Enterprise to equity bridge – more fair value required

A largely cost-based measurement approach in financial reporting generally provides sufficient information about operating ‘flows’ to enable investors to apply enterprise value based DCF (or DCF proxy) valuation models. However, fair values are crucial for the ‘bridge’ from enterprise to equity value.

Fair values are available for many, but not all, of the assets, liabilities and equity claims that should be included in the enterprise to equity bridge. We explain the limitations of current financial reporting and where you may need to do further analysis.

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Bitcoin: The financial reporting challenge for investors

Whether you view Bitcoin as a modern-day tulip bulb mania bubble, that will inevitably burst, or an unstoppable development in finance, one thing is certain, companies are increasingly purchasing this asset. But how do Bitcoin and other cryptocurrencies affect reported financial position and performance metrics?

There are no accounting rules dedicated to cryptocurrencies. Under current US GAAP and, usually under IFRS, intangible asset accounting is applied.  We use the reporting by MicroStrategy to illustrate why this does not provide the right information for investors and explain how you should include cryptocurrency assets in your analysis.

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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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Allocating value: An option-based approach – Air France-KLM

You might assume that a change in enterprise value completely accrues to equity investors; however, this is often not the case. Other claims, such as debt or equity warrants, also change in value as enterprise value changes. Understanding this effect can be important when analysing many companies, especially those in financial distress.

Option-like characteristics of debt and equity claims drive the allocation of changes in enterprise value between debt and equity investors. We apply an interactive model to analyse recent changes in the enterprise value of Air France–KLM.

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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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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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