Letter number 5 of April 2005


News : Communication regarding the switch to IFRS

Many listed companies have just published their estimations on the impact of the switch to IFRS on their results. Others will do so in the weeks ahead. The general impression is a zero impact (or an impact that is imperceptible, which amounts to the same thing!) on share prices, reflecting the comments of financial analysts who study these reports:

  • «a gentle transition to IFRS» (Michelin)
  • «a seemingly spectacular impact, but which had no influence on value» (Vodafone)
  • «The switch to IFRS – insignificant, as expected» (Schneider).

We have identified three main reasons for this:

  • Many financial analysts and accountants identified the key differences over three years ago and played a vital role in educating investors (1). So Danone’s announcement that its debt to equity ratio under IFRS would rise from 75% to 113% had no impact on its share price, since everyone had known about and been expecting this for a long time
  • Groups that issued regular statements on this topic were more often than not listed in the USA, and were already publishing and explaining reconciliations with US GAAP, which are similar to IFRS on a number of points
  • Finally, and fundamentally, even though replacing one’s spectacles may sometimes change the way one sees the world, this does not change the world itself!

At this stage however we cannot exclude the possibility that some smaller groups may not have been as well prepared, probably because smaller groups tend to be less sophisticated and unaccustomed to communicating with the market, and because analysts do not keep as close an eye on them.

What then are the major impacts expected?

1. Fundamental impacts:

Goodwill arising on mergers and acquisitions is no longer depreciated over a finite period, but kept on the balance sheet under assets at the original amount, unless an annual impairment test shows that it should be totally or partially written off (2). This is one of the most apparent impacts on the income statement, but since most analysts base their forecasts on results before depreciation of goodwill, the actual financial impact is zero. This is how Vodafone was able to eliminate a £15bn charge which had been keeping it in the red. This made no difference at all to its results, but it was perfectly justified in doing so.

The scope of intangible assets is modified: market shares can no longer be capitalised and should be reclassified as goodwill. Development costs have to be capitalised if certain conditions are met.

Securities, excluding consolidated participating interests, are valued at their fair value. There are three possible scenarios: If the securities in question are held for trading, fluctuations in value are included on the income statement. In most other cases, the company is not planning on selling the securities even if they are available for sale if need be. Latent capital gains or losses (and subsequent variations) are only reflected on the income statement when they are effectively realised as a result of a sale. In the intervening period, capital gains (and variations thereof) are booked directly as shareholders’ equity without being reflected on the income statement. This is how Mediobanca reevalued its stake in Generali, and accordingly its shareholders equity, of close to €3bn. Finally, in the very specific and infrequent cases when securities are kept until their final redemption date, they are valued at their historic cost, adjusted by any partial repayments already made.

Hedging instruments are recorded on the balance sheet at their fair value, and any capital gains or losses are reflected on the income statement. When it can be demonstrated that these instruments are being held with a view to efficient hedging, the capital gains or losses are recorded on the balance sheet under shareholders' equity (with no impact on the income statement) if the hedging applies to future flows. If this is not the case, they are entered directly on the income statement and thus set off any changes in the opposite direction.

Tangible assets may be booked at their fair value. This is an option for all or part of the tangible assets. Vinci stated that it would not be revising the value of its tangible assets, but Publicis valued its headquarters located at the top of the Champs Elysées at €164m, which previously appeared on its consolidated balance sheet for €4m.

Deferred taxes can not be calculated at their present value, which is somewhat inconsistent, given the IASB’s central preoccupation with measuring value.

The cost of stock-options should be calculated and booked under expenses as an employee benefit (3) .

Treasury shares (including those held by subsidiaries) should systematically be deducted from equity, even when they are used to cover stock option plans or to regulate share prices. Consequently, any change in the share price will not impact on the income statement.

Hybrid securities should be booked for the amount of their equity component under equity, and for the amount of their debt component under borrowings. So Publicis’ €1,881m in hybrid securities was broken down into €654m of equity and €1,227m of debt. The theoretical cost is reflected on the income statement. Financial expense thus includes some non cash items which reduces the impact of the interest cover ratio (Ebita or Ebit divided by financial charges).

Buy-out and earn-out provisions should be booked as debts.

Certain expenses are deducted directly from sales and accordingly, are not booked as expenses – fees and taxes collected on behalf of third parties (Bouygues), discounts for prompt payment (Unilever).

2. Impacts on presentation:

The IAS balance sheet is not structured on the basis of liquidity but on the basis of the difference between current and non current assets and liabilities.

The IAS income statement does not reflect exceptional or extraordinary items which are normally integrated at the level of operating income, unless the company elects, as recommended by the CNC in France, to isolate non-recurring items on a separate line, which is good practice in financial reporting.

Reporting of financial information should be more detailed and more specific (by segment and by geographic region) than is currently the case.
On the whole, there seems to be a general negative impact on opening equity, mainly resulting from the treatment of pension funds. The impact on net income is slightly positive (given that there is no more depreciation of goodwill and notwithstanding the booking of stock options and pension fund requirements as an expense), but this is not necessarily significant as the first two are already factored in or neutralised in the investors’ minds.

(1) See chapter 7 of the Vernimmen.
(2) For more details see The Vernimmen.com Newsletter n° 2 of January 20005.
(3) For more details see The Vernimmen.com Newsletter n° 3 of February 2005.

Statistics : Asset betas in Europe

Asset beta is the beta of the company’s capital employed as reconstituted from the company’s beta of shareholders’ equity and financial structure. It is used to determine the cost of capital. Here are the asset betas for some sectors:

For more on asset beta, see chapter 23 of the Vernimmen.

Research : Culture, openness and finance

René Stulz and Rohan Williamson (1) looked at the impact of culture on the governance of financial markets and on corporate governance in different countries. This is an issue of great interest, given that social scientists have for many years attempted to link economic development to culture (2). Finance could well be the channel (or one of the channels) via which culture impacts on economic growth.

There are some who believe that the obvious model to follow, for those seeking to entrench the protection of investors, is the Anglo-American model. In a situation where financial markets are competing with each other on a global scale to attract investors, and given the fundamental impact of capital on economic growth, we would expect to see a convergence towards this supposedly ideal model. However, this is not what appears to be happening.

R. La Porta, F. Lopez-de-Silanes, A. Shleifer and R.Vishny (3), pioneers in the field of international comparison of financial governance systems, attribute this diversity to the different legal systems in place in different countries. This analysis is not neutral, and assumes the superiority of the Anglo-American common law system over the civil law system originally created by the French. René Stulz and Rohan Williamson suggest the exercise of greater caution before judgements are leapt to, and submit that culture could be the underlying cause of this diversity and of its refusal to go away.

Culture can influence the financial sphere for three reasons. Firstly, culture has an influence on a society's values, more specifically through the underlying principles of the dominant religion in that society. The values of a society in turn are what condition the behaviour of its agents. For example, charging interest (usury) was for a long time considered to be a sin by the Catholic Church, whereas for Protestants, charging interest was a normal part of commercial life. This meant that in Calvinist countries, the debt market was able to develop to a much greater degree than in Catholic countries. Similarly, although individualism is a feature of most western societies, there are fundamental differences between Catholic countries in which private property takes second place to the “greater good of the community”, while in Protestant countries, each individual is expected to be able to tell what is “right and good” for him or herself.

The second reason is that culture can have an influence on a country’s institutions, such as its legal system. Accordingly, the culture in Protestant countries strongly encouraged the introduction of a decentralised legal system, under which the power to pass judgement was devolved to judges and where case law prevailed, while the civil law system still in place in may Catholic countries centralises and prescribes the law, paying close attention to detail, through the civil code. This dichotomy in the legal system highlights the key difference between the Protestant and Catholic religions. While individual faith is the keystone of Calvinism, which is what underlies the decentralisation of authority, knowledge lies at the basis of the Catholic faith, resulting in the establishment of a centralised authority intended to transmit knowledge down via the church hierarchy.

The third and final influence of culture on the world of finance is its role in determining how resources are allocated in the economy. For example, looking at human capital, we note that over a long period, the most outstanding minds in Catholic countries were reluctant to go into the financial professions, knowing that they might well be excommunicated. Fortunatly, for the writers of this newsletter, this is no longer the case today.

In order to test the influence of culture on the level of investor protection worldwide, the authors used the data of R. La Porta et al. (3) on 49 countries in Asia, Europe, North America, South America, Africa and Australia. Additionally, the authors rely on two variables for determining the cultural factor – the dominant religion and language of a country. The underlying idea is that religion lies at the heart of the cultural differences between countries, and that language, if it is shared, encourages the sharing of the same deep-seated cultural values between countries. The results they obtain are very interesting, especially when compared with those obtained by R. La Porta et al.

Cultural factors would appear to have little influence on levels of shareholder protection. It is true that in English speaking countries where the Protestant religion dominates, shareholder voting is encouraged through various means (postal voting, no blocking of voting rights, etc.) and shareholders are more likely to take legal action against company managers. It is however difficult to conclude that these countries, as a result of cultural aspects, afford better protection to their shareholders than other countries, and especially non-English-speaking Roman Catholic countries. In fact, there are certain features of Catholic countries which encourage better protection of shareholders, for example preferential subscription rights granted to shareholders when new shares are issued, or the possibility of accumulating votes in order to get a seat on the Board.

On the other hand, religion would appear to have a major influence on levels of creditor protection. In Catholic countries, levels of creditor protection seem to be much lower than in other countries, particularly Protestant countries. For example, when a company is restructured following default on debt repayments, the managers of companies in Catholic countries hold onto their jobs, while in other countries, managers are systematically fired in such cases. It is also interesting to note that in non-Christian countries (Buddhist and Islamic countries) creditors are afforded more protection than in Protestant countries.

The authors also looked at the efficiency of different legal systems. This analysis looked at the risk of expropriation, the risk of corruption, the risk of contracts being repudiated, as measured by international rating agencies, as well as accounting standards. Here again, religion would appear to play a major role. Christian countries, and especially Protestant countries, are far more efficient than others when it comes to complying with laws and accounting standards.

All of these results stand up when the relevance of cultural factors is checked on the basis of criteria for a country’s economic development and the origin of its legal system. The authors also show that in countries which are very open to international trade, there is better protection for both shareholders and creditors, setting off some of the negative effects linked to their culture. These results challenge some of the conclusions arrived at in the pioneering study by R. La Porta et al. The authors do concede that there would appear to be a strong correlation between the origin of a country's legal system and the level of shareholder protection. Nevertheless, as far as creditor protection is concerned, the efficiency of the legal system and accounting standards and religious-based cultural differences provide a better yard stick for measuring levels of investor protection, than whether the country has a common law or civil law system in place.

(1) René Stulz and Rohan Williamson Culture, Openness, and Finance, Journal of Financial Economics, December 2003.
(2) See Max Weber for example.
(3) R. La Porta, F. Lopez-de-Silanes, A. Shleifer et R. Vishny, Law and Finance, Journal of Political Economy, December 1998.

Q&A : What are credit derivatives?

Since they first appeared in 1995, credit derivatives have taken off. Credit derivatives make it possible to separate the credit risk on an asset or liability from the actual ownership of that asset or liability.

At first, credit derivatives were used mainly by financial institutions, but are starting to catch on with major industrial and commercial groups, mainly to reduce the credit risk of certain clients who account for an excessive proportion of their loan portfolios, or to hedge against a negative trend in the margin of a future debt instrument.

Credit derivatives work very much like fixed-income or currency derivatives. It is merely the nature of the risk that they manage that is different: that of insolvency of one counterparty or a change in its debt rating instead of interest rate or currency risk.

The most conventional form of credit derivative is the credit default swap through which the buyer of protection from insolvency of a counterparty, pays a third party a regular cash flow and receives from this third party a pre-determined amount in the event of bankruptcy. The credit risk is thus transferred from the buyer of the protection (a company, an investor or a bank) to a third party, who can be an investor, an insurance company or another entity, in exchange for payment.

Credit derivatives are traded over the counter and play the same economic role as insurance contracts.

Meanwhile, a second category of derivatives is emerging that is not an insurance-type product but rather a futures-type product, through which the company can lock in the spread of a bond to be issued in the future. This makes it possible to buy and sell an issue’s spread at a pre-determined level. And, of course, where forward purchases and sales exist, financial intermediaries will see an opportunity to create options on these purchases and sales and we end up with an insurance product – the future spread option!

For more on credit derivatives, see chapter 48 of the Vernimmen.