There is much controversy over the differences between U.S. Generally Accepted Accounting Principles and the more flexible International Accounting Standards.
Much of the debate is pointless.
IAS is growing in use worldwide. Moreover, investors need to invest globally and should not wait for U.S. GAAP accounting before venturing to invest in non-U.S. companies. Finally, the globalization of markets is happening at a rapid pace, which threatens to leave the United States behind as the leading world market.
International accounting standards differ widely from GAAP. These differences occur in nearly every account in financial statements including depreciation rates, pension treatment, provisions for deferred taxes, reserve accounting, valuation of assets, provisions for bad debts or receivables.
Today, the International Accounting Standards Committee is working to reduce the differences among countries' standards and to develop a common international standard. The IASC, however, is a cumbersome group, comprising 116 organizations from 86 countries. The United States, for example, is represented by four organizations: the American Institute of Certified Public Accountants, the Institute of Internal Auditors, the Institute of Management Accountants and the National Association of State Boards of Accountancy. With so many diverse interests at stake, it is a natural progress that has been slow.
Meanwhile, the world has not waited. The market capitalization of world equities rose to $20.2 trillion in 1996 from $4.7 trillion in 1985, and the purchase by U.S. investors of foreign securities alone rose to more than $475 billion in 1996 from only $17 billion in 1983.
This presents a challenge for investors who feel the need to invest internationally but who are concerned about accounting standards.
What do analysts want?
A crucial topic for investors today is the discussion by accountants of reciprocity, the regulatory acceptance of another country's accounting standards; reconciliation, the presentation of adjustments to meet another country's accounting standards; and the eventual global acceptance of a set of International Accounting Standards.
In choosing their position, investors need to determine their priorities among four conflicting goals for their investments: legitimacy, comparability, access and liquidity. Because the U.S. has the world's largest market, with the highest trading volume and lowest transactions costs, it is the market of choice for investors who seek access to the world's companies with the best liquidity for trading in them.
Investors must insist on protection of the legitimacy of their investments, but they should sacrifice global comparability for more rapid improvement in access to foreign markets and in trading liquidity.
The case for global investing
After a 15-year bull market in the United States, investors have become accustomed to unsustainable 15% annual returns and often are hesitant to invest in non-U.S. markets. This is a dangerous position.
As shown in Exhibit 1, international returns were higher than those in the United States from 1970 through 1995. It is only the recent period that has been more rewarding here. Still, even during the past 10 years, there has been significantly greater gain in emerging markets, 22% compounded, than in the United States, 16%.
Also from the perspective of valuation, the United States is less attractive, selling at a price/book value ratio of over 3.5x vs. roughly 3x for Germany and the United Kingdom and 2x for France and Japan (which had reached 5x in 1989). Since accounting practices in the foreign countries generally permit more rapid depreciation of assets than the United States, book values outside the U.S. are understated relative to U.S. GAAP; and thus, the differences in published price/book ratios are actually understated.
While many U.S. investors are unaware of these differences in returns and price/book ratios, another misconception is that they already have international exposure because they are invested in multinational U.S. companies. While companies such as Gillette Co., IBM and Coca Cola Co., have more than 50% of sales and earnings outside of the United States, they nevertheless behave more like the S&P 500 Stock Index than foreign stocks. We constructed a portfolio of these companies, including the 75 largest U.S. companies with more than half of sales and earnings abroad, and then calculated the correlation of that portfolio with the U.S. market. As Exhibit 2 shows, these multinationals have a correlation with the S&P roughly 0.9, which is similar to the correlation of a typical U.S. core portfolio. These stocks have only a 0.4 correlation with stocks in the MSCI*EAFE*Index.
Thus, we believe the case of global investing is compelling. Investors need the returns, valuations and diversification benefits of foreign stocks today.
Imperfections of accounting
Accounting is an imperfect science, and observers agree accounting abuses are widespread. Accounting today springs from two separate roots: microbased accounting, which focuses on the performance of the individual business entity; and macrobased accounting, in countries like Germany and France, which is designed for tax reporting to the government. Within this world of accounting, there are many unusual practices, from the treatment of employee bonuses as profit in China to the treatment of zero-coupon convertible debentures as debt in India. Most abuses, however, occur in reserves, taxes and depreciation.
In addition to these examples of "creative accounting" abroad, there are others here at home. The fact is analysts everywhere need to analyze financial statements carefully. The innocent "man in the street" is not totally protected even by GAAP. Internationally, the current state of IAS offers investors basic protections that are similar to GAAP to assure the legitimacy of the company and the shareholder's position.
The tide of globalization
While accountants debate the issues of IAS, reciprocity and reconciliation, the tide of globalization is rising. Exhibit 3 shows the vast increase in the market capitalization of equities worldwide. While the United States has risen 3.6 times since 1985 to $8.5 trillion, developed markets abroad have increased 4.4 times and now are larger, at $9.5 trillion. Most impressive has been the increase in emerging markets since 1985 to more than $2.2 trillion today. The United States' share of world equities has continued its slide, to 42% now from 66% in 1970.
The change in trading volume has been even more dramatic, as shown in Exhibit 4.
U.S. volume is up 7.1 times since 1985; volume in other developed countries is up 8.1 times; and volume in emerging markets is up a whopping 35 times. Finally, in terms of the number of issues, the U.S. is now only 20% of the total and emerging markets represent 53%! Thus over the last decade, with or without IAS and GAAP, investors have become increasingly active globally, regardless of the differences in accounting standards. There is no evidence any of these trends are slowing.
There are two urgent pressures on international accounting today.
One is the explosive globalization of stock markets, as non-U.S. companies become more important and there is a continued decline in the share of world financial markets represented by U.S. stocks. The second is investors' compelling need to diversify by having effective liquid access to non-U.S. equities.
Meanwhile, accountants are deliberating the threat to the quality of GAAP reporting requirements from accepting IAS statements from non-U.S. companies.
We believe the urgency of globalization should outweigh the theoretical goal of accounting comparability. Rather than demanding GAAP, U.S. financial analysts should demand more global opportunities, and apply their analytical skills to picking the best investments in the world, based on either IAS or GAAP.
Lawrence S. Speidell is director of global/systematic portfolio management and research at Nicholas-Applegate Capital Management, San Diego.