Pension leverage under IFRS and US GAAP – Delta Air Lines

US GAAP and IFRS present the effects of pension leverage differently in financial statements, notably leverage arising from pension fund asset allocation. This complicates the comparison and interpretation of performance measures and valuation multiples.

We use Delta Air Lines to illustrate the positive impact of the US GAAP ‘expected return’ approach on reported profit, including the effect of optimistic return assumptions. If Delta had applied the IFRS ‘net interest’ approach we estimate that a ‘gain’ of $594m would have been excluded from profit and loss and instead reported in OCI.

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Most likely profit may not be the most relevant profit

Analyst forecasts may not take into account the distribution, particularly the skewness, of potential outcomes. A forecast of the most likely profit can significantly differ from the more relevant probability weighted expected value.

Whether a forecast is a mean or a mode is also important in financial reporting. Most IFRS standards, including IFRS 9 regarding loan impairments, require a probability weighted expected value; however, this is not universal. In some cases, such as IAS 37 regarding provisions, the requirements are unclear.

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Forecasting ‘sticky’ stock-based compensation

Stock-based compensation grants to employees in 2020 are likely to be affected by the changes to share prices and reduction in profitability currently being experienced by many companies. However, the impact on the related expense and on reported profit may not be what you might expect.

For most companies, stock-based compensation is a ‘sticky’ expense that is only indirectly or partially affected by current period changes. Limited disclosure in financial statements makes forecasting this expense a challenge. You should focus on the value of new grants, the vesting period and the effect of potential changes to assumptions. Our interactive model will help.

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Intangible asset accounting and the ‘value’ false negative

Few people seem to be satisfied with intangible asset accounting; depending on your perspective, there is either not enough or far too much of it. What is clear is that many valuable intangible assets go unrecognised in financial statements. The result is distorted financial ratios, including price to book.

The lack of intangible asset recognition means that most investors know to use book value with caution. This may not be the case for index providers, ‘smart beta’ funds and quant-based investing where price to book ratios are used to identify ‘value’ stocks and related indices.

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Amazon free cash flow – an update

Last year we published an article about the calculation of free cash flow and the alternative approaches used by Amazon. That original article is still very relevant; recent accounting changes have prompted us to publish an update.

New accounting rules effective in 2019 change and improve the data available to you when making the adjustments we advocate. We explain these changes, provide updated free cash flow measures for Amazon based upon their 2019 financial statements, and consider the relevance of maintenance and growth capex in the analysis of free cash flow.

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Operating profit – improved presentation coming soon

Most investors make extensive use of operating profit to assess company performance and as a starting point for valuation. But operating profit, like many company-provided subtotals, is not defined by IFRS; it is largely up to companies to decide what subtotals to include and even what to call them. However, the IASB may soon bring an end to this operating profit ‘free for all’.

The proposal will lead to significant changes to the presentation of financial statements, notably the income statement, and end the current diversity in presentation of income from associates and joint ventures. We examine some of the changes and the impact on financial analysis and valuation methods.

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Leasing and leverage – credit rating agencies disagree

Rating agency Fitch recently announced its approach to dealing with the new lease accounting in its credit metrics. Their approach is at odds with that already published by Moody’s and Standard & Poor’s. Of particular interest is the way the rating agencies deal with the differences between IFRS and US GAAP.

We explain the different approaches of the rating agencies, how we think investors should calculate key metrics, such as leverage and cash flow, and the importance of considering the impact of leasing on operating leverage and business flexibility.

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Multi-employer pensions: Liability missing, expense unhelpful

Defined benefit pension liabilities arising from participation in multi-employer plans may not be recognised on the balance sheet. Under IFRS, companies can avoid recognition by simply asserting that “information is not available”. Disclosures in the footnotes help, but these may be measured on an ‘actuarial’ basis which is not relevant for investors.

We use retailer Ahold-Delhaize to illustrate the challenge for investors. It participates in several US multi-employer schemes and discloses an unrecognised actuarial liability of €1.1bn as per year end 2018. We estimate the more relevant IAS 19 liability, which we think should be recognised on-balance sheet, to be €2.2bn.

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Leverage and cash flow effects of supply chain finance

Supply chain finance, such as factoring and reverse factoring, are often labelled as tools used by companies in financial distress. Although we believe they are valid financing techniques, the reporting of these arrangements can affect leverage and cash flow. Due to poor disclosure you may not even know about it. 

Debt finance may not appear as debt in the balance sheet.  Operating cash flows may not include payments for some operating expenses or may be distorted by changes in financing being classified as operating. We explain how supply chain finance works and how you may need to adjust key metrics.

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Beware the IFRS 16 inflation headwind – Tesco

The capitalised lease liability of an inflation-linked lease does not include expected inflation. This results in a lower liability and lower initial expense compared with an equivalent lease with no inflation link. The IFRS 16 figures are updated as the inflation uplift occurs, but these catch-up adjustments create a profit ‘headwind’.

We estimate that Tesco’s inflation-linked leases result in a pre-tax profit headwind of about 2.2 percentage points of growth.  If inflation were included in the measurement of the lease liability instead, we estimate it would increase from the reported £10.3bn to approximately £15.2bn.

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Goodwill impairments may not identify impaired goodwill

Failed acquisitions do not always result in goodwill impairments. Management optimism is part of the problem, but so is application of the impairment test in a way that maximises the shielding effect of other assets. This reduces the value of goodwill impairments for investors.

Analysing the success or failure of M&A is important to assess management stewardship. We applaud the IASB’s proposal for more disclosure, but also believe the goodwill impairment test needs a critical review. Some use the ‘too little, too late’ character of impairment to advocate re-introducing goodwill amortisation. We do not agree.

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Don’t rely on APMs, disaggregate IFRS – GlaxoSmithKline

Alternative performance measures (APMs) can be helpful for investors, but not necessarily the figure itself. It is the disaggregation of performance that is the real benefit. Focusing solely on adjusted measures means you will miss important aspects of profitability.

We explain how you can use APMs to better understand performance, but without missing key elements. In our view this approach would provide a better basis for investor forecasts, as we demonstrate by disaggregating the IFRS earnings of GlaxoSmithKline.

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Deferred tax fails to reflect economic value – Vodafone

Most deferred tax adjustments in financial statements help investors – but not always. The ‘economic value’ of deferred tax assets arising from unused tax losses may be significantly less than the balance sheet figure. However, as a consequence, profit forecasts may be understated, potentially leading to an undervaluation by investors. 

We estimate that if the £24bn deferred tax asset of Vodafone were discounted to an economic value then it would instead be closer to £8bn, but forecast profit would rise by about £500m.

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Dot-com bubble accounting still going strong – Tesla

Some 20 years ago the dot-com bubble was in full swing. A feature of many technology companies at the time, and arguably a factor contributing to the bubble, was not expensing the significant amounts of stock options granted to employees.

Today stock-based compensation is included in IFRS and GAAP profit measures. However, many companies still exclude this item from key performance metrics provided to investors. Surely it is time for this practice to stop? We use the alternative performance measures given by Tesla to illustrate.

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Operating leases: You may still need to adjust

Do you invest in both IFRS and US GAAP reporters? If so, then in recent financial statements you might have noticed differences in the accounting for leases. This could result in a significant lack of comparability in key metrics.

Both IFRS and US GAAP now better reflect the economics of leasing and so the old adjustments to capitalise operating leases are no longer necessary. Unfortunately, you now need to make other adjustments to get comparability between US and IFRS reporters. We explain the adjustments and provide an interactive model to help.

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Ignore this ‘recycled’ profit – Ping An

There is a particular gain or loss in the income statement of many companies that, in our view, is irrelevant to investors. Fortunately, it is gradually disappearing from most IFRS financial statements due to the introduction of IFRS 9. However, if you invest in insurance companies you might not be so lucky.

Chinese insurer Ping An’s pre-2018 results were significantly impacted. But no longer – the company is one of the few IFRS reporters in the global insurance sector where investors now benefit from the elimination of this ‘irrelevant’ component of profit & loss.

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When investors need to restate liabilities – EDF

In measuring its €40bn French nuclear decommissioning liability, EDF applies a 10-year historical ‘sliding average’ discount rate to a current estimate of cash flows. In our view, this leads to an out of date (and at present understated) liability that you should not use in your analysis, even though the approach is deemed to comply with IFRS.

Smoothing out the effects of discount rate changes may reduce apparent volatility, but it does not help investors. Balance sheets should include realistic and fully up to date estimates of the present value of decommissioning and other similar obligations.

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Investors need fair value, not fake value

Equity investments currently reported at fair value could be measured at cost or some other ‘fake value’ in EU companies’ financial statements, depending on the outcome of a European Commission consultation.

There seems to be a never-ending debate in Europe about fair value measurement, particularly regarding equity investments. In our view any move to change the current financial reporting requirements would be detrimental for users of financial statements.

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Pension liabilities: Not so ‘prudent’ actuarial values

The valuation of pension obligations can be an important component in determining the value of an equity investment. But should you include in your analysis the pension surplus or deficit based on the accounting liability or, as some argue, the lower actuarial ‘funding’ valuation?

It is all about the discount rate. The problem is that there are very different opinions about the appropriate rate for pension obligations and what measurement approach is most relevant for investors. We examine a view expressed by many, including BAE Systems.

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