily because of differences

in the treatment of reserves.

Such differences in international accounting standards pose a problem for financial analysts who attempt to compare firms using data from their financial statements. This is why foreign firms must restate their financial results using the generally accepted accounting principles (GAAP) of the United States before their shares can be listed on a U.S. stock exchange. Many firms have been reluctant to do this and have chosen to list

their shares elsewhere.

Other countries allow foreign firms to be listed on stock exchanges if their financial statements are prepared according to International Accounting Standards (IAS) rules, which impose considerable uniformity in accounting practices and are nearly as revealing as U.S. standards. The nearby box reports on current negotiations for international accounting standards.

The lesson here is clear. While accounting values are often the starting point for the financial analyst, it is usually necessary to probe more deeply. The financial manager needs to know how the values on the statements were computed and whether there are important assets or liabilities missing altogether.

The trend today is toward greater recognition of the market values of various assets and liabilities. Firms are now required to acknowledge on the balance sheet the value of unfunded pension liabilities and other postemployment benefits, such as medical benefits.

8 In addition, a growing (although still controversial) trend toward ¬market-value accounting ­ would have them record many assets at market value rather than at historical book value.

4You might think that interest payments also ought to be listed in this section. However, it is usual to include interest in the first section with cash flow from operations. This is because, unlike dividends, interest paymentsare not discretionary. The firm must pay interest when a payment comes due, so these payments are treated as a business expense rather than as a financing decision.

5 Some airlines at times actually have not had any aircraft on their balance sheets because their aircraft were all leased. In contrast, General Electric owns the world`s largest private airfleet because of its leasing business.

6 A warrant is the right to purchase a share of stock from the corporation for a specified price, called the exercise price.

7 For example, in their published financial statements most firms in the United States use straight-line depreciation. In other words, they make the same deduction for depreciation in each year of the asset`s life. However, when they calculate taxable income, the same companies usually use accelerated depreciation that is, they make larger deductions for depreciation in the early years of the asset`s life and smaller deductions in the later years.