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The "global market" concept is old news. Today, CPAS and their clients are more interested in focusing on opportunities and problems arising from Europe 1992. Expected changes in the European Community (EC) during the coming year have caused many U.S. companies to consider how they can best operate in this newly created market.

One alternative involves mergers and acquisitions. In 1988, more than 2,000 crossborder M&As took place in Europe, many involving U.S. companies. In 1989, almost 6,000 similar transactions occurred, and 12% of the total involved American dollars. A Conference Board survey of 1,000 publicly held U. S. manufacturers shows the following activities in EC countries in 1989:

* Seventy-two companies acquired EC companies.

* Twenty-four companies started joint ventures.

* Fourteen companies built new EC plants.

* Six companies expanded old plants. Almost 40% of total U. S. direct investment in foreign countries goes into EC industries.

U.S. accountants play a significant role as strategic planning consultants and in helping clients acquire or expand European operations. Helping clients evaluate EC opportunities is likely to involve an examination of the foreign company's financial statements. In these examinations it is essential U.S. CPAS understand the accounting rules followed by European companies.


All companies in the EC follow the Ec's fourth directive, issued in 1978, which sets forth general guidelines for reporting financial results. When the E C issues a directive, member countries must incorporate its guidelines into their domestic laws and financial reporting requirements. In this sense, harmonization exists.

However, because of the general nature of the fourth directive, there is much latitude. How EC companies prepare financial statements varies considerably. Some of what is allowed represents procedural differences from U. S. generally accepted accounting principles and is relatively easy to understand and interpret; however, it's also true there are some unexpected conceptual and philosophical differences.

This article examines the major differences between accounting policies in the United States and the EC and seeks to provide a basis for U.S. accountants to understand financial statements prepared in various countries. To begin, exhibit 1, page 73, lists EC countries and some of their accounting policies.


Inflation's general impact on the balance sheet and income statement is typically well understood in most countries. Approaches for dealing with inflation are quite different among EC countries, however, and U.S. accountants need to examine financial statements carefully to determine which approach is being used.

For example, exhibit 2, page 74, shows a partial balance sheet for a hypothetical French company. The assets listed seem much like those found in the annual report of a U. S. corporation. However, France periodically mandates an upward revaluation of assets. The shareholders' equity section of the balance sheet shows the total assets amount of FF 15,235,906,000 to be FF 1,857,146,000 (about 12%) above original cost, since a reserve for revaluation of assets account was used to offset an increase on the asset side of the balance sheet.

France, Greece, Portugal and Spain use a countrywide revaluation approach-all companies are required by the government to revalue to current cost at the same time. The government normally specifies an indexing system or provides other write-up guidelines. Companies essentially have no choice but to revalue. When a countrywide approach is used, the revaluation occurs once every few years. Most other EC countries allow companies to revalue assets periodically at their own discretion.

Normally, companies use replacement cost as a basis for write-ups. The replacement cost approach represents current cost adjusted for years of use for property, plant and equipment. In the Netherlands, some companies go one step further and use current market values. For inventory, sale prices can be significantly in excess of current costs. Only Germany and Luxembourg prohibit write-ups and instead stick with historical cost.

Not all companies write up assets in countries that allow voluntary write-ups; the key account for U.S. CPAS to watch for is the revaluation reserve account, which must be disclosed and is found in the equity section of the balance sheet. U. S. accountants also must be aware that depreciation charges are based on the increased basis of assets in the 10 EC countries requiring or allowing write-ups.


The shareholders' equity section in exhibit 2 shows accounts for legal reserves, other reserves and reserves for long-term capital gains. In the United States, loss contingencies are accrued if the criteria of Financial Accounting Standards Board Statement no. 5, Accounting for Contingencies, are met. Otherwise, reserves are not normally found and the term is not used. EC countries frequently use reserves, which tend to be of three types.

Statutory reserves. Several countries have statutory reserves. Denmark, for example, requires 10% of profit to be allocated to a reserve account. This account accumulates until it is 10% of share capital. Statutory reserves protect creditors in that some portion of profits must be permanently retained as assets. Statutory reserves are clearly labeled and should present no problems for U.S. CPAS. General reserves. These reserves may create some questions. Since several countries permit a fairly liberal contingency loss rule, companies may adjust net income more easily in most EC countries than in the United States. Normally, changes in general reserves must be disclosed. As a result, careful analysis should provide a means to evaluate these reserves. Hidden or secret reserves. These present a problem in any country, including the United States. They occur when there are asset understatements or liability overstatements.

In the United States, these reserves usually are limited to taking excessive depreciation, bad-debt charges, warranty expense and other accrued items related to accounting estimates.

U.S. auditors generally take issue with suspected hidden reserves. In the EC, there is a different philosophy. To be tax deductible in many EC countries, expenses must be reported in the accounting record in conformity with the tax returns. For example, if tax law permits bad-debt writeoffs of 5%, a company probably will book a 5% bad-debt writeoff to minimize taxes, even if actual bad-debt losses are less. This creates a hidden reserve, which EC accountants generally accept because of the company's tax minimization objectives.

According to a 1985 United Nations report, International Accounting and Reporting Issues: 1985 Review, hidden reserves likely are created in other ways in some countries. For example, by writing off capital expenditures in the year of acquisition, an excessive charge over reasonable depreciation occurs and an asset that is in use does not appear on the balance sheet.

It has been suggested the Deutsche Bank wrote down its new headquarters in Frankfurt to one deutsche mark (from a probable cost of over DM 1 billion) on the premise it was a specially built facility with no tangible value to any other user. Likewise, some EC companies record expenses and create a reserve but hide the reserve account by netting the reserve against assets. Another approach is to bury the reserve in other liability accounts or simply to show totals for liability categories (which will include but not disclose the reserve).

EC companies that create hidden reserves seldom intend to be fraudulent. Rather, the company creates such reserves simply to smooth earnings (when needed, the reserve will be reversed). The rationale is long-term performance is much more relevant than annual results. Without question, however, hidden reserves are hard to detect and U.S. CPAS are generally unfamiliar with the concept.


Less emphasis in the EC on an accurately calculated annual profit results in several other differences. First, as stated in the Ec's fourth directive, extraordinary items arise otherwise than in the course of the company's ordinary activities." Therefore, some items will be labeled extraordinary that to the U.S. CPA seem nonextraordinary. As shown in the hypothetical British report in exhibit 3, above, neither of the items listed as extraordinary income would appear to meet extraordinary criteria according to U.S. GAAP.

A second area that affects the income statement is the use of the equity method of accounting for investments, which the fourth directive allows but does not require. As a result, particularly when investment ownership is between 20% and 50%, the U.S. CPA'S expectation is the equity method will be used. EC companies need to be evaluated carefully to determine whether subsidiary earnings or dividends are included in income.

A third area of difference results from EC companies' inconsistent consideration of "substance over form." Capitalizing leases and interest, for example, are not common accounting practices. Not all EC companies impute interest on non-interest-bearing notes. As a result, net income is apt to be different from that in the United States. All of these possible differences make it difficult to make comparisons.


The final major differences between the United States and the EC relate to the income statement format, the value-added statement and the lack of a cash flow statement in some countries.

EC companies have four options in formatting an income statement. They can use (1) a vertical or (2) a horizontal approach coupled with a choice between (3) listing expenses by function, such as cost of sales and general and selling expenses, or (4) listing expenses by class, such as purchases, depreciation and wages and salaries. Any U.S. CPA could easily cope with the horizontal format, even though a U.S. income statement almost always is vertical. However, expenses listed by class present a problem. In the income statement shown in exhibit 4, page 75, depreciation and amortization, wages and salaries and purchases are not allocated to production, selling and administrative categories. Therefore, no cost of goods sold appears and any ratio analysis on gross margin is impossible. Unfortunately for those accustomed to a vertical and functional income statement, the typical European income statement is apt to be horizontal and lists expenses by class.

The annual reports of many EC companies include a value-added statement. Exhibit 5, below, is a value-added statement that includes income statement information from exhibit 4, plus payments to shareholders (dividends). The purpose of a valueadded statement is to show the company's use of money and contributions toward society through the payment of salaries, taxes, interest to creditors and dividends to shareholders. The value-added statement is not difficult to interpret but does represent a fairly common reporting difference from the statements U.S. CPAS typically prepare. The Y,8,772 retained in the corporation represents net income 210, 131) plus depreciation and amortization 4:2,641) minus dividends to shareholders 9,4,000).

Finally, while EC companies may prepare value-added statements, in 6 of the 12 countries (see exhibit 1), it's unlikely cash (funds) flow statements would be found. In the 6 countries preparing funds flow statements, none restricts the definition of funds to cash as U. S. GAAP does. However, U. S. CPAS should not have difficulty evaluating funds flow on a different basis.


It's clearly difficult to compare EC financial statements to those of U.S. companies or to U. S. industry averages. Asset writeups, reserves, liberal definitions, lack of substance over form and expenses listed by class render any ratio analysis useless if these ratios are compared to U.S. ratios. However, just as U.S. CPAS would not compare a utility company with its regulatory accounting requirements to a manufacturer but would compare the utility to other utilities, so should U.S. accountants evaluate EC companies, by making comparisons only where accounting presentations are similar.

This article highlighted areas of major differences between U.S. and EC financial reports. There are numerous minor and procedural differences as well. To help clients consider how to best operate in the E C market, U. S. CPAS need to understand foreign financial statements. CPAS can then ask appropriate questions to provide depth to the understanding attained through statement review. The task is challenging but necessary until international harmonization of accounting standards, including those of the United States, is achieved.
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Title Annotation:accounting differences between European Community countries and the United States
Author:Schwieger, Bradley
Publication:Journal of Accountancy
Date:Mar 1, 1992
Previous Article:How business is dealing with FASB 106.
Next Article:Convertible bonds settled for cash upon conversion and balance sheet treatment for certain sales of mortgage servicing rights.

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