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 u...| The Footnotes Analyst
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 under both IFRS and US GAAP when making the adjustments we advocate. We explain these changes, provide updated free cash flow measures for Amazon, based upon their 2019 financial st...| The Footnotes Analyst
Financial reporting, equity analysis and equity valuation insights for investors| The Footnotes Analyst
Pension accounting can produce some odd results, such as companies that report a pension surplus, but which still make ‘deficit reduction’ cash contributions. This illustrates an underlying problem in financial reporting where pension assets and liabilities may not reflect the true economic position of the sponsoring company. We think the increasing closure of defined benefit schemes to new accrual, and the growing trend to de-risk, including the use of pension buy-ins and buy-outs, makes...| The Footnotes Analyst
Amazon provides investors with three alternative calculations of a free cash flow metric. For 2018 these range from $8.4bn to $19.4bn. In contrast our preferred approach gives a negative free cash flow of $3.4bn. What explains these material differences? The disclosures by Amazon about its free cash flow measures are good and the calculations go further than many other companies. However, in our view important components are missing. We explain our additional adjustments in respect of leased ...| The Footnotes Analyst
Companies that use property assets in their business may adopt very different real-estate strategies. Ownership versus leasing and the choice of different lease structures can significantly impact key performance and valuation metrics. We show that separating the operating and property components, using ‘Opco-Propoc’ analysis, improves comparability. Some investors argue that the new IFRS 16 lease accounting reduces comparability. We disagree. In our view IFRS 16 reveals important differe...| The Footnotes Analyst
Defined benefit pension schemes create two leverage effects - financial leverage due to the debt like nature of pension deficits and asset allocation leverage if pension assets are not matched with pension liabilities. In DCF valuation these effects must be correctly, and consistently, included in both the discount rate and free cash flow. We use an interactive model to demonstrate four possible DCF approaches based on enterprise and equity cash flows. Our preferred approach is based on enter...| The Footnotes Analyst
The mark-to-market of commodity supply contracts, such as power purchase agreements and related derivatives, can create significant volatility in profit and loss. But are these gains and losses meaningful, and should you remove them from performance measures as many companies do in their non-GAAP reporting? There are 4 methods of accounting for power purchase agreements and, confusingly, you could find all of them applied by one company. We explain how each method works, when fair value gains...| The Footnotes Analyst
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 MicroStrate...| The Footnotes Analyst
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 s...| The Footnotes Analyst
A change in accounting, such as the introduction of IFRS 16, does not in itself change underlying economics. It follows that equity values derived from DCF models should also be unchanged. However, the IFRS 16 lease accounting changes seem to be creating some confusion. We explain how to correctly adjust your DCF calculations and provide an interactive pre and post lease capitalisation model to illustrate. IFRS 16 makes DCF analysis easier and less prone to error; leaving your model based on ...| The Footnotes Analyst
Reported operating cash flow, leverage and net working capital measures, may be misleading if a company engages in supply chain financing. The impact can be significant but, at present, calculating the effect and making adjustments is difficult. Additional IFRS disclosures proposed by the IASB will help. We explain the new disclosures and provide an interactive model to illustrate how to use them to calculate more realistic measures of cash flow, leverage and working capital. The adjustments ...| The Footnotes Analyst
Limited disaggregation of income and expense items with different characteristics impair investors’ ability to assess and forecast performance. Recent proposals by the IASB for a new disaggregation principle and related disclosures of ‘unusual’ items will help. However, in our view, they do not go far enough. The IASB also proposes to include management alternative performance measures (non-GAAP or non-IFRS) within audited financial statements. We welcome this. Additional subtotals can ...| The Footnotes Analyst
The problem with cash flow statements is that ... they only include cash flows. This may seem odd, given that the purpose of cash flow statements is simply to report cash movements. However, most cash flow analysis is focused on sub-totals and it is here that offsetting flows arising from non-cash transactions become important. We explain why adjustments are required and for which transactions you should adjust.| The Footnotes Analyst
Losses caused by the rise in interest rates in 2022, coupled with inadequate interest rate risk management, appear to be the trigger for the collapse of Silicon Valley Bank. However, most of the losses on its fixed rate assets were not recognised in either the balance sheet or in profit and loss. We discuss why investors may have thought the bank was better hedged against interest rate risk than turned out to be the case, and show how 2022 profit would have been very different when measured o...| The Footnotes Analyst
If a valuation multiple, such as EV/EBITDA, is used to calculate a DCF terminal value, the multiple should reflect expected business dynamics at the end of the explicit forecast period and not at the valuation date. This is best achieved by basing the exit multiple on forward-priced multiples for the selected group of comparable companies. We explain and illustrate with an interactive model the use of forward-priced multiples in DCF. We also discuss the choice of multiple (including why EV/EB...| The Footnotes Analyst
Taxation is a significant expense for most companies and an important driver of profitability and value. Differences in the effective tax rate matter in equity analysis, but how should you calculate this metric and what rate should you use as a basis for forecasting? We explain the different calculations of effective tax rates, why it is important to examine the tax rate reconciliation footnote, the impact of exceptional gains and losses, and how intangible amortisation complicates the analys...| The Footnotes Analyst
Stock-based compensation can have a significant impact on the effective tax rate. For US companies the effect is driven to a large extent by changes in the stock price. In 2021 this reduced the effective tax rate for many companies; however, in 2022 you could well see the reverse. We use Netflix to explain the effect of stock-based compensation on cash taxes and deferred tax adjustments. The accounting is complex and made even more challenging for investors by differences between IFRS and US ...| The Footnotes Analyst
The profit of insurance companies that report under IFRS is affected by three rates of return – the liability pricing rate, the return from investments, and the IFRS 17 discount rate. The first two largely determine the magnitude of aggregate profit; the last mainly affects the timing of profit recognition and its classification as a service result or net financial result. We use an interactive model to explain how interest rates determine the reported results of insurance companies. The il...| The Footnotes Analyst
Non-GAAP measurers, but they are also controversial. Some argue that certain non-GAAP adjustments are unacceptable and should not be permitted. This recently happened to US company MicroStrategy, where the SEC required it to amend the presentation of cryptocurrency gains and losses. We do not agree with the SEC approach and believe MicroStrategy gives valid reasons for its cryptocurrency non-GAAP adjustment. We have less sympathy with other aspects of the company’s non-GAAP earnings calcula...| The Footnotes Analyst
IFRS 17 will result in significant changes to insurance company financial statements as of next year. Benefits for investors include a more relevant top line, consistent profit recognition, source of earnings analysis, updated assumptions, value of new business disclosures and an end to confusing asset-based discount rates. We think IFRS 17 will make insurance financial statements accessible to the broader investment community rather than just insurance specialists. However, compromises and o...| The Footnotes Analyst
Companies are continuously reshuffling their business portfolio by either spinning off assets (GlaxoSmithKline, Vivendi) or increasing their share in existing businesses (BMW, Siemens Energy). However, the M&A accounting applied to these transactions can produce some unusual and potentially confusing effects. In 2022, German luxury car manufacturer BMW increased its stake in its Chinese joint venture BMW Brilliance from 50% to 75%. Surprisingly, this produced a gain in profit and loss (even t...| The Footnotes Analyst
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 current period changes. Limited disclosure in financial statements makes forecasting this ex...| The Footnotes Analyst
A forecast of profit is used for both valuation multiples and as a starting point in deriving free cash flow for DCF valuations. But should you use a forecast of the reported IFRS or GAAP measure, or a forecast of the adjusted non-IFRS or non-GAAP alternative performance measure (APM) presented by management? We think equity valuations should be based on forecasts of reported IFRS or GAAP earnings (albeit with some adjustment related to intangible assets). Forecasts of management APMs can b...| The Footnotes Analyst
It can be observed that higher financial leverage increases equity beta. However, the relationship between the unleveraged asset or enterprise beta (the beta of the underlying operating business), and leveraged equity beta that is commonly applied in practice, is incomplete. We explain the relevance of asset betas in equity valuation and why it is important to analyse the beta of debt finance and the value, and riskiness, of the debt interest tax shield when delevering and relevering equity b...| The Footnotes Analyst
Equity beta is a valid measure of investment risk and an important metric in equity analysis. However, don’t just plug into your models the equity beta given by a data provider - beta should be analysed and adjusted by investors with the same diligence that is applied to performance metrics. We present an interactive equity beta analysis model to assist investors in better understanding the drivers of equity beta and its application in equity valuation. The model features the calculation of...| The Footnotes Analyst
Investors require financial data that is comparable over time, comparable within a single set of financial statements, and comparable between companies. Unfortunately, this is not always the case. We explain how differences between IFRS and US GAAP, accounting policy options, differing interpretations and accounting estimates, can all reduce comparability. Convergence and comparability should be a priority for the IASB and FASB. Present consultations by the IASB and FASB regarding the account...| The Footnotes Analyst