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 monthly magazine 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.

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.

1/ WHAT ARE CASH ASSETS?

Cash assets correspond to short-term investment of a company’s cash surpluses (see Chapter 50).

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.

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?

In a period of negative short-term interest rates, such as in the Eurozone, Switzerland and Japan since 2015, it is advisable to be particularly vigilant about cash assets generating zero or positive returns, which cannot fail to involve risk taking.

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.

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.²

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.

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.³ 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 accounts⁴ 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.

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 with a tax base that is 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 generally higher than their tax base used to calculate tax-deductible depreciation and amortisation or capital gains and losses;
• capitalised 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\ePubPageBreak?> 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?

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.

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 51). 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 51).

2/ HOW ARE THEY ACCOUNTED FOR?

Accounting for financial hedging instruments made up of derivatives (options, futures, swaps, etc.) is very complicated.

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 financial products are acquired to hedge against a specific risk, then a system known as hedge accounting can be put in place in a proportion for which the company is able to prove (and document) that the hedge is adjusted (amount, duration) to the underlying amount. The remainder will not qualify for hedge accounting and 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.

3/ HOW SHOULD FINANCIAL ANALYSTS TREAT THEM?

Before all else, financial managers must try to check that the financial instruments are not linked to speculative transactions (and this independently of the accounting option that was possible). They 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.

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 assets⁸ 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. 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 transaction¹⁰ 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 81, we consider impairment losses on intangible fixed assets (including goodwill) as non-operating items to be excluded from EBITDA and EBIT.¹¹

1/ START-UP COSTS

2/ RESEARCH AND DEVELOPMENT COSTS

3/ BRANDS AND MARKET SHARE

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.

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?

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, hence excluded from the income statement. 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 simply higher or lower accordingly.

Hence the reluctance of certain companies 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, 2019 and 2020, 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.

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 377).

Finance 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 lease¹³ or an operating lease.

The distinction between operating or financial leases depends on whether or not a purchase option exists, on the length of the contract (greater than or equal to 75% of the life of the asset) and the present value of the rents in relation to the value of the asset (greater than or equal to 90% of the value).

Under IFRS, and since the application of IRFS 16 beginning in 2019, companies no longer distinguish between financial and operating leases. All leases must be recognised as tangible fixed assets on their balance sheets, whenever the length of the contract is longer than one year, is for an asset worth more than €5,000, where the rent is not indexed to a variable indicator of the company such as sales made in the rented property (store, cinema), and in instances where the contract cannot be considered as a service, for example renting 1,000 sq. m of storage space in a hangar, without knowing the precise area in the hangar for the products.

To determine the value to be recorded as a right of use in the balance sheet, one must discount the expected rents over the probable duration of the lease. The discount rate is either the implicit interest rate contained within the (financial) lease or the marginal interest rate at which the company could incur debt to finance the acquisition of the operating asset. The asset is then depreciated on a straight-line basis over the life of the lease. As a counterparty to this new asset, the company records a new financial debt in its liabilities. This debt is reduced each year by an amount corresponding to the rent paid less financial expenses calculated, using the aforementioned interest rate. In the first few years, the rental debt is therefore higher than the value of the rental asset.

In the income statement, the rental expense is removed from other external expenses. Two items appear: financial expenses, generated by the rental debt sitting on the balance sheet at the given interest rate, and a depreciation expense stemming from usage rights and amortised over the length retained for the rental contract. The sum of these two expenses is frequently different to that of the rent paid, exceeding it at the beginning of the contract, and below it at the end of the contract. Initially, it would appear as if the EBITDA is inflated by the amount of the rent, and the operating result by the amount of the financial expenses. We will come back to this shortly.

In the cash flow statement, operating cash flow increases by the amount of the depreciation expense on the leased assets. Here, we allow readers to stop and pinch themselves. No, they are not dreaming: a change in accounting rules, which does not physically change cash flows, nevertheless changes the operating cash flows in the IFRS cash flow statements!

As the IASB is unfortunately unable to make cash magically appear in cash registers, the final reconciliation is done in the financing cash flows with a pseudo cash outflow created due to the reduction in rental debts.

Under US accounting standards, a usage right is recorded in the balance sheet under fixed assets with a corresponding financial lease liability. But under a widespread consensus, American groups identify operating lease rents in the income and cash flow statements as an operating expense and will continue to treat financial leases as financial leases. The decrease in the value of usage rights is carried out on the balance sheet by a parallel reduction in the rental debt.

Therefore, it is no longer possible to compare EBITDA or operating margins between US groups and groups operating under IFRS.

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.

As finance leases are a real debt, it is logical to capitalise the assets financed in this way in the balance sheet and to add the value of rental commitments made to financial debts. When this is not done in the financial statements, they should be restated in this way using the information provided in the notes.

On the other hand, since operating leases do not correspond, with a few exceptions, to a real debt, the new IFRS (and American) accounting standards do not seem, to us, to provide a fair view of the company’s situation. Ideally, the analyst should revert to a distinction between operating leases (not treated as debt) and financial leases (treated as debt) by reversing the effects of IFRS 16 on the financial statements.¹⁴

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, commitments that have been made but will not necessarily come into effect (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, deposits). 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:

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, and the difference, if any, normally gives rise to a pension provision. 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 due¹⁵;
• 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,¹⁶ where the company recognises an annual financial charge that is not paid until the bond is redeemed.

Consequently, we suggest treating such provisions as financial debt. When the pension provision does not cover 100% of the deficit between pension commitments and assets held to cover these commitments, the pension provision must be topped up until it is equal to this debt, which would then decrease the shareholders’ equity by an equal amount. The result of the past situation is thus taken into account.

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 the differences between 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.

1/ WHAT ARE PREFERENCE SHARES?

Preference shares combine¹⁷ 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.¹⁸

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 fixed¹⁹ 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.

1/ RESTRUCTURING PROVISIONS

2/ PROVISIONS FOR DECOMMISSIONING OR RESTORATION OF SITES

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 ten 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 period²¹ 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,²² 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.

1/ WHAT ARE TANGIBLE ASSETS?

Tangible assets (or property, plant and equipment)²³ 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),²⁴ except:

• on first implementation of IFRS;
• following an acquisition, where it is required for the tangible assets of the purchased company.²⁵

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.

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 back 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 computing market capitalisation.