Accounting Diversity and International Valuation
Posted: 21 May 1998
Date Written: March 1996
International differences in accounting rules pose a significant challenge to investors interested in making cross-border comparisons of firm value. While current efforts to harmonize international standards are laudable, they are unlikely to completely eliminate cross-border diversity. In this study, we suggest an alternative, and complimentary, approach for coping with international accounting diversity.Our approach is based on a valuation technique referred to as the Discounted Residual Income or the Edwards-Bell-Ohlson (EBO) model. We show this theory can be operationalized to create "V," a measure of firms' fundamental value which is conceptually identical to the present value of the future cash flows (or dividends), but is based on a firm's book value and expected earnings. One of the most appealing features of V is that it is theoretically immune to differences in accounting methods across firms or countries. In this paper, we develop the theoretical underpinnings of the EBO valuation model in an international context. We explain whey the model has the potential to become a "universal translator," that is, a vehicle by which accounting earnings and balance sheet numbers produced under alternative national accounting systems can be translated into consistent measures of firm value. Conceptually, the model operates equally well under any accounting system provided a set of minimal conditions is satisfied. We define these conditions, and evaluate existing accounting systems across different countries in the context of these conditions.We also present empirical evidence on the usefulness of this model in global asset allocation decisions, and in explaining cross-sectional stock prices in different countries. We document the value-relevance of earnings forecasts provided by local financial analysts, and argue that these earnings forecasts represent a potential omitted variable for the current set of accounting studies dealing with the information content of U.S. GAAP reconciliation (Form 20-F) disclosures.Our results suggest that a proper valuation model can greatly mitigate accounting diversity problems in international valuations. Given reliable earnings forecasts and book values, a detailed reconciliation of accounting differences is not necessary to make cross-border value comparisons. Our analyses also imply that regulatory efforts need not focus on achieving "superficially comparable" earnings and book values, or standardizing such specific rules as the amortization of goodwill. Rather, greater emphasis might be more profitably placed on ensuring that professional analysts have necessary information to make reliable earnings forecasts consistent with local accounting standards.
JEL Classification: M41, G12
Suggested Citation: Suggested Citation