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Impact of differences between international financial reporting standards and us generally accepted accounting principles on perceived company performance.

INTRODUCTION

Given a choice, firms interested in raising funds prefer to have access to capital markets in the United States of America (US) (Leuz, 2003). The US Securities and Exchange Commission (SEC) prior to November 15, 2007, required US-listed foreign issuers of securities to either prepare financial statements in accordance with US Generally Accepted Accounting Principles (USGAAP) or include reconciliation to US-GAAP as a part of the financial statements (SEC, 2011) to ensure comparable and reliable assessment of company performance. Since January 1, 2005, most US-listed European Union (EU) companies started using International Financial Reporting Standards (IFRS) as required by the Council of Ministers of the EU and provided reconciliation to US-GAAP in their 20-F form until the reconciliation requirement was removed since November 15, 2007.

Significant differences between measures reported per IFRS and US-GAAP has been found in previous research. Harris and Muller (1999) discovered that US-GAAP and International Accounting Standards (IAS), former name for IFRS, measurements for all US-listed foreign companies adopting IAS from 1992 to 1996 were found to be valued differently by the market. Haverty (2006) found evidence for lack of comparability between IFRS and US-GAAP reported net income and identified a trend of convergence with the reconciliation data from fourteen US-listed foreign firms from P. R. China for 1996-2002. Chen and Sami (2007) revealed that such reconciliation captures information that is reflected in investors' decisions about their stock holdings with data from 1995 through 2004. Jermakowicz, Prather-Kinsey, and Wulf (2007) found a significant increase in the value relevance of earnings after the adoption of IFRS in German firms, also using data from 1995-2004.

Liu (2009) and Liu and O'Farrell (2010) found significant differences between IFRS reported net income and net assets and US-GAAP reported values for the same company during the 20042006 period. The SEC's decision to remove the necessity of reconciliation from IFRS to USGAAP has the result of making US-GAAP income and equity information unavailable to investors.

Little analysis has been made on how US-listed EU companies' performance may be assessed differently given current differences between IFRS and US-GAAP and how the removal of the US-GAAP reconciliation requirement may impact investor's perception of such companies' potential performance in the future.

This research uses a US-listed German company, Siemens AG (Siemens) as an example to examine such impacts by conducting performance assessment with financial ratios based on different measurements per IFRS and US-GAAP. A German company is studied because German companies are the most frequently used comparison in studies of IFRS (Soderstrom and Sun, 2007) due to Germany's strong legal system in terms of rule of law and efficiency of the judicial system to ensure compliance with the chosen accounting standards (Hung and Subrama-nyam, 2007). Financial ratio analysis is studied because it is a popular tool used by investors to determine a company's past performance and potential future performance. This example recognizes and addresses the different ratio results from the two different standards and the impact the varying results may have on investors.

The results reveal that perceived company profitability based on IFRS was higher than that based on US-GAAP and that profitability measures based on US-GAAP are more value relevant. US-GAAP income is found to be more conservative than IFRS income in EU and more valued by the market in this study.

This study contributes to the literature in two ways. First, the authors analyze the impact of differences between IFRS and US-GAAP on performance assessment through profitability, liquidity, solvency, and market value ratio analysis. In contrast, prior research typically focuses on such differences' impact on net income. Second, the authors use financial data right before the removal of reconciliation requirement. Findings from prior research are based on financial data ranging from 1992 to 2006. This study's findings can warn investors of differences in perceived company performance due to differences between IFRS and US-GAAP for use in their investment decisions.

The remainder of the study is organized as follows. The next section provides background information on Siemens. This is followed by an introduction of IFRS. Then, Form 20-F for Siemens is explained. The following section assesses the company's performance under two different accounting standards. The final section provides a conclusion.

SIEMENS AKTIENGESELLSCHAFT

Company information (found on Siemens' website under investor relations from SEC Form 20-F and referenced as Siemens, 2013) is summarized here to provide context to the case study. Advances in telegraph technology in 1847 spurred the growth of Siemens and Halske when it began to expand in numerous product segments and in geographical scope (Siemens, 2013). It became a stock corporation in 1897 in Berlin, Germany. In 1949, the Corporation moved its headquarters to Munich and changed its name to Siemens Aktiengesellschaft under the Federal Laws of Germany. Siemens trades under the ticker symbol SI as an American Depository Receipt (ADR) on the New York Stock Exchange (NYSE). Siemens trades in Munich, Germany under the ticker symbol SIEN. The company operates on a fiscal year ending September 30.

During fiscal year 2007, Siemens had an average of 386,200 employees in approximately 190 nations. The Corporation's corporate level strategy is to maintain its leadership in electronics and electrical engineering. The Corporation seeks to maintain this strategy through its Research and Development expenditures in order to competitively serve the following sectors: energy; industry; and, healthcare. Siemens' energy sector is categorized as follows: Groups Power Generation and Power Transmission and Distribution. The Corporation's industry sector consists of Group's Automation and Drives, Industrial Solutions and Services, Siemens' Building Technologies, and Osram and Transportation Systems.

For fiscal year 2007, Siemens experienced higher net income and earnings per share, increased profitability, strong global growth, stronger cash flows, and an increased dividend than previous years. The amounts under IFRS and U.S. GAAP will be included in the comparative analysis.

INTERNATIONAL FINANCIAL REPORTING STANDARDS

IFRS are issued by the International Accounting Standards Board (IASB). The IASB is headquartered in London and is the leader in international convergence for accounting standards. As a result of an EU directive, in 2005, the consolidated financial statements of publicly listed companies were required, thereafter, to file according to IFRS. The EU implemented this directive in the hope that it would encourage intra-European movements of capital.

The directive strives to achieve comparability within the EU, which before IFRS each country had different accounting standards, thus making it more complex for investors to decipher which investment opportunity was more favorable. On a global level, the differences in different countries' accounting standards are more pronounced. A challenging aspect of international business is the fact that no two countries have exactly the same standards and procedures. A seemingly subtle difference may hide or exacerbate a given financial risk, thus luring or turning away a potential foreign investor (Haverty, 2006).

Many countries outside of Europe now require companies to file according to IFRS: over 100 countries require companies to file according to IFRS (Cabrera, 2008). Its widespread acceptance is attributing to its ability to raise international capital since the global economic politics view IFRS as a set of high quality standards. The US has not adopted IFRS. US-listed foreign companies such as Siemens were required to reconcile income and equity as per IFRS as adopted by the IASB to US-GAAP. Such reconciliation is not required for statements prepared since November 15, 2007. The special treatment of statements reported per IFRS is a testament to the quality of IFRS and its widespread acceptance.

Technical summaries for each IFRS are available on the IASB website. IFRS 1 provides instruction on how a company should transition from another set of standards to IFRS. This standard is perhaps the most encompassing because it does not give instructions on how to record certain types of transactions but instead gives direction on how to apply IFRS for the first time. IFRS 1 will continue to gain importance as widespread acceptance of IFRS continues. The focus narrows for IFRS 2 through 8. These standards are more specific than IFRS 1 because they are issue oriented. IFRS 2 through 8 address the following issues: share-based payment; business combinations; insurance contracts; non-current assets held for sale and discontinued operations; financial instruments; and, operating segments; respectively.

SIEMENS AG FORM 20-F

Siemens, like many other large multi-nationals, lists it's stock in the U.S. and is traded on the NYSE under the ticker symbol SI. American companies that are publicly traded in the US are required to file their annual reports with the SEC using a Form 10-K. Similarly, foreign companies publicly traded in the US must file their annual reports using a Form 20-F. For Siemens, the Form 20-F contains similar information as Form 10-K except for IFRS explanations and the equity and income reconciliation from IFRS to US-GAAP. The reconciliations from IFRS to US-GAAP as well as the explanations of significant IFRS are located in the Notes to the Consolidated Financial Statements. The data is found on Siemens' website under investor relations from SEC Form 20-F (Siemens, 2013).

Note 1 on page F-13 of the SEC filing is titled Basis of Presentation. It states the basics of IFRS and their implementation under the EU directive. More importantly, Note 1 states that Siemens adopted all standards and interpretations issued by the IASB that were effective September 30, 2007. In addition, Note 1 states the early adoptions of standards and interpretations of the IASB that made a significant impact on the financial statements. These standards and interpretations include the following: IFRS 7, Financial Instruments: Disclosures and IFRS 8, Operating Segments.

The objective of IFRS 7 is to disclose information to investors in order to allow them to understand and assess the importance of financial instruments for the entity's financial condition and performance and to evaluate and understand the risks associated with financial instruments. IFRS 7 combines the disclosure requirements from IAS 32, Financial Instruments: Presentations and IAS 30, Disclosures in the Financial Statements of Banks and Similar Financial Institutions. This standard became a requirement effective January 2007. Siemens decided to implement this standard since 2006 and also presents it comparatively with fiscal year 2005. Implementing IFRS 7 early makes it a significant note to the financial statements. The early adoption skews the financial statements' comparability with other IFRS companies who had not yet adopted that standard. Furthermore, the early adoption creates a cumulative difference that would not have occurred if Siemens had not adopted the standard early.

IFRS 8, Operating Segments replaces IAS 14, Segment Reporting. IFRS 8 is similar to SFAS 131, Disclosures about Segments of an Enterprise and Related Information, which is currently a part of US-GAAP. This international standard focuses on reportable segments by requiring companies to disclose descriptive and financial information about each reportable segment. According to Siemens (2013), Form 20-F page F-13, "Reportable segments are operating segments or aggregations of operating segments that meet specified criteria." Operating segments are subunits of an entity for which separate financial information is kept. This financial information is meant to measure the performance of the sub-unit so that the entity may allocate resources effectively among the sub-units. This internal information is also used for reporting purposes according to IFRS 8. In the notes to the consolidated statements, Siemens considers IFRS 8 a standard that has significant impact because, like IFRS 7, it was voluntarily adopted earlier than the effective date. Mandatory compliance with IFRS 8 began in January of 2009. Since Siemens voluntarily adopted the standard, IFRS must be disclosed in the notes to the consolidated financial statements so that Siemens' financial statements maintain their comparability with other companies' IFRS financial statements.

As stated previously, Note 1 on page F-13 of Form 20-F is titled Basis of Presentation. It explains a basic timetable for past IFRS adoption, as well as a brief history of IFRS and the EU directives surrounding its implementation. Note 1 also explains to the financial statement user that the IFRS required by the EU is the same as the IFRS set forth from the IASB. Consequently, Note 1 is meant to convey that there are no comparability issues with this filing and the IFRS pronouncements from the IASB. On the other hand, Note 1 explains how IFRS 7 and 8 raise a significant issue for financial statement comparability with other companies who use IFRS. While Note 1 addresses the issues of comparability within IFRS, Note 40 addresses the comparability of IFRS and US-GAAP with disclosures and the SEC mandated reconciliation of equity and income from IFRS to US-GAAP.

Note 40, Reconciliation and additional US-GAAP disclosures, is perhaps one of the most important sections of Siemens' financial statements with respect to IFRS comparability with USGAAP. Note 40 explains IFRS 1 and how that standard affects Siemens. As explained earlier, IFRS 1 describes how non-IFRS companies should adopt the standards. Furthermore, Note 40 describes how IFRS 1 mandates retrospective application of its standards. According to the IASC IFRS 1 (IFRS, 2013) technical summary, "The IFRS grants limited exemptions from these requirements in specified areas where the cost of complying with them would be likely to exceed the benefits to users of financial statements." Accordingly, Siemens indicates that it has applied three exemptions. The exemptions relate to business combinations, currency translation differences, and share-based payment. In addition to these exemptions, Note 40 reconciles IFRS net income and equity to US-GAAP net income and equity.

PERFORMANCE ASSESSMENTTHROUGH FINANCIAL STATEMENT ANALYSIS

Financial analysts have consistently given company annual reports the highest ranking as the most important source of information on company performance (Gibson, 1987). Ratio analysis is an integral part of the analysis of financial statements, which is a critical step before making any foreign investment (Reuvid & Li, 2000), because it quantifies a company's performance on many aspects such as the company's ability to make a profit (profitability), ability to pay off debts due within a year (liquidity), ability to pay off debts due after a year (solvency or stability), and others. For Siemens, investors in different capital markets may derive different returns and yield varying ratios because of the differences in accounting methods employed by IFRS and US-GAAP.

A survey of 400 Chartered Financial Analysts (CFAs) demonstrated that CFAs rated profitability ratios such as return on equity, profit margin, and return on assets as the most significant performance measure (Gibson, 1987). They viewed profitability and what was being paid for those profits as more significant than liquidity and debt (Gibson, 1987).

Of the profitability ratios, return on equity was given the highest significance by a wide margin in the survey. It measures return as a percentage of stockholders' equity. Stockholders' equity refers to stockholders' residual rights in a company's assets after all liabilities have been paid. The simplest way to determine return on equity is to divide net income by total stockholders' equity. Under IFRS, the return on equity for 2007 is 13.63% with a total equity of 29,627 million [euro] and a net income of 4,038 million [euro]. Under US-GAAP, the return on equity for 2007 is 7.96% with a total equity of 30,379 million [euro] and a net income of 2,417 million [euro]. Apparently, the return on equity under IFRS is materially higher than that under US-GAAP.

Profit margin, another critical profitability ratio, can be derived from dividing net income by sales. Under IFRS, Siemens has sales of 72,448 million [euro] and net income of 4,038 million [euro] for 2007. These values yield a profit margin of 5.57%, indicating that every 1 [euro] in sales yields nearly 6 cents of profit. On the other hand, under US-GAAP, Siemens has sales of 78,890 million [euro] and a net income of 2,417 million [euro], yielding a profit margin of nearly 3.1%. The profit margins may seem similar to the untrained eye. However, the profit margin under IFRS is a staggering 80% greater than that under US-GAAP ((5.57%-3.1%)/3.1%). An investor using Siemens' IFRS measures to calculate the profit margin ratio will find Siemens to produce a higher profit on its sales than one who uses the US-GAAP measures.

Return on assets is another profitability ratio that provides information on how profitable balance sheet assets are. The ratio could be used to determine how capital intensive the company is. In addition, it can be used to measure the company's asset profitability within its industry. In its simplest form, the ratio is calculated through dividing net income by total assets. Under IFRS, Siemens' return on assets for 2007 is 4.41% with total assets of 91,555 million [euro] and net income of 4,038 million [euro]. Under US-GAAP, the ratio is merely 2.59% with total assets of 93,470 million [euro] and net income of 2,417 million [euro]. Return on assets per IFRS is 70% ((4.41%-2.59%)/2.59%) higher than that per US-GAAP.

All three profitability ratios per IFRS overstate the company's performance in generating profit than those per US-GAAP. US-GAAP appears to be a more conservative accounting method with respect to Siemens' earnings.

Price-earnings ratio, a market ratio, received the second-highest significance rating by CFAs (Gibson, 1987). This ratio helps clarify how much investors are willing to pay for a company's earnings and is often quoted near the stock price in any finance periodical or website. It is usually calculated using the past year's earnings by dividing a company's current stock price with its historical earnings per share. Siemens is listed on the Frankfurt Stock Exchange (FWB) and quoted in Euros. It is also listed on the NYSE where its stock price is quoted in US dollars. On September 8, 2008, Siemens share price on the NYSE closed at $99.90, and its 12 month trailing earnings per share were $13.70. Therefore, its price to earnings multiple was approximately 7.30. In other words, investors paid $7.30 for every $1 in earnings. On September 8, 2008, the share price on the FWB for Siemens closed at 70.35 [euro]. In addition, the exchange rate between the US dollar and the euro on September 8, 2008 was .7089 [euro] per US dollar. When the exchange rate for September 8 is applied to Siemens' closing NYSE stock price, the price of Siemens stock on the NYSE is 70.82 [euro]. The difference in the stock prices is immaterial considering the materiality in the difference in USGAAP income and IFRS income as shown in the profitability ratios. In other words, investors in different markets pay the same for earnings as they would if the accounting standards are the same. For Siemens, IFRS income is considerably higher than US-GAAP income; however, that does not mean IFRS users value the company higher. The price similarities in the two markets reveal that US-GAAP earning measures are considered more value relevant by the market. After adjusting for the exchange rates, any differences in price in the two capital markets would be eliminated through arbitrage i.e. riskless profits by buying in the lower priced markets and selling in the higher priced one. For example, if investors using IFRS value Siemens stock higher than investors using the reconciliations to US-GAAP. They may buy the shares on the NYSE at a lower price and sell them in the German capital markets at a higher price for a riskless profit. Another alternative may be to buy the NYSE shares and short sell the German shares.

Dividend payout ratio, another market ratio, measures the percentage of earnings returned to shareholders as dividends. It shows how much of earnings have been returned to the shareholders in the form of dividends. It is important to note that although Siemens has two significantly different net income measurements under IFRS and US-GAAP, it pays the same dividends under IFRS and US-GAAP. The reasoning seems simple on the surface since the accounting method does not make the company more or less prosperous in substance. However, an important underlying assumption exists. Despite the higher earnings under IFRS, the amount of dividend remains the same. This purports that the earnings under IFRS are not as meaningful to an investor who seeks dividend income. In both the FWB and NYSE capital markets, the dividend yield for Siemens is approximately 1.80%. Despite the same dividend yields, the payout ratios are markedly different. In the SEC filing 20-F, net income per share under IFRS is 4.10 [euro], and the net income per share under US-GAAP is 2.68 [euro]. The dividend per share for 2007 was approximately 1.31 [euro]. The payout ratio is about 32% under IFRS and about 49% under US-GAAP. This significant difference may lead an investor who uses US-GAAP to believe that Siemens uses a more significant portion of its earnings to pay dividends than an investor using IFRS.

Simply put, liquidity and debt ratios measure a company's ability to pay its debt. Liquidity ratios focus on a company's ability to pay its current debt with its current assets. On the other hand, debt ratios measure a company's ability to pay its long-term debt. The current ratio is one of the most important liquidity ratios. Debt to equity and debt to asset ratios are among the most important debt ratios. The liquidity ratios and the debt ratios vary only slightly between IFRS and US-GAAP for Siemens. The reason is that debt is accounted for similarly under the two accounting methods. The current liabilities and the long-term debt under IFRS are 43,894 million [euro] and 9,860 [euro] million respectively, whereas the current liabilities and the long-term debt under US-GAAP are 43,712 million [euro] and 9,853 million [euro] respectively. The differences are slight so as to yield similar debt and liquidity ratios. Thus, investors in different capital markets using IFRS versus US-GAAP may derive similar debt and liquidity ratios.

CONCLUSION

Ratio analysis for Siemens reveals materially different performance assessments under IFRS and US-GAAP. The major source of such differences is different net income measurements. IFRS net income is significantly higher than US-GAAP income. Net income differences yields materially different profitability ratios. However, the market ratios show the true nature of the earnings. Siemens stock is traded at the same price in different capital markets: in Germany and in the US. Investors do not put as much emphasis on IFRS earnings as they do US-GAAP earnings. However, this study concludes with a much more plausible explanation for this phenomenon. Market forces act in a way to keep the stock price of Siemens the same in Germany and on the NYSE through arbitrage. The market acting as an equalizer does in fact support the earlier assertion that IFRS earnings are not as strong, dollar per dollar, as the US-GAAP earnings for Siemens. This could potentially lead to lower earnings quality under IFRS.

In summary, income statement and balance sheet differences between IFRS and US-GAAP cause discrepancies in performance assessment through ratio analysis. These discrepancies may skew an investor's opinion due to differences in Siemens' profitability, market, liquidity, and debt ratios.

REFERENCES

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Gibson, C. (1987). How chartered financial analysts view financial ratios. Financial Analysts Journal, 43(3), 73-76.

Harris, M.S., & Muller, K.A. (1999). The market valuation of IAS versus US-GAAP accounting measures using Form 20-F reconciliations. Journal of Accounting and Economics 26, 285312.

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SEC (August 12, 2011). Securities and Exchange Commission 17CFR210.4-01. Technical Amendments to Commission Rules and Forms Related to the FASB 's Accounting Standards Codification. Retrieved June 15, 2015, from https://www.sec.gov/rules/final/2011/33-9250.pdf

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Soderstrom, N. S., & Sun, K. J. (2007). IFRS adoption and accounting quality: a review. European Accounting Review, 16(4), 675-702.

Grace O'Farrell

University of Winnipeg

Chunhui Liu

Khalifa University of Science, Technology & Research

Dedicated to the memory of Dr. Lee J. Yao

About the Authors:

Chunhui Liu is an Associate Professor in the Department of Humanities and Social Sciences at Khalifa University of Science, Technology, and Research. Her current research interests include international accounting harmonization, accounting information systems, emerging markets, ecommerce, and computer-user interface. Dr. Liu has been published in Decision Support Systems, Information & Management, Journal of Accounting, Auditing, and Finance, International Journal of Accounting Information Systems, Journal of Accounting and Public Policy, International Journal of Human Computer Studies, Electronic Markets, and Issues in Accounting Education. She has presented papers in these fields in numerous academic conferences including the IABPAD conference.

Grace O'Farrell is an Associate Professor in the Department of Business and Administration at the University of Winnipeg. Her current research interests include international accounting harmonization, cost/benefit analysis of employee benefit programs, respect in the workplace, and person-organization fit. She has published in Decision Support Systems; Ivey Business Journal; International Journal of Business, Accounting and Finance; International Journal of Services and Standards, International Journal of Managerial and Financial Accounting, HR Professional Magazine; and, the Journal of Drug Issues, among others. She has presented papers at a multitude of academic conferences including the IABPAD, ASAC, and Western Academy of Management conferences. She is the correspondence author for this manuscript.
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Author:O'Farrell, Grace; Liu, Chunhui
Publication:International Journal of Business, Accounting and Finance (IJBAF)
Article Type:Report
Geographic Code:4EUGE
Date:Sep 22, 2015
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