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ADRs: increasingly popular financial instruments.

ADRs: INCREASINGLY POPULAR FINANCIAL INSTRUMENTS

Because of today's global markets, personal financial planners and tax accountants are finding more and more American depositary receipts (ADRs) in clients' portfolios. Advisers must know the pros and cons of these securities.

ADRs give investors title to shares in a foreign company. They are issued by a depositary bank, which holds the company shares backing the ADRs. For example, investors who want to own Volvo shares need not purchase Swedish securities but, instead, can buy Volvo ADRs--certificates that represent ownership of Volvo shares held by a depositary bank.

INTERNATIONAL DIVERSIFICATION

ADRs simplify international diversification of portfolios, which can enhance yields and improve risk-adjusted returns. Research suggests they reduce overall portfolio risk because they do not respond solely to the U.S. economy. ADRs also will offer easier access to investments in the European Community when the EC becomes one marketplace after 1992.

ADRs minimize the administrative problems often associated with foreign investments. They are priced and dividends are paid in U.S. dollars. Clearing and settlement occur in the United States and commissions are the same as for U.S. stocks. Because the investor is not buying a foreign security, there is no fee for maintaining custody of the certificate abroad or for insuring and shipping the certificate to the United States.

An active market. The market for certain ADRs is broad and liquid. Many large institutions such as pension funds and insurance companies are not permitted to purchase foreign stocks for their portfolios but can buy ADRs if they are listed and registered with the Securities and Exchange Commission. In fact, the market for ADRs may be more liquid than that for the underlying shares. In 1986, 15% of one British company's shares was held as ADRs, but the company estimated about half of all trades were executed in the ADR market.

In addition, the securities markets are becoming globally coordinated. The National Association of Securities Dealers Automated Quotations (NASDAQ) has electronic links with the London stock exchange, which means it's possible to obtain simultaneous quotes on U.S. ADRs and on the underlying U.K. stock. NASDAQ intends to extend this service between the United States and Singapore exchanges, improving coordination between the U.S. and Pacific Basin markets. Any unusual price differences among markets are quickly narrowed by arbitrageurs, who react to changes in currency rates and underlying stock prices.

ADR RISKS

ADRs have two disadvantages that American securities do not: currency and information risks.

Currency risk. ADRs are denominated in U.S. dollars but reflect both the home market valuation of the stock and the value of the foreign currency. Even if the stock price holds steady, fluctuations in exchange rates will cause the ADR price to change. When the dollar becomes stronger, the ADR price and dividend decline--and vice versa. For example, assume a German company's ADR is quoted at 100 German marks per share. If the exchange rate is 2 German marks per U.S. dollar, an ADR representing one share of the German company will trade at $50. If the exchange rate rises to 5 German marks per U.S. dollar, the ADR will trade at $20.

If the domestic price of the underlying stock increases as the dollar goes down, the currency fluctuation should magnify the ADR's gain. However, increases in the value of the dollar may overpower price appreciation of the underlying stock and reduce the ADR's value.

These general rules may not apply if significant profits are made in the United States and repatriated to the home country. For example, Japanese automakers repatriate profits from U.S.-made cars. As the dollar rises, the ADR price may rise because more yen can be purchased with each dollar sent home.

Investments in multinational companies, such as Reuters Holdings, that earn revenues and incur expenses in many countries reduce ADR currency risk, because exchange rate fluctuations lower the impact foreign-source income has on the ADR price. On the other hand, virtually all of British Telecom's revenues and expenses come from the United Kingdom, and its ADR prices are significantly affected by changes in the value of the British pound.

Information risk. The amount of information a U.S. investor receives depends on whether an ADR is sponsored by a single depositary or unsponsored. ADRs that trade on the New York or American Stock Exchange or that are used to raise capital in the United States for initial public offerings (IPOs) must be sponsored. There is a good flow of financial information on such securities. The foreign company works exclusively with one depositary bank and pays it for the administrative costs of information and dividend processing.

Unsponsored ADRs may trade on the NASDAQ or on the over-the-counter (OTC interbroker pink sheet trading) market. Investors in unsponsored ADRs may find financial information difficult to obtain. The ADRs may be issued by more than one depositary and the administrative costs for information and dividend processing are deducted from dividends.

For IPOs using ADRs and for ADRs listed on the NYSE or AMEX, the SEC reporting requirements are similar to those for U.S. stocks. An ADR trading on NASDAQ or on the pink sheet market, however, may file for exemption from the Securities Exchange Act of 1934. If it is granted, the exempt company must register with the SEC but is required to supply only the information reported in the home country.

SEC filing requirements for ADRs subject to the Securities Exchange Act of 1934 (registered ADRs) may be less stringent than those for U.S. companies. Issuers can meet SEC requirements by complying with the domestic country's rules. For example, a company can forgo the quarterly reports required in the United States if interim statements are prepared semiannually in the home country. And if annual reports are due six months after yearend in the home country, companies may be exempted from the SEC requirement that reports be issued within 120 days of yearend. Many countries don't require outside directors or disclosure of salaries of top management and the SEC may waive these rules for an ADR issuer.

FINANCIAL STATEMENTS

Most financial statements are shown in the home country currency and may include a currency translation into U.S. dollars. The translation is for convenience only and is not in conformity with acceptable currency translation principles. For registered ADRs, statements are prepared either in conformity with U.S. generally accepted accounting principles or with the domestic country's generally accepted accounting principles, with a reconciliation to U.S. GAAP. Exempt ADRs provide only the financial reports prepared for the domestic market.

The statements for registered ADRs disclose variations in methods of applying accounting principles. Common areas of divergence are deferred taxation, goodwill, extraordinary items, discontinued operations, business combinations, intangible and fixed assets and dividends. For example, in the United Kingdom, property is not necessarily valued at historical cost; revaluation of tangible, fixed assets is permitted. In Australia, a balance sheet may contain valuation and revaluation of company-developed intangibles, such as brand names. In Japan, accelerated depreciation is used for both financial and tax reporting purposes. Neither Japan nor Germany uses the equity method of accounting for subsidiaries; they show dividend income only and omit undistributed earnings from the balance sheet. In Germany, a sustained growth pattern in net income is highly valued. Reserve accounts often are adjusted to ensure that a desirable growth pattern is reported.

Investors may be better off analyzing cash flow rather than reported earnings for ADRs. Cash flow analysis may neutralize many of the differences among accounting conventions.

ACCESS TO NEW MARKETS

ADRs facilitate American investment in foreign companies and provide excellent access to U.S. equity and debt markets. They also offer global support for a stock's price and an increased shareholder base, as well as a larger market for government industries being privatized. They are now being used in foreign corporations' marketing strategies to increase product visibility and name recognition.

ADRs offer investors greater diversification and simplified access to international markets. ADRs are not new--they have been linking foreign corporations with U.S. investors since the 1920s, but they have recently experienced tremendous growth. In the first half of 1989, more than 1.4 billion changed hands. CPAs who understand these securities will be able to help clients take advantage of opportunities in the international marketplace.

M. A. Houston, CPA, instructor of accountancy, and S. A. Brecha, CPA, DBA, assistant professor of accountancy, at Wright State University, Dayton, Ohio, describe a vehicle for making international investments.
COPYRIGHT 1990 American Institute of CPA's
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Copyright 1990, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

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Title Annotation:American depository receipts
Author:Brecha, S.A.
Publication:Journal of Accountancy
Date:Jun 1, 1990
Words:1422
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