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.

The gain or loss that we think is irrelevant for investors is the amount recycled from other comprehensive income (OCI) to profit & loss due to the sale or impairment of available for sale (AFS) equity investments reported under IAS 39. Apologies for all the accounting jargon. Before we get into why it is irrelevant, let’s first explain what this is all about.

Financial instrument accounting

The equity investments to which we refer are those accounted for under IAS 39 and its replacement IFRS 9; these are the IFRS standards that deal with financial instruments. The investments are the minority equity stakes held in other companies that do not qualify as subsidiaries, associates or joint arrangements (for which consolidation or equity accounting is applied). Such investments are reported at fair value in the balance sheet under the new IFRS 9, as were the majority under IAS 39. However, the problem is not the balance sheet measurement but what appears in profit & loss.

First, let’s look at the accounting under each standard. Companies reporting for the calendar year ending December 2018 or after must use IFRS 9, except for those that predominantly engage in insurance. Because of the significant change in IFRS insurance accounting that will likely take effect in 2022 (IFRS 17), companies that qualify as insurers can choose to defer the application of IFRS 9 until that same date.

Most insurance companies have deferred the application of IFRS 9

If you are analysing insurance companies that still apply IAS 39, then this article is especially relevant for you as as they will continue to present this ‘irrelevant’ profit & loss figure. However, you should read on even if you, understandably, seek to avoid the complexities of insurance accounting. The change in accounting for equity investments affects other companies. Also, understanding the process and limitations of OCI recycling remains relevant in other situations.

IAS 39 accounting

Under IAS 39, equity investments are reported at fair value with fair value changes included in profit & loss if they are held for trading purposes (for realisation of short-term gains) or where the entity elects to do so using the ‘fair value option’. The majority of other equity investments are measured at fair value with fair value changes reported in other comprehensive income (OCI); so-called available for sale or AFS accounting. Only fair value changes are reported in OCI for AFS accounting; dividend income is included in profit & loss.

The fair value gains or losses arising from AFS accounting eventually affect profit & loss through a process called reclassification or recycling. If, for example, there are fair value gains in OCI then recycling would mean reporting a loss in OCI and an equivalent gain in profit & loss in the same period.

Recycling occurs when past unrealised fair value changes are ‘realised’ due to the sale of the investment or, alternatively, where there is no sale but the value of the investment has declined and is assessed to be ‘impaired’. An impairment loss is reported when the decline in value is “significant or prolonged”.

IFRS 9 accounting

The new IFRS standard on accounting for financial instruments applies a simpler approach. The default method is that investments in equity securities are now accounted for at fair value through profit & loss. The exception is that companies may elect to report fair value changes of particular equity investments through other comprehensive income (FVOCI). However, unlike IAS 39, if reported in OCI then there is no recycling either on sale or if the asset is ‘impaired’.

As with IAS 39, all dividend income, including that related to FVOCI investments, is recognised in profit & loss.

Ping An reporting under IAS 39 pre-2018

Chinese insurer, Ping An, applies full IFRS because of its listing in Hong Kong. It is unusual amongst insurers in that it is required to apply IFRS 9 to its 2018 consolidated results, having applied IAS 39 in prior periods. It did not qualify for continued use of IAS 39 for its consolidated financial statements because it is not a pure insurer; Ping An also has a major banking operation.

Ping An has a substantial portfolio of equity investments; at 31 December 2017 (its last year of reporting under IAS 39) the balance sheet amount was Rmb 631bn (about USD 93bn). Of this just Rmb 77bn was accounted for at fair value through profit & loss, with the majority, Rmb 553bn, classified as available for sale; a significant figure considering group shareholders’ equity of Rmb 588bn.

Recycled gains or losses are generally most significant for equity investments

Equity investments represent only a minority of the overall investment portfolio of Ping An, as they do for most insurers, since it is investment in bonds that generally gives a better match with the cash flow profile of insurance liabilities. Nevertheless, the size of the equity investments and the higher uncertainty of associated returns means that this is a major contributor to overall performance. The Table below shows the amount of fair value changes reported in OCI and the recycling deductions from OCI due to realisation and impairment. As we explain above, these recycled amounts reappear in profit & loss in the same period. The figures actually relate to all AFS investments, as the split between equity and debt securities is not given in the OCI footnote. However, we can tell from elsewhere in the financial statements that the AFS fair value changes and recycled amounts predominantly relate to equity investments.

Ping An recycling from OCI to profit & loss under IAS 39
Source: Ping An financial statements

In 2017, for example, the company reported fair value gains in respect of its AFS investments of 46.7bn, with this gain included in OCI and not profit & loss. The realised gains in the year of 9.0bn are recycled to the income statement and hence appear as a loss in OCI and a gain in profit & loss. There is also an impairment loss of 0.9bn (an unrealised decline in value assessed not to be recoverable) that is recycled to the income statement and hence presented as a positive item in OCI and corresponding loss in profit & loss. The amount related to AFS investments that is included in the pre-tax profit of 134.7bn is therefore a net 8.1bn. This is very different from the change in fair value of the portfolio of 46.7bn, which we consider to be more relevant for investors.

So, what is wrong with these figures and what is ‘irrelevant’ about the recycled amounts? In terms of compliance with accounting standards nothing is wrong at all; Ping An follows the rules in IAS 39. It is just that, in our view, the figures produced by those rules have little or no use for investors.  We believe that it is the fair value change in the period that provides useful information and not the recycled amount. There is clearly a significant difference between the two in the case of Ping An.

There are three problems with AFS equity investment recycling under IAS 39: (1) the amounts reported are, in part, arbitrary; (2) the amounts can be controlled to an extent by management and, therefore, can potentially be used for earnings management; and (3) the amounts reported say little about current period performance and are completely useless for the purpose of valuation.

Arbitrary amounts

When equity investments are sold the amount of profit realised would seem to be easy to calculate – sale proceeds less original cost. However, where assets are fungible and the purchase of a holding takes place on more than one date, then some sort of arbitrary rule (such as FIFO or average cost) is needed to identify the exact cost of the particular portion of a holding that is sold. Only if the full holding is sold does the gain become unambiguous.

Impairment charges are also largely arbitrary. The requirement to report a decline in value of AFS equity investments in profit & loss when “significant or prolonged” is open to interpretation. How large does a decline need to be for it to be significant and for how long does the fair value need to be below the original cost for it to be prolonged are a matter of judgement for each company. For example, Ping An, based its impairment of equity investments on a 50% decline in value being significant and one that persists for 12 months as being prolonged. However, we have seen different thresholds used by other companies. Even if all companies were to use the same criteria, the concept of an impairment is, in our view, fundamentally flawed as it creates an arbitrary cut off and can never reliably identify declines in value that will not be recovered.

Earnings management

Because different assets in a portfolio have different amounts of unrealised gains or losses, the timing of sales and the selection of which assets to sell can be managed such that the amount reclassified from OCI is at least partially under the control of the company. Earnings management through realisation is a powerful tool for any company with a significant IAS 39 AFS portfolio. However, the problem for investors is that it is almost impossible to identify whether, or to what extent, this particular earnings management tool is being used.

We are certainly not suggesting that Ping An managed asset sales with a view to achieving a particular reported profit. Nevertheless, is is likely that some companies do.

Meaningless in terms of performance

Even if the timing of asset sales is not used for earnings management, the amount of gains recognised in profit & loss has more to do with the process of managing a portfolio than a reflection of the performance of that portfolio. Warren Buffett, for example, has previously advised shareholders in Berkshire Hathaway not to consider the realised AFS gains as a valid measure of the performance of its equity investment portfolio.

The gains reported are the accumulation of past value changes (modified by any unreversed impairments) from when the assets now sold were originally purchased. The majority of these gains are a reflection of performance in a variety of past periods and say nothing about current performance. Also, it only applies to that part of the portfolio actually sold. Overall, the realised gain is a complex mix of different items which is almost impossible for an investor to interpret in a portfolio context.

You can guess by now that we are not fans of recycled OCI! The good news is that recycling no longer applies to equity investments accounted for under IFRS 9 (although it still does for certain debt securities). The bad news is that probably until 2022 (the exact date is currently being reviewed) most insurance companies, Ping An excluded, will continue to recycle equity investment gains and losses.

Ping An reporting under IFRS 9 in 2018

In 2018 Ping An adopted IFRS 9. As a result, reported profit no longer includes the equity investment recycled gain or loss. We think this is a significant improvement.

Under IFRS 9 the company had to decide which of its equity investments were to be reported at fair value through profit & loss and which through OCI. The criterion it uses is to report in OCI only those equity assets it intends to hold for the long-term. At 31 December 2018 this resulted in equity investments worth Rmb 349bn being reported at FVPL and Rmb 222bn at FVOCI. Remember that the use of OCI is a free choice, unless the assets are held for ‘trading’, and other companies may adopt different methodologies for deciding when and how it is used.

Below is the full OCI statement shown in the 2018 annual financial statements. You will notice that the comparatives for 2017 in this note are still on the old IAS 39 basis because the company elected not to restate. The amount reported in OCI for equity investments in 2018 is a loss of Rmb19.1bn. In our view it would have been better for investors had this been reported in profit & loss and the FVOCI option had not been used. The value change of assets that are intended to be held for the long term are no less relevant to investors than other fair value changes. Our advice for investors is to include this amount as a component of overall performance.

However, the benefit for investors of the new reporting is that there is no longer any confusing recycled amount affecting reported performance metrics.

Ping An: Other Comprehensive Income – year to 31 December 2018
Source: Ping An 2018 financial statements

A brief note on shadow accounting: You will have noticed references to ‘shadow accounting’ in both tables above. A feature of investments made by insurance companies is that not all of the investment gains and losses affect shareholders. For some insurance contracts part of the investment returns are passed on to policyholders and are offset by changes in the measurement of insurance liabilities. The shadow accounting adjustment in OCI is the portion of the insurance liability change that relates to the investment gains and losses reported in OCI (net of recycling where relevant). The impact of recycling on profit & loss for insurers needs to be considered net of the shadow accounting adjustment.

Our advice – performance metrics and equity investments

  • For insurers still reporting under IAS 39, and for all companies’ results before 2018, ignore any gains or losses reported in profit & loss that arise from the recycling of AFS equity investments fair value changes previously reported in OCI.
  • For companies reporting under IFRS 9, restate profit & loss performance metrics to include those fair value changes recognised in OCI. It is a significant improvement not to have recycling under IFRS 9, but we don’t think the continued use of OCI is useful, especially as what is included in OCI will vary by company.
  • Focus on periodic fair value changes of an equity investment portfolio for assessing performance. But remember that for insurers this needs to be in the context of the insurance products held and the risk & return sharing with policyholders.
  • Disaggregate profit to separate changes in investment value from other components of performance. Think in terms of a ‘multiple of one and more than one’. For investment portfolios it is the current fair value that matters more than periodic changes in value.

And finally …

IAS 39 AFS accounting for equity investments is much loved by companies, even though, in our view, it has been the scourge of investors for many years. For companies it meant having less volatility in profit & loss and hence avoiding the need to explain that volatility to investors. More importantly, it gave the opportunity to manage earnings through the timing of sales and selection of assets to be sold. Realised profits can be very easily managed, unlike the harsh reality of changes in market value.

AFS was so liked by companies that some have lobbied to get IFRS 9 amended. In Europe there is even a movement dedicated to persuading the EU to ‘carve-in’ an amendment to IFRS 9 to reintroduce recycling when equity investments are sold or impaired. We think investors are far better off without it.