Chapter 7
How to cope with the most complex
points in financial accounts
Everything you always wanted to know but never dared to ask!
This chapter is rather different from the others. It is not intended to be read from start to finish, but consulted from time to time, whenever readers experience problems interpreting, analysing or processing a particular accounting item.
Each of these complex points will be analysed from these angles:
- from an economic standpoint so that readers gain a thorough understanding of its real substance;
- from an accounting standpoint to help readers understand the accounting treatment applied and how this treatment affects the published accounts;
- from a financial standpoint to draw a conclusion as to how best to deal with this problem.
Our experience tells us that this is the best way of getting to grips with and solving problems. The key point to understand in this chapter is the method we use to deal with complex issues, since we cannot look at every single point here. When faced with a different problem, readers will have to come up with their own solutions using our methodology – unless they contact us through the vernimmen.com website.
The following bullet list shows, in alphabetical order, the main line items and principal problems that readers are likely to face:
Section 7.1 Accruals
1. What are accruals?
Accruals are used to recognise revenue and costs booked in one period but relating to another period. To accrue basically means to transfer revenue or costs from the P&L to the balance sheet.
2. How are they accounted for?
The main categories of accruals are:
- prepaid costs, i.e. costs relating to goods or services to be supplied later. For instance, three-quarters of a rental charge payable in advance for a 12-month period on 1 October each year will be recorded under prepaid costs on the asset side of the balance sheet at 31 December;1
- deferred income, i.e. income accounted for before the corresponding goods or services have been delivered or carried out. For instance, a cable company records three-quarters of the annual subscription payments it receives on 1 October under deferred income on the liabilities side of its balance sheet at 31 December.2
We should also mention accrued income and cost, which work in the same way as deferred income and prepaid cost, only in reverse. For example, a company can accrue R&D costs, i.e. consider that it should not appear in the P&L but as an intangible asset that will be amortised or depreciated.
3. How should financial analysts treat them?
Deferred income and prepaid cost form part of operating working capital.
Section 7.2 Cash assets
1. What are cash assets?
Cash assets correspond to short-term investment of a company’s cash surpluses (see Chapter 49).
2. How are they accounted for?
From an accounting point of view, such investments can only be considered as cash equivalent if they are very liquid, short term, easily converted into cash for a known amount and exposed to a negligible risk of change in value.
In practice, a certain number of criteria are applied (especially for UCITS): benchmark index, frequency of liquidity value, penalties in the event of exit, volatility, counterparty risk, etc.
The tightening up of restrictions on classifying investments as cash equivalents is a result of the failings which occurred following the liquidity crisis of 2007–2008, during which some investors discovered that so-called monetary investments were in reality risky investments (thus not liquid at the time of the crisis and highly volatile). In periods of zero or negative short-term interest rates, as in 2015–2017 in Germany, Japan, Switzerland or France, it is necessary to be particularly vigilant regarding cash assets generating positive profitability, as it cannot be obtained without taking risks.
Under IFRS, cash assets are valued on the basis of their fair value, with any gains and losses recognised in the income statement as financial income.
3. How should financial analysts treat them?
The classification of cash assets or long-term investment assets is important when evaluating the liquidity of a company. From an economic point of view, the analyst will try to understand, first and foremost, whether the asset contributes to operating earnings (and should thus be integrated into capital employed), or if it is a financial investment (whether long or short term). It will then be deducted from net debt.
Section 7.3 Construction contracts
1. What are construction contracts?
In some cases, it may take more than a year for a company to complete a project. For instance, a group that builds dams or ships may work for several years on a single project.
2. How are they accounted for?
Construction contracts are accounted for using the percentage of completion method, which consists of recognising at the end of each financial year the sales and profit/loss anticipated on the project in proportion to the percentage of the work completed at that time. US accounting rules recognise both the percentage of completion method and the completed contract method, where revenue recognition is deferred until completion of the contract.3
3. How should financial analysts treat them?
Construction projects in progress are part of the operating working capital. The percentage of completion method results in less volatile profits as they are spread over several fiscal years, even if the completed contract method may seem more prudent. Analysts should be aware of changes in accounting methods for construction contracts (which are not possible under IFRS) as such changes may indicate an attempt to artificially improve the published net income for a given year.
Section 7.4 Convertible bonds and loans
1. What are convertible bonds and loans?
Convertible bonds are bonds that may be converted at the request of their holders into shares in the issuing company. Conversion is thus initiated by the investor.4 If they are not converted, they are repaid in cash at maturity.
2. How are they accounted for?
When they are issued, convertible bonds and loans are allocated between debt and equity accounts5 since they are analysed under IFRS standards as compound financial instruments made up of a straight bond and a call option (see Chapter 24). The present value of the coupons and reimbursement amount discounted at a fair borrowing rate of the firm is accounted for as debt. The remainder is accounted for as equity. In addition, each year the company will account for the interest as it would be paid for a standard bond (part of this amount corresponding to the actual amount paid, the rest being a notional amount).
3. How should financial analysts treat them?
The approach we recommend is to examine the conditions governing conversion of the bonds and to make the equity/debt classification based on the results of this analysis. For instance, if the share price already lies well above the conversion price, then the bonds are very likely indeed to be converted, so they should be treated as equity. For valuation purposes, the related interest expense net of tax should be reversed out of the income statement, leading to an increase in net income. The number of shares should also be increased by those to be issued through the conversion of the convertible bonds.
On the other hand, if the share price is below the conversion price, then convertible bonds should be treated as conventional bonds and stay classified as borrowings.
Section 7.5 Currency translation adjustments
See Chapter 6.
Section 7.6 Deferred tax assets and liabilities
1. What are deferred tax assets and liabilities?
Deferred taxation giving rise to deferred tax assets or liabilities stems from differences between the taxable and book values of assets and liabilities.
On the income statement, certain revenues and charges are recognised in different periods for the purpose of calculating pre-tax accounting profit and taxable profit.
In some cases, the difference may be temporary due to the method used to derive taxable profit from pre-tax accounting profit. For instance, a cost has been recognised in the accounts, but is not yet deductible for tax purposes (e.g. employee profit-sharing in some countries), or vice versa. The same may apply to certain types of revenue. Such differences are known as timing differences.
In other circumstances, the differences may be definitive, i.e. for revenue or charges that will never be taken into account in the computation of taxable profit (e.g. tax penalties or fines that are not deductible for tax purposes). Consequently, there is no deferred tax recognition.
On the balance sheet, the historical cost of an asset or liability may not be the same as its tax base, which creates a temporary difference. Depending on the situation, temporary differences may give rise to a future tax charge and thus deferred tax liabilities, while others may lead to future tax deductions and thus deferred tax assets. For instance, deferred tax liabilities may arise from:
- assets that give rise to tax deductions that are lower than their book value when sold or used. The most common example of this derives from the revaluation of assets upon the first-time consolidation of a subsidiary. Their value on the consolidated balance sheet is higher than the tax base used to calculate depreciation and amortisation or capital gains and losses;
- capitalised financial costs that are deductible immediately for tax purposes, but that are accounted for on the income statement over several years or deferred;
- revenues, the taxation of which is deferred, such as accrued financial income that becomes taxable only once it has been actually received.
Deferred tax assets may arise in various situations including costs that are expensed in the accounts but are deductible for tax purposes in later years only, such as:
- provisions that are deductible only when the stated risk or liability materialises (for retirement indemnities in certain countries);
- certain tax losses that may be offset against tax expense in the future (i.e. tax-loss carryforwards, long-term capital losses).
Finally, if the company were to take certain decisions, it would have to pay additional tax. These taxes represent contingent tax liabilities, e.g. stemming from the distribution of reserves on which tax has not been paid at the standard rate.
2. How are they accounted for?
It is mandatory for companies to recognise all their deferred tax liabilities in consolidated accounts. Deferred tax assets arising from tax losses should be recognised when it is probable that the deferred tax asset can be used to reduce tax to be paid.
Deferred tax liabilities are not recognised on goodwill where goodwill depreciation is not deductible for tax purposes, as is the case in the UK, Italy or France. Likewise, they are not recorded in respect of tax payable by the consolidating company on distributions (e.g. dividend withholding tax) since they are taken directly to shareholders’ equity.
In some more unusual circumstances, the temporary difference relates to a transaction that directly affects shareholders’ equity (e.g. a change in accounting method), in which case the temporary difference will also be set off against the company’s shareholders’ equity.
IFRS does not permit the discounting of deferred tax assets and liabilities to net present value.
Deferred tax is not the same as contingent taxation, which reflects the tax payable by the company if it takes certain decisions. As examples one may think about tax charges payable if certain reserves are distributed (i.e. dividend withholding tax), or if assets are sold and a capital gain is registered, etc. The principle governing contingent taxation is straightforward: it is not recorded on the balance sheet and no charge appears on the income statement.
3. How should financial analysts treat them?
(a) The simple case of losses
A group makes a pre-tax book and tax loss of 100. From a tax point of view, the tax due is zero. From an accounting point of view, and if there is reason to believe that the company is likely to make profits in the future that will enable it to use this tax-loss carryforward, then the loss will be reduced by a tax credit of 34.6 Accordingly, the after-tax loss will be booked at 66. In order to balance the books, a tax credit carryforward of 34 will be recognised in the balance sheet on the assets side.
The following year, if our group makes an accounting and taxable profit of 100, it will not pay any tax, as the tax-loss carryforward created that year will be set off against the tax due. From an accounting point of view, we’ll recognise a theoretical tax expense of 34 and reduce the deferred tax recognised previously in the balance sheet to 0.
This example clearly shows that the deferred tax credit was created by reducing the amount of the net accounting loss and thus increasing equity by the same amount. From a financial point of view, it is only of value if future operations are able to generate enough profits. But under no circumstances can it be considered as an ordinary asset that could be sold for cash. And it is most certainly not an element of working capital as it does not result from the time lapse between the billing date and the payment date. We’ll consider it as a fixed asset. At worst, it could be reversed against shareholders’ equity, if there are serious doubts about the company’s future ability to make profits.
(b) The case of provisions that are not immediately tax-deductible
In some countries, provisions for retirement benefits, restructuring and environmental risks are not tax-deductible when they are recognised. They are only tax-deductible when the related expense is paid. The accounting rule for consolidated accounts is different because allocations to these provisions are treated as tax-deductible when they are recognised. This is what results in the gap between real flows and the accounting treatment.
Let’s consider a group that is making pre-tax profits of 100 per year. This year, it must allocate 100 to a reserve to cover a risk that may materialise in three years. From a tax point of view, the net result is 667 as the reserve is not tax-deductible and the tax recognised is 34. From an accounting point of view, as the reserve of 100 is a cost, the net result is 0. The tax effectively paid (34) appears on the income statement but is neutralised by a deferred tax income of 34, which, in order to balance the books, is also recorded on the assets side of the balance sheet. Finally, the net tax recorded on the income statement is 0.
In three years, all other things being equal, the net tax result is 0 since the cost is tax-deductible and the tax effectively paid that year is thus 0. From an accounting point of view, the written-back provision cancels out the expense, so the pre-tax result is 100 − 100 (cost) + 100 (provision written back) = 100. The tax recognised by accountants is 34, which is split into 0 tax paid and 34 recognised through deduction from the deferred tax credit recognised in the balance sheet three years ago, which is thus used up.
The deferred tax credit carried on the balance sheet for three years has a cross-entry under equity capital that is higher by 34. This is tax that has already been paid but from an accounting point of view is considered as a future expense. Unlike inventories of raw materials, which have been paid for and which are also a future expense, deferred tax has no monetary value.
The financial treatment we advocate is simple: it is cancelled from assets and deducted from the provision under liabilities (so that it appears after tax) or from equity to reverse the initial entry.
(c) Revaluing assets
Revaluing an asset when it is first consolidated or subsequently (when tested for impairment)8 has two consequences:
- The taxable capital gains if the asset is sold will be different from the book value of the capital gains recorded in the consolidated financial statements.
- The basis for depreciation will be different, and will thus generate deferred taxes.
A group acquires a new subsidiary which has land recorded on its balance sheet at its initial acquisition value of 100. This land is revalued in the consolidated financial statements at 150.
We will then book a deferred tax liability of (150 − 100) × 34% = 17 in the consolidated financial statements. What is this liability from an economic point of view? It is the difference that will be booked in the consolidated financial statements between the tax actually paid on the day when the land is sold at a price of P − (P − 100) × 34% and the tax that will be recognised (P − 150) × 34%. The cross-entry on the balance sheet for this deferred tax is a lesser reduction of goodwill, which is reduced not by 50 but by (50 − 17).
Is this a debt owed to the tax administration? Clearly not, since the land would have to be sold for a tax liability to appear and then for an amount of (P − 100) × 34% and probably not 17! How do we advise our readers to treat this deferred tax liability? Deduct it from goodwill.
So, what of the case of the asset that has been revalued but that is depreciable? There is an initial recognition of the deferred tax liability being gradually reduced over the duration of the residual life of the asset by deferred tax credits due to the difference between a tax depreciation calculated on the basis of 100 and book depreciation calculated on the basis of 150.
Section 7.7 Dilution profit and losses
1. What are dilution profit and losses?
Where a parent company does not subscribe either at all or only partially to a capital increase by one of its subsidiaries that takes place at a value above the subsidiary’s book value, the parent company records a dilution profit.
Likewise, if the valuation of the subsidiary for the purpose of the capital increase is less than its book value, the parent company records a dilution loss.
2. How are they accounted for?
For instance, let us consider the case of a parent company that has paid 200 for a 50% shareholding in a subsidiary with shareholders’ equity of 100. A capital increase of 80 then takes place, valuing the subsidiary at a total of 400. Since the parent company does not take up its allocation, its shareholding is diluted from 50% to 41.67%.
The parent company’s share of the subsidiary’s equity increases from 50% × 100 = 50 to 41.67% × (100 + 80) = 75, which generates a non-recurrent gain of 75 − 50 = 25. This profit of 25 corresponds exactly to the profit that the parent company would have made by selling an interest of 50% − 41.67% = 8.33% based on a valuation of 400 and a cost price of 100 for 100%, since 25 = 8.33% × (400 − 100).
3. How should financial analysts treat them?
Dilution gains and losses generate an accounting profit, whereas the parent company has not received any cash payments. They are, by their very nature, non-recurring. Otherwise, the group would soon not have any subsidiaries left. Naturally, they do not form part of a company’s normal earnings power and so they should be totally disregarded.
Section 7.8 Financial hedging instruments
1. What are financial hedging instruments?
Their purpose is to hedge against a financial risk linked to a variation in exchange rates, interest rates, raw materials prices, etc. (see Chapter 50). This may arise out of a commercial operation (receivable in foreign currency, for example, or a financial operation (such as a debt at a variable rate)). They rely on derivatives such as options, futures, swaps, etc. (see Chapter 50).
2. How are they accounted for?
Accounting for financial hedging instruments made up of derivatives (options, futures, swaps, etc.) is very complicated under IFRS.
Oversimplifying it, the basic principle is that financial hedging instruments must be booked on the balance sheet at their fair value (which is generally their market value) and changes in value must be booked as income or expense in the P&L.
Nevertheless, if the financial products are acquired to hedge against a specific risk, then a system known as hedge accounting can be put in place. However, in this case, the company must be able to prove (and to document) that the hedge is practically perfectly adjusted (amount, duration) to the underlying amount, otherwise the instrument in question will not qualify for hedge accounting and its variations in value will appear on the income statement.
IFRS distinguishes between two types of hedge:
- fair value hedge, and
- cash flow hedge.
The difference between the two is not always that clear. For example, hedging against a foreign exchange risk of a receivable in dollars could be considered to be a fair value hedge since it is used to secure the value of this receivable or as a cash flow hedge guaranteeing the counter value of the effective payment by the client.
(a) Fair value hedges
On principle, receivables and debts are booked at their historic cost (amortised cost) while financial instruments are booked at their fair value. The application of these principles could lead to an absurd situation. Let’s take, for example, a company that hedges a fixed-rate debt with a swap. If the company closes its financial year before the debt matures, the change in the value of the debt has no impact on the income statement, while the change in the value of the swap does impact the income statement. This is so even though both can set each other off!
In order to remedy this problem, IFRS recommends booking the changes in value of a receivable or a debt hedged by a financial instrument on the income statement. In this way, the gains or losses on the underlying asset are set off by the losses or gains on the hedging instrument. And there is no impact on the result.
(b) Cash flow hedges
Let’s take the example of a chocolate producer that hedges the future price of cocoa with a forward purchase. The company closes its financial year after putting the hedging in place but before the actual purchase of the cocoa. If the price of cocoa has fallen since the hedging was put in place, then the principle of fair value applied to financial instruments holds that the company should book a loss in terms of the change in the value of the forward contract. This isn’t logical as this loss only exists because the company wanted to be sure that the price at which it was to purchase its cocoa was fixed in advance so as to eliminate its risk.
The change in value of the financial hedging instrument is booked on the asset side and under equity (under “other comprehensive income”) without a loss or a gain being recorded on the income statement. Gains and losses on the hedging instrument only appear when underlying flows effectively take place, i.e. at the time of the effective purchase of the cocoa in our example. Our producer will then record a total expense (purchase price of cocoa lower than forecast and loss on the forward contract), which will reflect the price fixed in advance in its hedging contract.
3. How should financial analysts treat them?
Before all else, the financial manager must try to check that the financial instruments are not linked to speculative transactions (and this independently of the accounting option that was possible). She should also try to divide hedging operations into commercial operations and financial operations.
Accordingly, it would be logical to integrate into EBIT the changes in the value of financial instruments if these were contracted to hedge operating receivables or debts. The balance of assets/liabilities of financial instruments must then be included in capital employed (generally under working capital).
If the financial instruments are hedging placements or financial debts, then they should be attached to net debt (on the balance sheet) and the change in their value to the income statement.
Section 7.9 Impairment losses
1. What are impairment losses?
Impairment losses are set aside to cover capital losses, or those that may be reasonably anticipated, on assets. They can be incurred on goodwill, other intangible assets and tangible assets.
2. How are they accounted for?
Impairment losses are computed based on the value of cash generating units (CGUs).9 The firm needs to define a maximum number of largely independent CGUs and allocate assets for each one. Each year, the recoverable value of the CGU is computed if there is an indication that there might be a decrease in value or if it includes goodwill.10 If the recoverable value of the CGU is lower than the carrying amount, then an impairment loss needs to be recognised. Impairment is first allocated to goodwill (if any) and then among the other assets.
The recoverable value is defined as the highest of:
- the value in use, i.e. the present value of the cash flows expected to be realised from the asset;
- the net selling price, i.e. the amount obtainable from the sale of an asset in an arm’s-length transaction11 less the costs of disposal.
If the value of the CGU increases again, then the impairment can be reversed on all assets but goodwill.
3. How should financial analysts treat them?
Impairment losses are netted off directly against assets, and provided that these losses are justified, there is no need for any restatements. Conversely, we regard impairment losses on tangible assets as non-recurring items. As discussed on page 80, we consider impairment losses on intangible fixed assets (including goodwill) as non-operating items to be excluded from EBITDA and EBIT.12
Section 7.10 Intangible fixed assets
Under IFRS, these primarily encompass capitalised development costs, patents, licences, concessions and similar rights, leasehold rights, brands, software and goodwill arising on acquisitions (see Chapter 6).
This line item requires special attention since companies have some degree of latitude in treating these items that now represent a significant portion of companies’ balance sheets.
Under IFRS, a company is required to recognise an intangible asset (at cost) if and only if:
- it is probable that the future economic benefits that are attributable to the asset will flow to the company; and if
- the cost of the asset can be reliably measured.
Internally generated goodwill, brands, mastheads, publishing titles and customer lists should not be recognised as intangible assets. Internally generated goodwill is expensed as incurred. Costs of starting up a business, of training, of advertising, of relocating or reorganising a company receive the same treatment.
1. Start-up costs
(a) What are start-up costs?
Start-up costs are costs incurred in relation to the creation and the development of a company, such as incorporation, customer canvassing and advertising costs incurred when the business first starts operating, together with capital increases, merger and conversion fees.
(b) How are they accounted for?
Start-up costs are to be expensed as incurred under IFRS and US GAAP.
(c) How should financial analysts treat them?
It is easy to analyse such costs from a financial perspective. They have no value and should thus be deducted from the company’s shareholders’ equity.
2. Research and development costs
(a) What are research and development costs?
These costs are those incurred by a company on research and development for its own benefit.
(b) How are they accounted for?
Under IFRS, research costs are expensed as incurred in line with the conservatism principle governing the unpredictable nature of such activities.
Development costs should be capitalised on the balance sheet if the following conditions are met:
- the project or product is clearly identifiable and its costs measurable;
- the product’s feasibility can be demonstrated;
- the company intends to produce, market or use the product or project;
- the existence of a market for the project or product can be demonstrated;
- the utility of the product for the company, where it is intended for internal use, can be demonstrated;
- the company has or will have the resources to see the project through to completion and use or market the end product.
Under US GAAP, research and development costs generally cannot be capitalised (except specific web developments).
(c) How should financial analysts treat them?
We recommend leaving development costs in intangible fixed assets, while monitoring closely any increases in this category, since those could represent an attempt to hide losses.
3. Brands and market share
(a) What are brands and market share?
These are brands or market share purchased from third parties and valued, when allowed, upon their first-time consolidation by their new parent company.
(b) How are they accounted for?
Brands are not valued in the accounts unless they have been acquired. This gives rise to an accounting deficiency, which is especially critical in the mass consumer (e.g. food, textiles, automotive sectors) and luxury goods industries, particularly from a valuation standpoint. Brands have considerable value, so it makes no sense whatsoever not to take them into account in a company valuation. As we saw in Chapter 6, the allocation of goodwill on first-time consolidation to brands and market share leads to an accumulation of such assets on groups’ balance sheets. For instance, LVMH carries brands for €10 billion on its balance sheet, which thus account for 23% of its capital employed. Since the amortisation of brands is not tax-deductible in most countries, it has become common practice not to amortise such assets so that they have an indefinite life. Brands are, at most, written down where appropriate.
Under IFRS, market share cannot be carried on the balance sheet and neither can training or advertising expenses, which are consequently part of goodwill but not individually identified as such.
Intangible assets with finite lives are amortised over their useful life. Intangible assets with indefinite lives undergo an impairment test each year to verify that their net book value is consistent with the recoverable value of the corresponding assets (see Section 7.9).
US rules are very similar to the IASB’s.
(c) How should financial analysts treat them?
Some analysts, especially those working for lending banks, regard brands as having nil value from a financial standpoint. Such a view leads to deducting these items peremptorily from shareholders’ equity. We beg to differ with this approach.
These items usually add considerably to a company’s valuation, even though they may be intangible. For instance, what value would a top fashion house or a consumer goods company have without its brands?
4. Conclusion
To sum up, our approach to intangible fixed items is as follows: the higher the book value of intangibles, the lower their market value is likely to be; and the lower their book value, the more valuable they are likely to be. This situation is attributable to the accounting and financial policy of a profitable company that seeks to minimise its tax expense as much as possible by expensing every possible cost. Conversely, an ailing company or one that has made a very large acquisition may seek to maximise its intangible assets in order to keep its net profit and shareholders’ equity in positive territory.
Section 7.11 Inventories
1. What are inventories?
Inventories include items used as part of the company’s operating cycle. More specifically, they are:
- used up in the production process (inventories of raw materials);
- sold as they are (inventories of finished goods or goods for resale) or sold at the end of a transformation process that is either under way or will take place in the future (work in progress).
2. How are they accounted for?
(a) Costs that should be included in inventories
The way inventories are valued varies according to their nature: supplies of raw materials and goods for resale or finished products and work in progress. Supplies are valued at acquisition cost, including the purchase price before taxes, customs duties and costs related to the purchase and the delivery. Finished products and work in progress are valued at production cost, which includes the acquisition cost of raw materials used, direct and indirect production costs insofar as the latter may reasonably be allocated to the production of an item.
Costs must be calculated based on normal levels of activity, since allocating the costs of below-par business levels would be equivalent to deferring losses to future periods and artificially inflating profit for the current year. In practice, this calculation is not always properly performed, so we would advise readers to closely follow the cost allocation.
Financial charges, development costs and general and administrative costs are not usually included in the valuation of inventories unless specific operating conditions justify such a decision. IFRS requires interim interest payments13 to be included in the cost of inventories; US GAAP allows interim interest payments to be included in inventories in certain cases.
(b) Valuation methods
Under IFRS, there are three main methods for valuing inventories:
- the weighted average cost method;
- the FIFO (first in, first out) method;
- the identified purchase cost method.
Weighted average cost consists of valuing items withdrawn from the inventory at their weighted average cost, which is equal to the total purchase cost divided by quantities purchased.
The FIFO method values inventory withdrawals at the cost of the item that has been held in inventory for the longest.
The identified purchase cost is used for non-interchangeable items and goods or services produced and assigned to specific projects.
For items that are interchangeable, the IASB allows the weighted average cost and FIFO methods but no longer accepts the LIFO method (last in, first out) that values inventory withdrawals at the cost of the most recent addition to the inventory. US GAAP permits all methods (including LIFO) but the identified purchase cost method.
During periods of inflation, the FIFO method enables a company to post a higher profit than under the LIFO method. The FIFO method values items withdrawn from the inventory at the purchase cost of the items that were held for longest and thus at the lowest cost, hence giving a higher net income. The LIFO method produces a smaller net income as it values items withdrawn from the inventory at the most recent, and thus the highest, purchase cost. The net income figure generated by the weighted average cost method lies midway between these two figures.
Analysts need to be particularly careful when a company changes its inventory valuation method. These changes, which must be disclosed and justified in the notes to the accounts, make it harder to carry out comparisons between periods and may artificially inflate net profit or help to curb a loss.
Finally, where the market value of an inventory item is less than its calculated carrying amount, the company is obliged to recognise an impairment loss for the difference (i.e. an impairment loss on current assets).
3. How should financial analysts treat them?
Firstly, let us reiterate the importance of inventories from a financial standpoint. Inventories are assets booked by recognising deferred costs. Assuming quantities remain unchanged, the higher the carrying amount of inventories, the lower future profits will be. Put more precisely, assuming inventory volumes remain constant in real terms, valuation methods do not affect net profit for a given period. But, depending on the method used, inventory receives a higher or lower valuation, making shareholders’ equity higher or lower accordingly.
Hence the reluctance of certain managers to scale down their production even when demand contracts. Finally, we note that, tax-related effects apart, inventory valuation methods have no impact on a company’s cash position.
From a financial standpoint, it is true to say that the higher the level of inventories, the greater the vulnerability and uncertainty affecting net income for the given period. We recommend adopting a cash-oriented approach if, in addition, there is no market serving as a point of reference for valuing inventories, such as in the building and public infrastructure sectors, for instance. In such circumstances, cash generated by operating activities is a much more reliable indicator than net income, which is much too heavily influenced by the application of inventory valuation methods.
Consequently, during inflationary periods, inventories carry unrealised capital gains that are larger when inventories are moving more slowly. In the accounts, these gains will appear only as these inventories are being sold, even though these gains are there already. When prices are falling, inventories carry real losses that will appear only gradually in the accounts, unless the company writes down inventories, as was done by ArcelorMittal in 2015, for example.
The only financial approach that makes sense would be to work on a replacement cost basis and thus to recognise gains and losses incurred on inventories each year. In some sectors of activity where inventories move very slowly, this approach seems particularly important. In the early 2010s Italian banks carried loans on their books for amounts that were well above their value. We firmly believe that had loans been written down to their market value, the ensuing crisis in the sector would have been less severe. The Italian banks would have recognised losses in one year and then posted decent profits the next, instead of resorting to all kinds of creative solutions to spread losses over several years, earning them the reputation of a perpetually sick man.
Section 7.12 Leases
1. What are leases?
One must distinguish between operating leases allowing a company to use some of its operating fixed assets (i.e. buildings, plant and other fixed assets) under a rental system, and finance or capital leases allowing the company to purchase the asset at the end of the rental contract for a predetermined and usually very low amount (see page 378).
Leases raise two relatively complicated problems for external financial analysts:
- Firstly, leases are used by companies to finance the assets. Even if those items may not appear on the balance sheet, they may represent a considerable part of a company’s assets.
- Secondly, they represent a commitment, the extent of which varies depending on the type of contract:
- equipment leasing may be treated as similar to debt depending on the length of the period during which the agreement may not be terminated;
- real-estate leasing for buildings may not be treated as actual debt in view of the termination clause contained in the contract. Nonetheless, the utility of the leased property usually leads the company to see out the initially determined length of the lease, and the termination of the lease may then be treated as the early repayment of a borrowing (financed by the sale of the relevant asset).
2. How are they accounted for?
A lease is either a finance lease or an operating lease.
A finance lease14 according to IASB is “a lease that transfers substantially all the risk and rewards incident to ownership of an asset. Title may or may not eventually be transferred.”15 Indications of the financial nature of a lease include:
- the contract sets out that the asset will be transferred at the end of the lease to the company;
- the lessee has the option to purchase the asset at an “attractive” price;
- the lease is for the major part of the economic life of the asset;
- the present value of the rents is close to the fair value of the leased asset at the beginning of the contract;
- the assets leased are so specific that only the company can use them without major changes being made.
Although the idea is similar, US GAAP follows a more directive approach to distinguish financial and operating leases: an operating lease is a lease that is not a finance lease.
Under IFRS, finance leases are capitalised, which means they are recorded under fixed assets and a corresponding amount is booked under financial debt.
The lease payments to the lessor are treated partly as a repayment of financial debt and partly as financial expense. The capitalised asset under a finance lease is depreciated over its useful life. Accordingly, no rental costs are recorded on the income statement, merely financial and depreciation costs.
Classification of leases under US GAAP.
Operating leases are not capitalised and are treated as rents.
Sale and leaseback transactions, where an asset is sold only to be taken back immediately under a lease, are restated as follows: any capital gain on the disposal is deferred and recognised in income over the duration of the lease for finance leases or immediately for operating leases.
The IASB and the FASB have published new standards that consider all leases as financial leases. Implementation of these new standards will commence in 2019.
Assets appearing on the balance sheet will be significantly larger, as will liabilities on the liabilities side. This seems to be based on a misunderstanding.16 The purpose of an operating lease is flexibility (ability to easily change equipment or a building) as they are rented and not owned. The purpose of a finance lease is to carry out an acquisition financed by a debt pledged on the asset thus acquired. So far from being one and the same!
3. How should financial analysts treat them?
The reader should beware of a company with large operating leases. They add fixed costs to its income statement and raise its breakeven point.
Section 7.13 Off-balance-sheet commitments
1. What are off-balance-sheet commitments?
The balance sheet shows all the items resulting from transactions that were realised. But it is hard to show in company accounts transactions that have not yet been realised (e.g. the remaining payments due under an operating lease, orders placed but not yet recorded or paid for because the goods have not yet been delivered). However, such items may have a significant impact on a company’s financial position.
2. How are they accounted for?
These commitments may have:
- a positive impact – they are not recorded on the balance sheet, but are stated in the notes to the accounts, hence the term “off-balance-sheet”. These are known as contingent assets; or
- a negative impact – they cause a provision to be set aside if they are likely to be realised, or they give rise to a note to the accounts if they remain a possibility only. These are called contingent liabilities.
3. How should financial analysts treat them?
Analysts should always be concerned that a company may show some items as off-balance-sheet entries while they should actually appear on the balance sheet. It is therefore very important to analyse off-balance-sheet items because they reflect:
- the degree of accounting ingenuity used by the company; this judgement provides the basis for an opinion about the quality of the published accounts;
- the impending arrival on the balance sheet of the effects of the commitments (e.g. purchases of fixed assets or purchase commitments that will have to be financed with debt, guarantees given to a failed third party that will lead to losses and payments with nothing received in return).
The key points to watch are as follows:
Section 7.14 Pensions and other employee benefits
1. What are provisions for employee benefits and pensions?
Pension and related commitments include severance payments, early retirement and related payments, special retirement plans, top-up plans providing guaranteed resources and healthcare benefits, life insurance and similar entitlements that, in some cases, are granted under employment contracts and collective labour agreements.
A distinction is made between:
- defined benefit plans, where the employer commits to the amount or guarantees the level of benefits defined by the agreement. This is a commitment to a certain level of performance, usually according to the final salary and length of service of the retiring employee. These plans may be managed internally or externally;
- defined contribution plans, where the employer commits to making regular payments to an external organisation. Those payments are paid back to employees when they retire in the form of pensions together with the corresponding investment revenue. The size of the pension payments depends on the investment performance of the external organisation managing the plan. The employer does not guarantee the level of the pension paid (a resource-related obligation). This applies to most national social security systems.
2. How are they accounted for?
Defined contribution plans are fairly simple to account for as contributions to these plans are expensed each year as they are incurred.
Defined benefit plans require account holders to disclose detailed and specific information. A defined benefit plan gives rise to a liability corresponding to the actuarial present value of all the pension payments due at the balance sheet closing date (defined benefit obligation or, in US GAAP, projected benefit obligation (PBO)).
In countries where independent pension funds handle the company’s commitments to its workforce, the market value of the pension fund’s assets is set off against the actuarial value of the liability. The method used to assess the actuarial value is the projected unit credit method, which models the benefits vested with the entire workforce of the company at the assessment date. It is based on certain demographics, staff turnover and other assumptions (resignations, redundancies, mortality rates, etc.). The discount rate used is the yield on high-grade corporate bonds, in practice those rated AA.
Consequently, the net pension costs in the income statement for a given year are mainly composed of:
- a service cost, which represents the present value of benefits earned by employees during the year;
- an interest cost, which represents the increase in the present value of the pensions payments due at the balance sheet closing date since the previous year due to the passage of time – this is generally recognised in financial expense;
- a theoretical return on assets, computed using the discount rate used to compute the present value of pension payments due;
- other non-recurring items.
In a move that has broadened the debate, the IASB have stipulated that all benefits payable to employees (i.e. retirement savings, pensions, insurance and healthcare cover and severance payments) should be accounted for. These standards state in detail how the employee liabilities deriving from these benefits should be calculated. US accounting standards also provide for the inclusion of retirement benefits and commitments other than just pension obligations, i.e. mainly the reimbursement of medical costs by companies during the active service life of employees.
3. How should financial analysts treat them?
How, therefore, should we treat provisions for employees’ benefits and pensions that may, in some cases, reach very high levels, as is often the case with German companies?
Our view is that provisions for retirement benefit plans are very similar to a financial liability vis-à-vis employees. This liability is adjusted each year to reflect the actuarial (and automatic) increase in employees’ accrued benefits, just like a zero-coupon bond,17 where the company recognises an annual financial charge that is not paid until the bond is redeemed. Consequently, we suggest treating such provisions minus the market value of the pension fund’s assets as financial debt.
In terms of business valuation, future commitments towards its employees will be measured by discounting the annual pension service cost (discounted cash flows) or by applying a multiple (multiples method) to it. This assumes that interest costs and the theoretical return on pension assets are treated as financial charges. These must be deducted from EBITDA and EBIT and added to financial charges unless the company has already applied this rule in its accounts, as often – but not always – happens.
Section 7.15 Preference shares18
1. What are preference shares?
Preference shares combine characteristics of shares and bonds. They may have a fixed dividend (bonds pay interest), a redemption price (bonds) and a redemption date (bonds). If the company were to be liquidated, then the preference shareholders would be paid a given amount before the common shareholders would have a right to receive any of the proceeds. Sometimes the holders of preference shares may participate in earnings beyond the ordinary dividend rate, or have a cumulative feature allowing their dividends in arrears, if any, to be paid in full before shareholders can get a dividend, and so on.
Most of the time, in exchange for these financial advantages, the preference shares have no voting rights. They are known as actions de préférence in France, Vorzugsaktien in Germany, azioni risparmio in Italy and preferred stock in the US.19
2. How are they accounted for?
Under IFRS, preference shares are accounted for either as equity or financial debt, depending on the results of a “substance over form” analysis. If the preference share:
- provides for mandatory redemption by the issuer at a fixed20 date in the future; or
- if the holder has a put option allowing him to sell the preference share back to the issuer in the future; or
- if the preference share pays a fixed dividend regardless of the net income of the company
then it is financial debt.
Under US GAAP, preference shares are treated as equity.
3. How should financial analysts treat them?
Let’s call a spade a spade. If the preference share meets all our criteria for consideration as equity:
- returns linked solely to the company’s earnings;
- no repayment commitment;
- claims on the company ranking last in the event of liquidation
then it is equity. If not, it is a financial debt.
Section 7.16 Provisions
Provisions are set aside in anticipation of a future cost. Additions to provisions reduce net income in the year they are set aside and not in the year the corresponding cost will actually be incurred. Provisions will actually be written back the year the corresponding charge will be incurred, thereby neutralising the impact of recognising the charges in the income statement. Additions to provisions are therefore equivalent to an anticipation of costs.
1. Restructuring provisions
(a) What are restructuring provisions?
Restructuring provisions consist of taking a heavy upfront charge against earnings in a given year to cover a restructuring programme (site closures, redundancies, etc.). The future costs of this restructuring programme are eliminated on the income statement through the gradual write-back of the provision, thereby smoothing future earnings performance.
(b) How are they accounted for?
Restructuring costs represent a liability if they derive from an obligation for a company vis-à-vis third parties or members of its workforce. This liability must arise from a decision by the relevant authority and be confirmed prior to the end of the accounting period by the announcement of this decision to third parties and the affected members of the workforce. The company must not anticipate anything more from those third parties or members of its workforce. Conversely, a relocation leading to profits further ahead in the future should not give rise to such a provision.
(c) How should financial analysts treat them?
The whole crux of the matter boils down to whether restructuring provisions should be recorded under operating or non-operating items: the former are recurrent in nature, unlike the latter. Some groups consider productivity-enhancing restructuring charges as operating items and business shutdowns as non-recurrent items. This may be acceptable when the external analyst is able to verify the breakdown between these two categories. Other companies tend to treat the entire restructuring charge as a non-recurrent item.
Our view is that in today’s world of rapid technological change and endless restructuring in one division or another, restructuring charges are usually structural in nature, which means that they should be charged against operating profit. The situation may be different for SMEs,21 where those charges are more likely to be of a non-operating nature.
On the liability side of the balance sheet, we treat these restructuring provisions as comparable to financial debt.
2. Provisions for decommissioning or restoration of sites
(a) What are provisions for decommissioning or restoration?
Some industrial groups may have commitments due to environmental constraints to decommission an industrial plant after use (nuclear plant, etc.) or restore the site after use (mine, polluted site, etc.).
(b) How are they accounted for?
In such cases, as these commitments are generally over the very long term, provisions will be booked as the net present value of future commitments.
(c) How should financial analysts treat them?
These provisions should be treated as net debt.
Section 7.17 Stock options
1. What are stock options?
Stock options are options to buy existing shares or to subscribe to new shares at a fixed price. Their maturity is generally between three and 10 years after their issuance. They are granted free of charge to company employees, usually senior executives. Their purpose is to motivate executives to manage the company as efficiently as possible, thereby increasing its value and delivering them a financial gain when they exercise their stock options. As we will see in Chapter 26, they represent one of the ways of aligning the interests of managers with those of shareholders.
2. How are they accounted for?
Under IFRS, the issuance of fully vested stock options is presumed to relate to past service, requiring the full amount of the grant-date fair value to be expensed immediately. The issuance of stock options to employees with, say, a four-year vesting period22 is considered to relate to services over the vesting period. Therefore, the fair value of the share-based payment, determined at the grant date, should be expensed on the income statements over the vesting period. The corresponding entry is an increase in equity for the same amount.
Stock options are usually valued using standard option-pricing models,23 with some alterations or discounts to take into account cancellations of stock options during the vesting period (some holders may resign) and conditions which may be attached to their exercise, such as the share price reaching a minimum threshold or outperforming an index.
3. How should financial analysts treat them?
Do stock options and free shares make pre-existing shareholders poorer? Yes, because the eventual exercise of stock options and the granting of free shares mean that shares are issued at a lower price than their value at the time. Of course, we could hope that granting them would lead to higher motivation and greater loyalty on the part of the company’s staff, which would at least make up for the dilution. But as much as this may be true, it is very difficult to measure the positive effects, and they may go hand in hand with the pernicious effects they can have on managers who get stock options (e.g. retention of dividends and bias in favour of the riskiest investments and debt, and that doesn’t even include accounting manipulation, which is another story).
Can we say that the company gets poorer by the amount of the stock options granted freely? No, it is the shareholders who potentially get poorer while the recipients of these instruments benefit, not the company, whose assets and debts are still worth what they were.
Conceptually, an accounting charge is an item which increases the amount of a liability due, which reduces the value of an asset or which sooner or later results in cash being paid out. But here, this is not the case. The granting of stock options/free shares does not lead to any flows for the company if they are not exercised, or to new equity if they are. In a nutshell, a charge may lead to bankruptcy since sooner or later it generates a reduction in assets or an increase in debts. Granting stock options, on the other hand, strengthens the solvency of the company (and the granting of free shares certainly does not weaken it). How then can the granting of stock options or free shares be booked as a charge? For us, this just doesn’t make sense.
We recommend, in terms of valuation, deducting the value of stock options from the value of capital employed in order to obtain the value of equity, without modifying the number of shares issued.
Alternatively, we can reason in fully diluted terms, as if all the options granted that are in the money were exercised and the funds collected used to buy back existing shares at their current value (treasury method, described in Section 22.5), or to pay back a part of the debt or increase available cash (funds placement method, described in Section 22.5). The number of shares will obviously be adjusted as a consequence. Options that are out of the money must receive the same treatment after having multiplied their quantity by their delta, which measures the probability that they will end their lives in the money.
Section 7.18 Tangible assets
1. What are tangible assets?
Tangible assets (or property, plant and equipment)24 comprise land, buildings, technical assets, industrial equipment and tools, other tangible assets and tangible assets in process.
Together with intangible assets, tangible assets form the backbone of a company, namely its industrial and commercial base.
2. How are they accounted for?
Tangible assets are booked at acquisition cost and depreciated over time (except for land). IFRS allows them to be revalued at fair value. The fair value option then has to be taken for a whole category of assets (e.g. real estate). This option is not widely used by companies (in particular because the annual measurement of fair values and booking of changes in fair value is complex),25 except:
- on first implementation of IFRS;
- following an acquisition, where it is required for the tangible assets of the purchased company.26
Some tangible assets may be very substantial; they may have increased in value (e.g. a head office, a store, a plant located in an urban centre) and thus become much more valuable than their historical costs suggest. Conversely, some tangible assets have virtually no value outside the company’s operations. Though it may be an exaggeration, we can say that they have no more value than certain start-up costs.
Note that certain companies also include interim financial expense into internally or externally produced fixed assets (provided that this cost is clearly identified). IFRS provides for the possibility of including borrowing costs related to the acquisition cost or the production of fixed assets when it is likely that they will give rise to future economic benefits for the company and that their cost may be assessed reliably. Under US GAAP, these financial costs must be included in the cost of fixed assets.
3. How should financial analysts treat them?
The accounting policies applied with respect to fixed assets may have a significant impact on various parameters, including the company’s or group’s net income and apparent solvency level.
For instance, a decision to capitalise a charge when it is allowed and record it as an asset increases net income in the corresponding year, but depresses earnings performance in subsequent periods because it leads to higher depreciation charges.
Accordingly, financial analysts need to take a much closer look at changes in fixed assets rather than fixed assets at a given point in time. The advantage of adjustments is that they are shown at their current value.
Section 7.19 Treasury shares
1. What are treasury shares?
Treasury shares are shares that a company or its subsidiaries owns in the company itself. We will examine the potential reasons for such a situation in Chapter 37.
2. How are they accounted for?
Under IFRS, treasury shares are systematically deducted from shareholders’ equity. If they are sold by the company in the future, the disposal price will directly increase equity, and no capital gain or loss will be recognised in the income statement.
3. How should financial analysts treat them?
Whatever their original purpose, we recommend deducting treasury shares from assets and from shareholders’ equity if this has not yet been done by the accountants. From a financial standpoint, we believe that share repurchases are equivalent to a capital reduction, regardless of the legal treatment. Likewise, if the company sells the shares, we recommend that these sales be analysed as a capital increase.
Treasury shares must thus be subtracted from the number of shares outstanding when calculating earnings per share or valuing the equity.