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04-03-2024 : Could you join the IASB and become an accounting regulator?

You'd stand a good chance if you can answer these 3 questions TRUE or FALSE, all relating to IAS 32, on which the IASB has published an exposure draft:

1/ A perpetual or hybrid debt must be recognised as equity even if, in the vast majority of cases, the issuer redeems it early after a few years to avoid having to bear a sharp rise in the interest rate, which is contractually provided for to prompt the issuer to redeem the perpetual bond early (which is bound to make you smile). 

2/ Under IFRS, a bond redeemable in shares (mandatory convertible bond, MCB) is recognised under shareholders' equity, with the exception of the present value of the interest paid before being redeemed in shares, which is recognised under financial debt. However, if the redemption parity of the MCB (3 shares against one MCB, for example) is variable (against 3 shares, or 4 or 2 depending on a given criterion), then the MCB must be recognised as a debt. 

3/ More difficult now. You have granted minority shareholders in a subsidiary that you control a put option allowing them to sell you their shares. The amount you may have to pay out if the minority shareholders exercise their put option is a financial liability, the creation of which is offset (so that the balance sheet remains balanced) by a deduction from shareholders' equity (group share) of the same amount, and not bya deduction from shareholders' equity (minority share).

Well, if you answered TRUE 3 times, you have every chance of succeeding at the IASB, which holds these positions in the exposure draft mentioned above. But you are unlikely to be a good financier.

Equity capital is so important to a company - it is the cornerstone of its existence and development - that in this area you have to call a spade a spade and be particularly rigorous. A debt that is repaid, even if it is wrongly called perpetual, is a debt, not equity. An MCB, with a fixed or variable parity, and which by definition does not involve any cash outlay, since it is redeemed in the issuer's shares, is an equity security, precisely because it is not redeemable in cash or debt securities.  As for the put on minority interests, the IASB is proposing a double penalty. Why not create a liability on the balance sheet in respect of minority interests. But where is the consistency in deducting the put amount from shareholders' equity, group share, and not from that of minority interests, who have just been assumed to be exercising their put by recording the put amount as a liability?

When will the IASB finally realise that, by proposing provisions so far removed from common sense, it is discrediting the accounting standards of which it should be the intelligent and scrupulous guardian? 

27-02-2024 : Warren Buffett's 2024 annual letter to shareholders

In this letter, Warren Buffett points out that what creates value is a company's ability to reinvest its profits at a rate of return higher than its cost of capital. Conversely, a company that reinvests its profits at a rate of return lower than its cost of capital destroys value. This explains why the share price of these companies jumps when their managers promise significantly higher returns. 

Barclays, for example, has just promised to return £10bn to its shareholders over the next 3 years (on a market capitalisation of £23bn). The share price has jumped by 10%. Not that shareholders are dividend-hungry leeches. It's just that they know how to count. To understand this, you need to remember that Barclays' equity of £71bn is only worth £23bn on the stock market, the result of Barclays' return on equity (7.3% in 2023) being lower than its cost of capital for years. This represents a 68% discount and a £48bn loss in value. 

10bn of dividends paid means £10bn of cash reaching shareholders' accounts and being worth £10bn. It also means a £10bn reduction in book equity, which at a constant 62% discount means a reduction in equity value of only £3.8bn. In net terms, +10 - 3.2 = +6.8. 

On the other hand, £10bn of reinvested earnings means a £10bn increase in the book value of shareholders' equity and a £3.2bn increase in its value at a constant 32% discount. 

+ 6.8bn if Barclays returns £10bn to shareholders, versus +£3.2bn if Barclays reinvests the £10bn in its business, whose marginal profitability is lower than the cost of capital, leading to a loss of value. No wonder shareholders are applauding with both hands. Especially as there could be a second-round effect, as at least 60% of the returns will take the form of share buy-backs, leading ipso facto to an increase in shareholders' equity per share, and at a constant discount, a corresponding increase in the share price.

On the other side of the Atlantic, once again this year, Berkshire Hathaway shareholders will overwhelmingly vote for no dividend, preferring reinvestment, confident in their leader's ability to generate returns in excess of the cost of capital. 

Having said that, Warren Buffett warns that Berkshire Hathaway's size ($900bn) means that its future performance will no longer be as exceptional as in the past. 

The day when Berkshire Hathaway will pay dividends is not far off; probably after the death of its founder, just as Apple waited until the death of Steve Jobs to do so, such is the power of these exceptional men. 

 



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The Vernimmen.com Letter

Number 155 of February 2024

News : Trials and tribulations of a start-up

Statistics : Corporate income tax rates

Research : ESG in SRI? Not in the US

Q&A : What is the rule of forty?

COMMENTS : Comments posted on Facebook