Letter number 133 of November 2020
- QUESTIONS & COMMENTS
We may as well come straight out and say it: this time the IASB seems to have done a good job and to have complied with its stated objective of prioritising the point of view of investors, since as the IASB explains, they are the ones who run the most risks and who therefore have an even greater interest in disposing of relevant accounting standards. If only this principle could have been followed for the accounting of leases, IFRS 16, on which we've already shared our not very flattering opinion!
Inveterate complainers will still say that this IASB plan to reform the presentation of income statement (for the most part) should have been carried out a lot earlier since, generally, it should make it mandatory to:
- include operating income in the presentation of the income statement;
- distinguish between recurring and non-recurring items;
- present expenses by nature in the appendix when the company has chosen to present its accounts by function.
For the first time, it provides a definition of operating profit/losses (profit/losses from non-discontinued operations before corporation tax, financial result and share of earnings from companies accounted for under the equity method).
It is fortunate that this project was identified as a priority by the IASB in 2015, because any positive impacts will only be reflected in the accounts of companies in 2025. So it's not just the Roman Catholic Church that isn't in a hurry to shake things up, although, with the whole of eternity lying before it, the latter isn't exactly pressed for time! And besides, good intentions are always to be encouraged, notwithstanding their reputation for paving the way to hell.
As surprising as it may seem to our readers, the IFRS standards are very light, as they currently stand, on the presentation of the income statement, making only the following items mandatory:
- financial expenses;
- share of earnings from companies consolidated under the equity method;
- income tax;
- result of discontinued activities;
- and net earnings.
Fortunately, for the analyst, almost all companies exceed this minimum and report operating income, or EBITDA.
The IASB project, which can therefore still evolve, provides for the mandatory inclusion of operating income and the breakdown of all expenses and income between operating, investment, financing and share of income from the earnings of companies accounted for under the equity method but not considered as integrated into the group's activity, for example the results of Nestlé' interest in L’Oréal, and results of investments in real estate for the few companies concerned. Financial items will unsurprisingly include financial income from cash and cash equivalent, financial charges on bank and financial loans and unwinding of discounts on provisions (mainly provisions for pensions). The IASB is making useful corrections, such as ending the option to include the effects of unwinding of discounts on provisions in operating expenses: they will now have to be included in financial income. In the other direction, income on currency hedges should be included in the operating income. Which is just common sense.
We should therefore have an income statement with several aggregates: operating income, earnings after share of earnings from companies accounted for under the equity method and integrated into the group's businesses, earnings before net cost of financing and tax on companies, then earnings before tax, before finishing off with net earnings.
Non-recurring items will always be swallowed up in operating income, but a note in the appendix will detail them, thus enabling analysts to do their job and eliminate from the company's recurring earnings what they do not think should be included. We do feel that it is a pity though that the IASB has not returned to its starting point where these non-recurring items appeared on an isolated line in the income statement, as is requires for earnings from discontinued activities, another item of non-recurring income.
Much more daring is to require companies presenting their income statements by function to give a breakdown of operating expenses by nature in the appendix to the accounts. A number are already doing so, but not all, and often only for part of their operating costs. Let's face it - issuers are really taking us for fools when they present an income statement with a “cost of sales” line which accounts for 85% of sales (Airbus in 2019) or 95% (ArcelorMittal in 2019) without providing a breakdown, making any analysis of the income statement an impossible task.
We hope the IASB will maintain this provision after the public consultation process where opponents have likely raised vehement arguments about the how much this provision will cost them.
In the same vein, the IASB confirms the prohibition of the format that falls halfway between the income statement by nature and the income statement by function that emerged a few years ago. It presents the income statement by function, but isolating on a separate line the depreciation allowance, cost therefore removed from the costs of functions. This presentation has probably developed to allow users to easily calculate EBITDA without having to consult the notes to the accounts or the cash flow statement. It is particularly common in the United States where 11 of the 30 largest market caps have adopted it. However, the United States has not replaced local standards with IFRS and is therefore not affected by this project.
Although in this project, the IASB provides a comprehensive list of the aggregates that must appear in the income statement, alternative aggregates, such as EBITDA, may appear in an appendix with a reconciliation with authorised aggregates.
It is regrettable that the IASB did not go further by giving a definition of EBITDA in order to harmonise practices and do away with baroque and obsolete definitions of EBITDA, or those concocted by companies, often to embellish their current, real situation. For a long time, we have used, for our part, the difference between all income and all operating expenses which sooner or later will result in an inflow of cash or a disbursement of cash, which we believe has the advantage of conceptual clarity and computational simplicity. EBITDA thus corresponds to the sum of operating income plus depreciation and amortisation. It would have been more daring to impose the inclusion of EBITDA in the income statement aggregates, taking into account that EBITDA is now often central in financial reasoning. That, however, would probably have meant the death of the presentation of the income statement by function, which remains the choice of the majority of companies publishing their accounts in line with IFRS.
Likewise, it's a pity that the IASB has got nowhere in the area of accounting for the effects of the energy transition in the accounts of companies. For example, requiring the inclusion of the cost of the company's carbon footprint, estimated as the product of the price of carbon credits times the number of tonnes emitted in the year, in the income statement would show the cost of externalities that the company imposes on the community as a result of its activity. Additionally, the amounts in question are not negligible. Danone estimated them at €952m in 2019, or 36% of its current income. Based on the principle that we don't manage what we don't measure, such a provision would raise awareness of the scale of the task, and probably enable investors to better allocate capital according to the efforts of companies in this area.
Of course, this area is still in embryonic stages and Danone is a pioneering example. Granted, this is a theoretical cost, at least for now, for as long as there is no carbon tax. But after the bursting of the TMT bubble, didn't the IASB require companies to recognise a charge, a fictitious one, for the costs of stock options of which they had made substantial use? The energy transition is an unprecedented and much bigger challenge and, in our view, it deserves the urgent attention of the IASB.
 We have no recollection of having seen a non-financial company that did not publish its operating income under IFRS.
 For more details on this point, see the following section where we give statistics of adoption of this practice by country.
 See Chapter 7 of the Vernimmen.
To illustrate the point of the previous article, the following table presents the diversity of practices of major groups in terms of presentation of profit and loss accounts. As we limited ourselves to the top 30 market capitalisations (meaning we looked at 360 annuals reports), there is probably a bias in favour of presentation by function, which is more often adopted by large entities than by SMEs, by listed companies than by non-listed companies.
Research : Allocation of securities during bond issues: effects comparable to initial public offerings
With the collaboration of Simon Gueguen, lecturer-researcher at CY Cergy Paris University
In issue 123 of the Vernimmen.com Newsletter, dated October 2019, we presented a study on the allocation of securities during initial public offerings. These are often a good one-off deal for investors, due to the IPO discount. Investors are therefore looking to obtain a large number of securities. It emerged from this study that banks sponsoring IPOs allocated securities as a priority to investors who provided them with information (promoting the success of transactions) or brokerage commissions on other transactions. In other words, there seems to be a form of give and take in the allocation process.
Our article this month explores the same phenomenon, but this time we focus on bond issues. Most of the effects identified are the same as for IPOs, but their magnitude is different.
Firstly, competition for securities also stems from an undervaluation at the time of the IPO. This undervaluation, measured by performance on the first day of listing, is much lower for bonds than for newly listed equities: around 40 basis points for US corporate bonds (over the period of the study, 2002 to 2014) against around 10% for equities listed. However, given the huge amount of bond issues (almost four times that of equity issues, IPOs and capital increases included), this undervaluation brings a very large profit to the investors who benefit from it. Over the period studied, Nikolova et al estimate the aggregate profit made by the beneficiaries of the bond allocation at more than $ 40 billion.
In order to study the allocation criteria, Nikolova et al used data from regulated publications by US insurance companies with the National Association of Insurance Commissioners (NAIC), the US insurance standards body. The advantage of this source is that it provides detailed data on bond acquisitions, in particular with the date and price paid, making it possible to establish whether or not this is an allocation in the primary market.
Analysis shows the same two effects as for IPOs. First, insurers who have expertise in bonds of the same type as those issued are allocated more securities than others. This is the informational effect: these insurers provide the bank placing the bonds with their expertise in setting the price and completing the transaction. In return, the bank favours them in its allocation.
Secondly, insurers that have a high volume of transactions with the bank placing the bonds in the previous year are given more securities. The bank therefore seems to favour investors with which it has long-term relationships. In economic terms, this effect is much stronger than the first: a standard deviation of the volume of transactions between the insurer and the bank translates into $ 800,000 in additional profit for the investor (five times more than for the informational effect).
In the case of IPOs, the effect of long-term relationships was again greater than the informational effect. But Nikolova et al still note that the informational effect, although identifiable, is particularly weak in bond markets. They attribute this to the fact that almost all issues (96% of their sample) are by regular bond issuers, and that in the majority of cases (72%) they are listed companies. Information asymmetries are therefore necessarily lower than for an IPO.
Whether for equity or bond issues, the primary market allows investors to make one-off profitable deals. Competition among institutions for allocation of the largest volumes is high. This article, in addition to that on IPOs, shows that banks most often choose to allocate securities to investors with which they also carry out a significant volume of business.
 S.NIKOLOVA, L.WANG and J.WU (2020), Institutional allocation in the primary market for corporate bonds, Journal of Financial Economics, vol.137-2, pages 470-490.
 Expertise measured by their prior holding of bonds issued by companies in the same economic sector.
Q&A : In the leverage formula, should financial expenses of the gross debt or the financial expenses net of financial income be taken into account?
The leverage formula: ROE = ROCE + (ROCE - i x (1 - Corporate income tax rate)) x D/E is based on an accounting tautology, which is total assets = total liabilities + shareholders’ equity, and which is quite generally observed in our time :-).
Consequently, all balance sheet and income statement accounting items must be taken into account, hence the reasoning in net debt (cash and cash equivalents and marketable securities), since cash, cash equivalents and marketable securities cannot be ignored. Similarly, the cost of debt cannot be limited to financial expenses, leaving aside financial income (even if nowadays they are usually zero due to the context of very low interest rates). Let's take an example to illustrate this.
A company has operating assets (fixed assets + working capital) of 1,000, financed by shareholders' equity of 500, gross bank and financial indebtedness of 700, and 500 net, once 200 of cash and cash equivalent are taken into account.
Operating profit is, say, 100, and corporate income tax rate is 33.3%. The ROCE of this company is therefore 6.7% i.e. 100 x (1 - 33.3%) /1,000.
The average interest rate on the gross debt is, say, 5%. The return on cash before corporate tax is 1%. The pre-tax profit is therefore 100 - 5% x 700 + 1% x 200 = 67. The corporate income tax is therefore 67 x (1- 33.3 %) = 22,3 and the net result is therefore 67 - 22,3 = 44.7. The ROE is 44.7 / 500 = 8.94%.
When we inject the ROE and the ROCE just calculated into the leverage formula recalled at the beginning of this article, the cost of debt before corporate income tax is 6.6%.
This 6.6% corresponds to the financial result divided by the net bank and financial debt, i.e. (5% x 700 - 1% x 200) / (700 - 200), and not to the interest rate on the gross debt of 5%.
It is therefore the net debt and net financial income that must be taken into account and not the gross debt and just financial expenses.
Admittedly, this results in a higher interest rate (here 6.6%) than that charged by lenders. But this only makes apparent the cost incurred by companies to keep cash on the balance sheet, in a sound financial management which is not without cost, without using it to repay a part of the debts; cash which naturally yields companies an interest rate smaller than the cost of debt.
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LVMH Tiffany, all for this?
We remember that LVMH and Tiffany agreed in November 2019 that LVMH would acquire Tiffany by paying a 50% premium on the share price before the announcement for a total price of $16.2 billion, and that in September LVMH launched a legal battle in the United States to obtain a price reduction by arguing Covid and using very harsh words. The parties have just agreed to reduce the price paid from $135 to $132.08 per share, a decrease of 2.2%. It should be noted that the price of $131.5 mentioned in the press release must be increased by the dividend of $0.58 paid by Tiffany to its shareholders before the takeover, as this is as much money as LVMH will not find in Tiffany's coffers.
Two days before, it was learned that the American company Teledyne had obtained a 15% reduction on the acquisition price of the French company Photonis.
The two situations are of course different. Ardian, the fund that owns Photonis, had put Photonis, which it had owned for 16 years, up for sale, whereas the shareholders of Tiffany had not put their company up for sale when LVMH came to offer them a final premium of 50%.
However, one cannot help but think that American law is much more protective of the interests of the sellers than other rights, and that the reputation of LVMH with the shareholders of its future targets is somewhat damaged. But it is the privilege of rich entities to have credit and to be able to use it.
Let's hope that the shareholders of Tiffany will have the elegance to break out the champagne (for breakfast, of course) with Dom Pérignon or Veuve Clicquot (owned by LVMH).