Investing Abroad: Challenges of Evaluating Accounting under IFRS vs. US GAAP
by Ryan DesJardin
Equity Analyst, Gradient Analytics LLC (a Sabrient Systems company)
Here at Gradient Analytics, our focus extends far beyond domestic equity research. We are known to cover an extensive group of publicly traded companies whose shares trade on a wide variety of stock exchanges around the globe. Our team of analysts must be vigilant in keeping up to date on new accounting standards issued by both the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB). More importantly, our team must be able to understand and reconcile the key differences between United States Generally Accepted Accounting Principles (US GAAP) and International Financial Accounting Standards (IFRS) in order to accurately assess a firm's financial health.
The ability to distinguish between these accounting standards has become a crucial skill for investors as IFRS has become increasingly prevalent in recent years. Today, more than 140 countries worldwide (including the United States in some cases) either permit or require the use of IFRS for publicly listed companies. In fact, there are only three major capital markets that don't currently mandate the use of IFRS for publicly traded firms: Japan, China, and the United States. Since 2010, when Japan added IFRS to its list of approved standards for domestic issuers, more than a third of companies traded on the Tokyo Stock Exchange have either adopted or instituted a plan to adopt IFRS in the near future. China continues to amend its accounting standards to broadly align with IFRS. Furthermore, domestic investors must also be mindful of the variations between accounting standards as the SEC allows foreign issuers to report under IFRS despite trading on US exchanges.
In 2002, the FASB and IASB entered into the "Norwalk Agreement," which aimed to eliminate the many variations between US GAAP and IFRS. Since then, the boards have worked together to issue several accounting standard updates in an attempt to enhance the consistency and comparability of global accounting standards. Despite these ongoing efforts, many key dissimilarities remain between the two standards that present a number of obstacles to investors. This article uses earnings quality and fundamental perspectives to discuss key challenges while providing tips on evaluating a firm’s true earnings power. Read on....
Evaluating Earnings Quality under IFRS vs. US GAAP: Inventory Accounting
Much of Gradient’s forensic accounting analysis involves a firm's working capital. Working capital accounts provide us with a great deal of information about the health and sustainability of a company's revenues and earnings growth. As an example, my focus today is on inventory and some of the games that management can play to enhance reported profitability. With inconsistent policies set forth regarding inventory valuation, both US GAAP and IFRS present unique opportunities for earnings manipulation. Identifying some of these tactics can be challenging for many investors, especially if they aren't aware of the significant differences between the accounting standards.
One of the more well-known discrepancies between accounting standards is that US GAAP allows for the Last In First Out (LIFO) method of inventory accounting, whereas IFRS does not. US GAAP provides companies with the discretion to apply either LIFO, First in First Out (FIFO), or the weighted-average costing method to value its inventory, while IFRS only allows FIFO and weighted-average cost. LIFO is typically viewed as the most aggressive approach to inventory valuation due to its tax-saving and cash flow benefits. Additionally, investors should be aware that LIFO opens up a couple of different opportunities for management to deliberately skew a firm's reported results.
Example 1: Columbus McKinnon beats Wall Street's expectations through LIFO liquidation
The first example is Columbus McKinnon Corporation's (CMCO) recent LIFO liquidation that enabled the firm to beat its consensus estimates. In a normal inflationary environment, LIFO would typically provide the most accurate measure of gross profit as current period procurement expenses are matched with current period revenues. However, this accounting method opens up the opportunity for a LIFO liquidation, which occurs when older layers of inventory are sold and matched with current period revenues. As a result, the firm's cost of goods sold is typically reduced (assuming lower costs associated with older layers) while gross profit and earnings receive a one-time, artificial boost.
During CMCO’s fiscal year ended 3/31/2020, the company sourced $2.8 million of additional income through the liquidation of its older LIFO inventory layers. The LIFO liquidation resulted from a sharp decline in inventory procurement over the 12-month period. Purchases, defined as ending inventory plus costs of goods sold less beginning inventory, fell 10.5% compared to the prior fiscal year. By reducing purchases, it was forced for accounting purposes to liquidate its older (and less costly) layers of LIFO inventory, and thereby artificially reduced its cost of goods sold by $3.4 million over the twelve-month period. Interestingly, our analysis found that absent this LIFO liquidation, CMCO would have missed its net income and earnings per share expectations for the fiscal year.
The company reported a gross margin of 35.3% for the twelve months ended 3/31/2020, which was 38 bps more than the prior year. However, after removing the $3.4 million one-time benefit to cost of goods sold, CMCO’s gross margin would have remained flat YOY (year-over-year) at 34.9%. Similarly, the company reported an adjusted net income of $66.4 million for the year, which grew 2.2% YOY and beat the consensus estimate of $64.4 million by $2.0 million (or 3.1%). Absent the $2.8 million after-tax benefit sourced through the LIFO liquidation, CMCO’s adjusted net income would have fallen 2.1% YOY to $63.6 million and missed the consensus estimate by $0.8 million (or 1.3%). We believe that backing out the unsustainable benefit sourced through CMCO's liquidation more accurately reflects the firm's true performance and provides investors with a realistic look into the underlying health of the firm.
Example 2: Air Products and Chemicals sources material gain through a change in accounting policy
The next example details an additional tactic that is commonly used by management teams to take advantage of US GAAP’s allowance of the LIFO valuation method by inflating reported profitability through an opportunistic change in inventory valuation. US GAAP permits firms to elect to change their accounting policies with respect to the method of inventory valuation. Depending on the structure of a firm, these changes can materially impact its reported operating result. On July 1, 2018, Air Products and Chemicals, Inc. (APD) decided to adopt the FIFO valuation method in favor of the previously utilized LIFO method. As a result of the switch from LIFO to FIFO, the company's cost of goods sold would appear lower in subsequent periods as the oldest (first in) and less-costly inventory layers would now be liquidated (first out), creating the illusion of increased profitability.
While a given company’s management may give many legitimate reasons for such a change in accounting practices, the underlying motivation for the change can sometimes be more nefarious. In this case, APD's management team cited various reasons for the change in valuation methods, including consistency, uniformity across all regions of its business, comparability with peers, and a better reflection of inventory levels on its balance sheet. While these are all reasonable explanations, we find it interesting that absent the $20.9 million after-tax benefit sourced through the change in inventory valuation methods, the firm would have missed its net income and earnings per share expectations in FQ4 2018. For the three months ended 9/30/18, APD reported GAAP net income and earnings per share of $452.9 million and $2.05, which beat the consensus estimates by $16.2 million (or 3.7%) and $0.04 (or 2.0%), respectively.
But if we remove the $20.9 million after-tax benefit, APD would have missed both its net income and earnings expectations. Our analysis shows that absent the adoption of the FIFO valuation method, APD would have reported a net income of just $432.0 million and missed its consensus estimate by 1.1%. Similarly, the firm would have reported GAAP EPS of only $1.96 and missed its consensus estimate by 2.7%. While allowed under US GAAP, these types of accounting tactics are often overlooked by investors and can materially alter the appearance of a firm's profitability.
Example 3: Goldmoney increases profitability by revaluing written down inventory
While the previous examples were primarily focused on the potential for inventory accounting gimmickry under US GAAP, IFRS also presents its own unique earnings management opportunities. Both accounting standards require inventory to be written down if management believes the inventory fair market value has fallen below its book value. When inventory is written down, the loss is typically recognized within cost of goods sold. However, IFRS allows these write-downs to be reversed in subsequent periods, resulting in gains realized within costs of goods sold and an increased gross profit. Given the level of discretion available to management teams regarding inventory valuation, the timing of these revaluations often can be used to a firm's advantage to shift reported profits from one period to another.
During the fiscal year ended 3/31/2020, Goldmoney Inc. (TSX: XAU) reported YOY revenue growth of 63.0% and gross profit growth of 79.8% over the same period. As a result, the firm's reported gross margin expanded 45 bps YOY to 4.9%, the highest level in the last five years. However, we found that over half of the firm's reported gross profit growth was directly attributable to a $5.0 million gain sourced through the revaluation of its precious metals inventory. While we recognize that the value of precious metals often varies from period to period, it's important to note that this $5.0 million revaluation was the single largest in the firm's history and accounted for 51.1% of Goldmoney's reported gross profit growth during the year.
In our analysis, we found that without the one-time benefit sourced through the inventory revaluation, Goldmoney's gross margin would have contracted 65 bps YOY to just 3.8%. As you can see, these results materially differ from the reported 45 bps YOY margin expansion and significantly change the firm's performance. Similarly, the firm's gross profit would have increased just 39.1% over the prior year compared to the reported 79.8%. Regardless of whether these revaluations are an intentional attempt to skew a firm's reported results, they can materially overstate a firm's profitability in a given period. We believe that it is crucial for investors to be aware of such accounting practices that would otherwise not be allowed for firms reporting under US GAAP.
As you can see through the examples above, both US GAAP and IFRS provide unique opportunities for companies to manipulate their reported results and mislead investors. While I only discuss inventory accounting in today's article, it is important to note that significant differences arise between the two standards throughout many other accounting and equity analyses.
Additional challenges of investing abroad: Inconsistent reporting frequencies
In addition to the differences in evaluating earnings quality under US GAAP and IFRS, many other challenges arise when investing in foreign markets – for example, inconsistent reporting frequencies. In the United States, publicly traded firms are required to consistently file annual reports on Form 10-K and quarterly reports on Form 10-Q with the Securities and Exchange Commission (SEC). Additionally, all reports must be certified by both the firm's CEO and CFO, and annual reports must be subject to audit by an independent auditor.
On the other hand, many firms traded on international exchanges are only required to report their financial results on a semiannual basis. In place of quarterly reports, many semiannual reporters release a quarterly "trading update" with limited information on the company's performance. These trading updates typically include highlights from the most recent quarter, an updated future outlook, and sometimes limited financial data, including revenues and earnings.
But without a detailed income statement or balance sheet information, it becomes quite difficult to evaluate a firm's underlying performance, leaving investors to rely on management's commentary. As pointed out above, much of our earnings quality analysis involves tracking the movements in a firm's various working capital accounts to assess the reliability of reported results. Without updated balance sheet information, we have limited visibility into the company's underlying health and are left to compare the current period results to outdated balance sheet information.
Less-frequent reporting also makes peer comparison increasingly difficult among quarterly and semiannual reporters as many diagnostic metrics and ratios become incompatible. Moreover, additional time between reporting periods poses an increased risk for investors as earnings quality may deteriorate undetected for an extended period. Furthermore, according to a study performed by researchers at Indiana University, stock price returns of semiannual reporting firms are significantly more volatile than their quarterly reporting counterparts as investors are deprived of timely information and must heavily rely on alternative information throughout "missing periods."
In summary:
Neither US GAAP nor IFRS offers the perfect solution for eliminating earnings management in global financial markets. Each presents its own unique loopholes that enable companies to skew their reported results and mislead investors. This is why the analyst team at Gradient Analytics stays informed and up to date on evolving accounting regulations both domestically and internationally. Our team maintains the expertise to uncover aggressive accounting practices that corporate executives around the world may exploit to present a more favorable picture of a firm’s underlying economic condition. Our buyside clients utilize this information to improve returns – whether by identifying high-potential short candidates or by avoiding troublesome long positions.
Disclosure: At the time of this writing, the author held no positions in the securities mentioned.
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