Letter number 64 of January 2012


News : Accounting and valuation: six debatable points
By François Meunier, former president of the French association of CFOs

In this article we look at the relationship between accounting and valuation. To what extent is the accountant restricted in the task of estimating and valuing accounting data? Can he/she accept the growing tolerance by accounting standards of information from the market or estimations that have been modelled?

This debate has, to a certain degree, always existed, but has taken on a new impetus over the last 20 years, with the advent of modern accounting law, and today, in the context of markets in turmoil. 

To demonstrate this, and without caricaturing the situation, we submit the following six propositions:

1 – Accounting data should not include any estimated or valuation figures

According to this rule, the accountant is there to record past flows. This is the “solid” terrain on which potential valuations can be based.

In practice, however, there is nothing solid about the terrain. It is illusory to believe that accounting could cut itself off from estimations and valuations. 

The first accountant who abandoned cash-based accounting and introduced non-cash expenses put a cat amongst the pigeons (and at the time, must have set off discussions that were as lively as those that took place more recently, with the introduction of fair value). 

This happened as soon as accountants were required to recognise, in one form or another, payables, debts and commitments by the company to third parties. 
Inevitably, the ideas of amortisation, provision and impairment appeared.

We had left the domain of the simple counting of a material flow (money spent), for a two-way appreciation of the reality of the debt.

There is undoubtedly an element of truth in the statement that accounting merely represents the figures side of the general law covering obligations and debts. 

When companies’ information systems and the level of training of accountants and financial directors was still rather basic, it was important to provide a tight framework for the conditions in which a provision could be made. For example, a debt would be provisioned if it had not been paid by 90 days, but not if it had not been paid by 60 days, etc. 

Accordingly, accounting kept a system of  standard values, i.e., prices at the beginning of the transaction, and, if applicable, revised these downwards, with rules that were as highly codified as possible. 

But obviously there remains a great deal of latitude, in order to take into account the nature of the activity or the degree of expected debt recovery. 

In addition to instructions that are easy to follow, the role of the accountant clearly used to include checking the validity of the estimation made. 

Modern accounting rules started a long time ago, long before IFRS, to introduce a different approach for certain assets, mainly financial assets that are traded on the market on a daily basis. 

In this regard, why start out from the standard value, with all of the complexities involved in setting criteria for a possible impairment, when we have the measurement given by the market?

For example, French insurance companies have been bound for a long time, by their special accounting code, to book impairment of assets in line with their current market value. The same goes for the measurement of the company's solvency, essential for insurance companies whose clients are forced into the role of creditor. 

Similarly, treasurers who invests their cash in certain financial assets cannot isolate themselves from the valuation of their portfolios – it is only natural that accounting takes this into account.

From the 1990s, US GAAP started to incorporate these principles, when the country was coming out of a major crisis of their banking system, the “Savings and Loans” crisis, which saw large numbers of banking institutions going bankrupt, even though their book equity remained clearly positive. 

By then as much as nowadays, the application field of the market principle (or fair value principle) remained very limited, since a large majority of assets continues to be measured using the principle of amortised cost. 

IFRS, which adopted the same principle in more or less the same field, became mandatory in Europe only from 2005, on the eve of the most serious financial crisis that the world has seen since after World War II, a crisis that would have destabilised even the most well-established of accounting systems. 

The baptism by fire was a roaring blaze. By contrast, in the USA, which had enough time for reasoned experimenting, debate on accounting standards was a lot less heated than it was in Europe, and particularly in France.

2.  Markets are not efficient.  Accordingly, it is both absurd and dangerous to base accounting on market values

It has rightly been said that the markets are crazy and only the crazy will rely on them. 

But let’s look at things the other way round.  If markets were efficient, comprehensive, without bubbles that inevitably burst, if market agents were rational, and if information were symmetrical and shared by all, then accounting would, indeed, be of no use. 

It would simply be an exercise in making an inventory of figures, and the accounting profession would have disappeared long ago, since computers would be able to make these calculations a lot more easily. (In such a world, there would be no need for provisions and impairment.  There would be a convergence of cash-based accounting and on-accrual basis of accounting, since the complete markets would provide prices for all transactions, present and future).

It is precisely because markets are not efficient that we need the principle of fair value, i.e., a reasoned distance with regard to price. The lumpsum price set at the time of the original transaction, which establishes the historical cost, is also subject to these aberrations.

It is thus logical, for the most frequently traded assets on a market, to start off from this market value, and if necessary adjust it in the event of a malfunction. 
It is only those who are ardent market supporters who will always religiously equalise (mark to market) the fair value to the current market price. 

Established practice, which has been progressively codified by US GAAP, has gradually emerged.  It involves grading the information that comes from the market according to several levels, from 1 to 3, depending on whether the accountant can rely on an active market in order to measure the price of the asset (level 1), on whether he/she can observe the price of a comparable asset on the market (level 2), or on whether he/she has no observable reference (level 3). 

This model is now an established accounting tool. To a certain degree, the amortised cost rule, by which reserving was done in the past (today we talk about “impairment”) represents a form of model which is both crude and, since it is less codified, often open to subjectivity.

The difficulty with IFRS, and to a lesser degree with US GAAP, is that this development is very recent and is not yet stabilised. The result is a quite legitimate defiance amongst accountants who have to deal, in a context that is often one of conflict, with complex cases where a lot is at stake.

An example is the contrast between the terminology used in IAS 36, the standard that governs the impairment of goodwill in consolidated financial statements, and IAS 39, which deals with the measurement of financial assets. 
The former refers to the recoverable amount, distinguishing between market value (measured immediately), and value in use (the measurement of which relies on a model, based on future cash flows). The second refers to the levels 1 to 3 set out above.

Since the underlying logic is the same, there should be consistency in the principles and their terminology. The only question is this: how should the estimation be made when the market is silent or provides partial information? 

How should we establish the rules for constructing models that will be acceptable substitutes for the market, that it will be possible to audit and that are sufficiently objective?  It is the aim of IFRS 13 to provide such a unified framework. 

3- Accounting systems that are based on market value rather than on amortised cost result in greater volatility in accounting measurement

This is true in the short term. Over the long term, much less so.

When we do not take a market price, we filter out the parasitic volatility of the market, which is a good thing. The problem is, however, that we filter out too much, which is not so good.

The noise from the market disappears, but at the cost of the disappearance of basic volatility, which means that any new information on an asset leads to a modification of its price. We are there in the area of second-best choices.

Which would be best – more immediate volatility of the accounts but better information, or less volatility, but information that is obsolete, possibly useless, or even misleading. 

For large corporations, which have qualified financial departments and are monitored by qualified auditors, both internal and external, the answer is clear – it would be best to go with the most recent information and accordingly not to deprive oneself from the source of such information, which is the market. With the amendments mentioned above. 

The issue is more debatable for smaller companies. It is safer that they stick to basic principles. The loss of quality of their accounts is minimal since their transactions are generally simple and therefore not much impacted by the principle of fair value. (If such a firm is involved in complex transactions, then it is healthy that it is required to keep complex accounts – embarking on a project without measuring what one has embarked upon is not good management).

Over the long term, attention should be paid to the volatility that is being measured. Japanese banks during the 1990s are a good illustration of the case.

They base their accounts on historical costs only, which led to a stability of their earnings and equity… until the moment of truth when the real values have to be recognised in the accounts.  Earnings and equity then drop suddenly. Measured over a long period, including the shock, it is not certain that the accounts are less volatile.

4-Accounting systems based on market value rather than on amortised cost lead to spiral effects in the event of market turmoil, and, in the end, financial destabilisation

There are without doubt, especially in the area of financial activities, cases of vicious circles, whereby a sudden sharp drop in market prices forces firms to liquidate their most liquid assets, which in turn drags down prices, in a downward spiral process.  (Moreover, they hold onto the least liquid assets, which in theory, are the worst assets).

There are two factors behind this phenomenon. 

The first is the existence of restrictive regulations, for example on margin calls or on required solvency, forcing sales at knock-down prices, which explains why this phenomenon is likely to occur, especially for financial institutions. 

The second is more general, and depends on what we may refer to as market “conventions”. For example, a net loss is a negative sign that lowers expectations, before the market adopts this new convention. We encounter the same phenomenon with agency ratings on solvency, and accordingly, the same criticism is valid. 

The instrument used for measuring is no longer neutral vis-à-vis the reality that it measures. It should be noted that the principle of amortised cost is not free from such criticism. At the time an impairment is booked, the anticipations may violently adjust and might cause the same spiral effects.

This is an issue that concerns bank regulators at the highest level. They monitor the overall stability of the financial system and they wish, at all costs, to limit cases of the markets giving way. However, they also want, at a micro level, to have access to the best information possible on each bank. 

If the bank has around 3% of equity in proportion to its assets (which was relatively frequent at the start of the financial crisis which began in 2007), an impairment of only 3% of it assets could bring it down. So, the correct measurement of assets takes on a decisive dimension.  That is why regulators generally preferred market-based principles of accounting.

Clearly, market participants need to be educated in this area. For example, market analysts, have, over the course of economic cycles, convinced themselves that the steel sector is by nature cyclical.

This fact, once it has been internalised, is no longer destabilising. Today we note from their share prices that they mitigate rather than amplify the variations in company earnings in the sector.

With regard to the financial sector, this education is unsuitable in the troubled period we are experiencing today, in which all of our reference points have been shifted. However, it is likely that the assessment that the stock market will make of this tomorrow will be based more on the measurement of their solvency and on their equity, than on their immediate results.

An important article (1) has shown that in practice, these spiral phenomena had little impact on US banking players during the 2008-2009 crisis.  The banks reluctantly made provisions on their real estate portfolios, cursing their obligations under US GAAP. They said that we would see a rise in the prices of unhealthy assets. Three year later, that has still not happened. 

Hank Greenberg, the former CEO of AIG was the most outspoken of opponents against the principle of fair value for the valuation of his assets, until he ended up owing the US Treasury $182bn following the 2008-2009 bailout of the insurance company.

5- Accounting estimations leave too much open to arbitrary decisions and give too much of a free hand to management

The accounting tradition was and still is a tradition in which it is better for management to remain outside the book-keeping process. In order to protect its interests, management is always seen as likely to try to influence the information produced. 

This is where historical cost accounting comes in, since it stands up in the event of dispute. According to this method, the independence of the accountant and the quality of the audit should rely, as much as possible, on standards and recommendations that are external to the company, and separate from management. 

Insufficient awareness has been raised regarding the fact that modern accounting systems, on the contrary, tend to use management’s expertise over the assets that it manages. 

Management is, in fact, an “insider” and has valuable information on the financial reality of the assets managed. 

A document issued by the FASB and the SEC states that:  “when there is no active market for a marketable security, the use of management estimations […] is acceptable.”.   It goes on to say that   “The determination of fair value often requires discernment (2)”. 

It should be noted that management’s responsibility will be somewhat lessened if it is kept too much on the sidelines, except, perversely, when the accounts produce an image that is so detrimental that it is forced to get involved, obviously in the wrong sense (3) .

So, without being naively optimistic, management should be put in a position where it is required to reveal the correct information on the asset. If the market is deep and liquid, and if management cannot prove otherwise, the market price should be booked.  If the market is not such a good guide, then management can cut itself off partially (level 2) or even completely (level 3) from market values.  

Obviously, there is a risk of bias in the model. But in what way would it be logical to do without the opinion of those who have the best technical ability to estimate the value of the assets? 

If there is manipulation, there should be prevention at another level, through the internal and external organs of good governance, and if necessary, through the involvement of independent experts. The new accounting standards cannot be separated from a corporate governance that is more narrow, more complex and more participatory.

Through their multiple mandates and their high level of accounting expertise, audit firms play a determining role in this participatory process. It is their responsibility to build and to disseminate, as is the case in other areas of the law, well-adapted jurisprudence, i.e., best practice. It is lamentable that they did not do so when the Greek debt was provisioned in the accounts of European banks during 2011. 

Obviously, this is a system for producing figures that is all in all more expensive, corresponding to financial departments that have richer and more complex information systems (which is why it is not possible, unless they were highly simplified, to impose IFRS on companies that do not have these resources or a sophisticated form of corporate governance). 

It is also a system that is more open to dispute than previous systems – as is the modern practice of law. But this is the condition for transparency, the sense of which is not to increase the volumes of information delivered to the outside world, but to provide information in a context that makes it relevant

6- Given the lack of perfection of US GAAP and IFRS, and the fact that they are still a “work in progress”, all criticism should be taken on board.

There is still a huge amount of work to be done and what is more, it has to be done at an international level. It will probably lead to a unification of the US accounting system and IFRS, where Europe would, once again, have played its traditional role in producing standards. 

For financial managers in companies with an international presence, this will be a major step forward.  It will result in a much simpler dialogue between its financial teams and in consistency between management control and accounting.

But the work still lies ahead and constructive criticism is necessary. 

This is called transparency and, for the standards authority, the way of consensus around standards that have been hotly debated and criticised is probably the only practicable way, being aware of the political forces at play in the field in which it operates.

In this context, the “numbers professions”, including and especially their supervisors, are in a position that is necessarily ambiguous. On the one hand, they are well-placed to observe the shortcomings and defects, and thus to criticise the standards. On the other hand, they are the guardians of the standards, in a fiduciary sense, and must ensure that they are respected. 

Accordingly, a systematic chipping away at these standards becomes dangerous, since it undermines confidence, encourages investors to no longer believe in anything, and companies to no longer respect the standards. 

At the end of the day, it could result in the deterioration of the accounting system and create inefficiency that it is intended to relieve. 

Let us hope that this risk has been weighed up by all those involved.

(1) Laux, Christian, and Christian Leuz. 2010. "Did Fair-Value Accounting Contribute to the Financial Crisis?" Journal of Economic Perspectives, 24(1): 93–118.
(2) SEC Office of the Chief Accountant and FASB Staff, 2008, « Clarifications on Fair Value Accounting », 30 septembre 2008, www.sec.gov.news/press/2008/2008-234.htm.
(3) Voir Meunier, François, 2009, « Les IFRS dans la tourmente des marchés », Revue Française de Comptabilité, mars, n°419, pp. 23-27.

Statistics : Late payments in Europe

Altares has computed that on average, European companies are late with payments to their trade debtors by 13.4 days. This figure is stable compared to figures from the previous study, carried out three months before. 30% of them are late by more than 15 days.

The most virtuous country is Germany where 59% of companies are punctual, versus an average of 41% in Europe and an average delay of 8 days. The worst behaved country is Portugal where 6% of companies are late by more than 120 days, which is in addition to regular payment delays of 100 days (see chapter 11 of the Vernimmen). 

Research : Nature or nurture in finance?

Original publications in finance often result from the exploitation of data bases that were not initially intended for academic research.  This is the case of the study we present this month (1). Three US academics came up with the idea of working on some Swedish data which is without equivalent worldwide: the largest data base on twins (the Swedish Twin Registry), along with information collected by the Swedish Tax Agency on the financial assets of individuals for the purposes of levying wealth tax (2).

This study is situated on the border between finance and psychology. The aim is to determine the source of the profile of individual savings, by distinguishing between the innate and the acquired.  Psychological studies have shown that the risk aversion of individuals, as well as their social behaviour and their cognitive capacities, have a genetic component.  Other studies, in the field of finance, have shown that these elements play a determining role in the portfolio choices of individuals. 

The authors were keen to establish a link between the two bodies of research, and to demonstrate the existence of a genetic component in portfolio choices (3).

The study covers twins over the age of 18 in 2002.  The data exploited corresponds to 37,504 twins of which 29% were identical twins (monozygotic twins who share the same DNA) and 79% were fraternal twins (dizygotic twins).  The descriptive statistics indicate that the proportions are in line with those found in other studies.  The portfolios of the two sub-samples (identical and fraternal twins) have an average similar value (of around $30,000), with the same average proportion of cash (42%) and the same average proportion of shares (46%).

The distinction between identical and fraternal twins enabled the researchers to isolate the genetic component from the component linked to acquired behaviour.  The econometric test indicates that this genetic component explains close to 30% of variations in the composition of the portfolios.  The inclusion of control variables (wealth, entrepreneurial activity, health, marital status) does not modify the results.  This is the main conclusion of the study – there is indeed a genetic component in portfolio choices, and its influence is highly significant.

There is another interesting result of the study.  The component linked to the family environment in portfolio choices becomes negligible when we factor in the genetic component.  In other words, if the results of the study are to be believed, parental influence on portfolio choices is genetic and not cultural.

Studies seeking to explain the allocation individuals' assets on the basis of their observable features have, until now, not yielded results.  This publication opens a new door, which is sure to solicit much reaction.

(1) A.BARNEA, H.CRONQVIST and S.SIEGEL (2010), Nature or nurture: what determines investor behavior?, Journal of Financial Economics, vol. 98, pages 583-604
(2) This return for wealth tax is filed by Swedish financial institutions for individuals holding assets worth more than SEK 1,500,000. The law was abolished in 2006.  Great news for Swedish tax payers!  Bad news for academic research!
(3) Three characteristics of portfolios are taken into account:  the presence or absence of shares, the proportion of shares and the volatility of the portfolio.

Q&A : The locked box mechanism in M&A transactions
By Alban Bouley, BNP Paribas – Corporate Finance

The locked box mechanism is a mechanism whereby, when a company is sold, the parties agree on a fixed sale / purchase price.  No adjustments are made to this price either before or after closing of the deal.  It is calculated on the basis of recent financial statements (last audited financial statements or, if these are not recent enough, the interim financial statements which generally are not audited), referred to as the reference financial statements.

So the company is transferred “economically” to the buyer as of the date of the reference financial statements, and “legally” at closing, which means that there is a risk zone for the buyer.

CMS estimates, in its annual study of European M&A practices (1), that for close to two-thirds of deals in France in 2010 where there was no price adjustment, a locked box mechanism was used, but just 41% in Germany, 24% in the UK and only 9% in Southern Europe.  This raises the assumption that there is also a cultural dimension at play here.

The use of a locked box mechanism for the sale of a company does obviously have certain advantages for the seller and its advisors:

• System which has a great deal of simplicity, compared with a transaction where there is a price adjustment once the financial statements have been finalised.  The price offered is fixed, without adjustment, and the offers received through an auction process are more easily comparable (clear breakdown of equity value and sale and purchase agreement potentially pre-negotiated).

• With fixed-price deals, it is possible to avoid mobilising excessive resources, both internally and externally, and to escape the risk of post-closing legal disputes when the adjustment price is implemented. 

•The absence of closing financial statements also results in much faster execution, and more specifically, provides the seller with the possibility of paying out the price received for the sale to its shareholders or investors, as early as the closing date. This explains why the locked box mechanism is so highly appreciated by private equity funds.

Notwithstanding its undeniable advantages, the use of a locked box mechanism is not without obstacles and problems, and pre-supposes certain conditions before it can be put in place, as well as a great deal of preparation on the part of the seller and its advisors.

A very high level of competition is necessary at the time of the contemplated sale in order for the locked box mechanism to be accepted by all or by the majority of potential buyers.  It should be noted that trade players are generally less accustomed to fixed-price deals than private equity funds are.  Depending on the type of buyer, the intensity of the competition (especially during phase 1 – submission of indicative offer), and the characteristics of the target company (stable financial performances, reliable and diligent accounting, etc.), the seller and its advisors will choose between a fixed-price transaction and a transaction with a price adjustment.

Additionally, it is essential for the seller and its advisors to prepare certain work phases that are vital for the smooth running of a sale carried out using a locked box mechanism.

Duration of the sale process: it is important to plan for a sufficiently long (7 to 8 weeks) phase 2 period for the submission of binding offers, so that the buyer has enough time to carry out in depth due diligence before submission of the binding offer / signature; 

Due diligence: preparation of a detailed Vendor Due Diligence (VDD) report and the holding of meetings with various experts (tax, legal, unions, environmental, pensions issues, etc.) are also very important, in order to provide the buyer with a maximum of comfort.  The liability of the said experts / advisors can, if applicable, be engaged by way of a reliance letter;

Reference accounts: if the date on which the last financial statements were audited is too long before the transaction, then interim financial statements (generally, unaudited) will be prepared by the seller.  In certain cases, the seller and the advisory bank may decide during phase 2 to provide potential buyers with estimations of cash flows between the estimated date of the interim financial statements and the date of completion of the transaction.  This is done in order to avoid negotiations on these estimations that can prove to be lengthy, given what is at stake for the buyer, as set out above;

Sale and Purchase Agreement (SPA): pre-negotiation meetings on the SPA can be held with lawyers during phase 2, with the aim of arriving at a binding offer with the SPA “virtually signable” and a locked box accepted by all when the binding offers are submitted.
Finally, although the locked box mechanism is relatively less protective for the buyer, given the lack of price adjustment after closing, we note that there are some forms of protection, and that the locked box mechanism can turn out to be advantageous for the buyer too.  Contractual protection can be negotiated, specifically to protect the buyer against losses in value during the intermediary period: permitted / non-permitted leakages (which define the amounts that the seller is entitled to withdraw from the company for the payment of dividends, management commission, etc.), ordinary course of business management clause, guarantee of reference financial statements, etc. 

The locked box mechanism can prove to be a major competitive advantage for a potential buyer in cases of a competitive bidding process (differences of appreciation among the buyers of the cash flows generated by the company during the intermediary period) and also enable the buyer to take advantage of the upside of the business plan between the date of the reference financial statements and closing.   

For more information on the process of selling a company, see chapter 43 of the Vernimmen 2012.
(1) CMS European M&A Study.