. 5
( 9)


This simple calculation can be illustrated from Figure 2.10 “ Cash Flow State-
ment for A Food Manufacturing Company:

2006 2005 2004 2003
Operating profit (£™000) 5082 5047 6708 4880
Net cash inflow from op. act (£™000) 22 848 8629 10 671 9311

As can be seen from the debtor days ratio, there was a potential problem with
debtor days in 2005, yet this was insufficient to cause the above test to fail.
Accordingly, where it does fail, every effort must be made to establish the

Of course, there are exceptions to every rule. A house builder™s stock days
might be high because the land bought for future development is included in
stock, for example. Therefore, it is likely that the correct judgement will be
made only if through appropriate research what could be considered the norm
is established for each industry.

Capital structure and basic tools of analysis

Cash Flow Statement for: A Food Manufacturing Company

31 Dec 06 31 Dec 05 31 Dec 04 31 Dec 03
£™000 £™000 £™000 £™000

Reconciliation of operating profit to net
cash inflow from operating activities

Operating profit 5,082 5,047 6,708 4,880
Amortisation of intangible assets 1,750 1,787 1,585 1,148
Depreciation of tangible assets 5,740 6,690 4,164 2,560

(Increase)/decrease in stocks 380 (1,500) (2,000) (2,658)
(Increase)/decrease in debtors 8,697 (10,220) (4,627) (4,726)
Increase/(decrease) in creditors 1,199 6,825 4,841 8,107

Net cash inflow from operating activities 22,848 8,629 10,671 9,311


Net cash inflow from operating activities 22,848 8,629 10,671 9,311

Return on investment 0 0 0 0
Servicing of Finance (2,503) (3,100) (3,077) (1,894)
Taxation (467) (98) (531) (581)
Capital expenditure 0 (7,194) (35,051) (28,482)
Dividends paid (173) (150) (135) (123)

Net cash inflow/(outflow) before financing 19,705 (1,913) (28,123) (21,769)

Financing “ issue of shares 0 426 679
Financing “ issue/(repayment) of loans (15,000) 0 25,000 19,991

Increase/(decrease) in cash 4,705 (1,913) (2,697) (1,099)

Reconciliation of cash flow with
movements in cash

Opening cash (4,449) (2,536) 161 1,260
Closing cash 256 (4,449) (2,536) 161

Movement in cash balances 4,705 (1,913) (2,697) (1,099)

Figure 2.10 A Food Manufacturing Co. “ Cash Flow Statement

Stock days
Stock days in the hotel and catering industry will be relatively low, as compa-
nies operating bars, restaurants and hotels are likely to have only a few days™
stock of food and only a few weeks™ stock of drink. A review of accounts of
five companies in this sector resulted in stock days being in the range 6“16
days, so when SFI plc™s accounts for the year ended 31 May 2001 came out
with 32 days™ stock it could be described as somewhat surprising. However,
these accounts did not really have an adverse impact on the market and the
shares continued to trade at around £2. The following year™s accounts, for the
year ended 31 May 2002, should have raised even more eyebrows, as stock
days went out to 43 days. Months later it was revealed that stock had been
overstated and the company ceased trading.

Accounting and Business Valuation Methods

Debtor days
Debtor days will vary from industry to industry. A retailer selling largely for
cash will have only a few debtor days, an industrial company may have debtors
at around 60 days, while other companies have to offer longer periods of credit.
Companies specialising in computer software often have long debtor days.
A particular contract might include stage payments, but the customer is likely
to hold a fair percentage of the contract price back until there is sufficient
evidence that the software works. Accordingly, debtor days at around 100 days
might not be too alarming for a software company.
Isoft plc is a computer software company and at its year ended 30 April 2003,
their accounts showed debtor days at 106 days, a little high against the norm,
but not alarmingly so. However, the calculation of debtor days from the fol-
lowing year™s accounts showed debtor days up to 223 days. Now, both these
figures (106 days and 223 days) were based on total debtors as shown in the
accounts and would have included debtors other than trade debtors, so we
cannot ascertain what the trade figures actually were. However, it was the
comparison between the two years that would have caused concern.
The market was clearly not concerned as the shares continued to trade in the
range of 350 pence“450 pence. However, the company announced later that it
was changing the way it calculated the sales value of ongoing contracts and
the share price fell back to 50 pence.

Case study “ Amanda™ completion meeting
Finally, after months of hard work, everyone is meeting in a boardroom located
in Amanda™s firm of solicitors. Amanda is with her solicitor and sat opposite
are the proposed non-executive chairman of the new business, a representative
of the business angel and the business angel™s solicitor. In front of them is a
mountain of legal documents that covers:
• The setting up of the new company, including articles and memorandum
of association.
• The sale of Amanda™s old business to the new company.
• The subscription agreement setting out the terms of investment, including
the deal structure.
• Agreement between the new company and the non-executive chairman.
• Amanda™s contract of employment.
Eventually, all the documents are signed and Amanda is back in business.

Capital structure and basic tools of analysis

Discussion Questions
The Profit and Loss Account of ABKZ Retail plc is shown below for the year
ended 31 December 2005 and for the year ended 31 December 2006. Also
shown is the Balance Sheet at these dates. ABKZ Retail Limited is a clothes
retailer servicing the younger end of the market.

You are given the following information:
(1) The line in the Profit and Loss Account headed ˜Goodwill™ is wholly
amortisation of intangible assets.
(2) There were no intangible assets purchased in 2006.
(3) No tangible assets were sold in 2006.
(4) Included in ˜Distribution and Administration™ for 2006 is depreciation
of tangible assets amounting to £20.33 million.
The requirement for this question:

(1) Prepare the Cash Flow Statement for ABKZ Retail plc for the year ended
31 December 2006, using the shell provided.

Accounting and Business Valuation Methods

Profit and Loss Account of ABKZ Retail plc

31 Dec 06 31 Dec 05
Year ended
£™000 £™000

Turnover 675,780 548,640

Cost of sales 604,520 489,720

Gross profit 58,920

Distribution and Administration 38,880

Operating profit/(loss) before amortisation 29,060 20,040

Goodwill/amortisation/impairment/exceptional 6,900 4,920

Operating profit/(loss) 22,160 15,120
Interest payable/(receivable) (3,400) (8,000)
Tax on profits 7,900 5,040

Earnings 17,660 18,080
Dividends 7,920 6,600

Retained profit/(loss) for the year 9,740 11,480

Number of ordinary shares (™000) 91,300 83,000
Balance Sheet
31 Dec 06 31 Dec 05
Year ended
£™000 £™000

Intangible assets 12,660 19,560
Tangible Assets + other long term assets 105,330 101,160
Fixed Assets 120,720

115,240 56,160
37,030 34,560
Trade Debtors
Other debtors/current assets
21,580 44,400
Cash at bank
173,850 135,120
Total Current Assets

90,400 67,080
Trade creditors
5,840 5,160
Corporation tax
6,336 5,280
Dividends due
102,576 77,520
Total Current Liabilities

71,274 57,600
Net Current Assets/(Liabilities)

189,264 178,320
Total Assets less Current Liabilities

34,600 39,840
Other long term liabilities (creditors)

Long term debt

154,664 138,480
Net Assets

47,256 42,960
Share capital
23,628 21,480
Share premium account
0 0
Other capital reserves
83,780 74,040
Profit and Loss Account
Other revenue reserves
154,664 138,480
Equity shareholders™ funds

Capital structure and basic tools of analysis

Profit and Loss Account of ABKZ Retail plc

31 Dec 06
Reconciliation of operating profit to net cash inflow from
operating activities

Operating profit
Amortisation of intangible assets
Depreciation of tangible assets
(Increase)/decrease in stocks
(Increase)/decrease in debtors
Increase/(decrease) in creditors
Net cash inflow from operating activities


Net cash inflow from operating activities
Return on investment
Servicing of Finance
Capital expenditure
Dividends paid

Net cash inflow/(outflow) before financing
Financing “ issue of shares
Financing “ issue/(repayment) of loans

Increase/(decrease) in cash

Reconciliation of cash flow with movements in cash

Opening cash
Closing cash
Movement in cash balances

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Financial reporting and IFRS
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Financial reporting and IFRS

In Chapter 3, we do not meet Amanda, although it can be assumed that her
business is progressing. This chapter looks at published accounts and the
standards that impact such accounts. The message that comes across is that
despite more and more regulation and the desire to ensure all companies
follow the same standards, the production of a set of accounts requires those
responsible to make a series of judgements, where no two people are likely to
come to exactly the same conclusion.

The topics covered are the following:

• Accounting is a series of judgements
• Auditors, their responsibility and the limitations of an audit
• International Financial Reporting Standards
• Revenue recognition
• Research and development
• Share-based payments
• Intangible assets
• Investment property and investment property under development
(case study “ UNITE Group plc)
• Dividends
• Salary-related pension schemes
• Financial derivatives
• Leases
• Minor adjustments (IFRS vs. UK GAAP)
• Corporate governance
• The Report of the Directors
• The Directors™ Remuneration Report
• Optional (non-statutory) reports
• Annual report “ summary
• Enron and the Sarbanes-Oxley Act
• Shareholders™ power

Accounting is a series of judgements
Accounts are never black and white, but many shades of grey as they have to
be based on a series of judgements. The problem investors have is to evaluate
exactly what shade they are looking at when reviewing a particular set of
accounts, because judgement is always clouded by human nature.

Accounting and Business Valuation Methods

The problems often start with unrealistic expectations. The ˜market™ seems to
believe that companies should endlessly grow in terms of sales and profitabil-
ity, although it does not show the same level of concern about cash generation.
Reality, usually, is often different; companies operate in cycles where their for-
tunes tend to go up and down. Directors know that an announcement reporting
a declining growth percentage or a statement suggesting that ˜profits will not
meet market expectations™ could result in their company™s share price being
savaged. So, the pressure to perform starts at the top.

This pressure percolates down the organisation, so that managers can be sub-
jected to the carrot and stick routine. High remuneration is linked with a high
standard of performance where mistakes are not allowed. So if things go wrong,
managers are tempted to bend the rules; the more punitive an organisation
is, greater is the likelihood that some will crack. Sometimes the pressure is
self-induced but the point is that it is usually pressure that causes managers to
stray from the straight and narrow. Sometimes, though, it may be simply the
case that a particular manager wants to impress the senior management and
will go to any lengths to achieve this. It is impossible, in the final analysis, to
know for certain what motivates employees to bend the rules, but when they
do, it can be disastrous for shareholders.

Most organisations produce monthly management accounts, so non-performing
managers can be found out well before financial accounts have to be published;
so an under-pressure manager might be tempted to add in (say) two days™
sales from the following month to the current month. The plea to the branch
accountant might be the promise that things will be put right at the end of the
following month. But two days becomes four days and so on. Of course, the
opposite might happen. If monthly sales are ahead of plan, then the manager
might hold sales back, in case things go wrong sometime in future. Of course,
such indiscretions could be relatively minor and not necessarily significant. In
other cases, they could be more serious.

On 26 February 2007, McAlpine (Alfred) plc announced that they had uncov-
ered a serious accounting problem. The company said that in the previous
week they had discovered a systematic misrepresentation of production vol-
umes and sales over a number of years, by a number of senior managers at
their Slate subsidiary.

The company reported that those involved sought to conceal the financial
implications of their action through the pre-selling of slate at substantially
discounted prices in deliberate and possibly fraudulently behaviour. Their

Financial reporting and IFRS

actions had led to suspensions pending further investigation. The company
added that independent accountants would be brought in to conduct a detailed
forensic analysis that would likely take 4“6 weeks.

The effect of the above announcement was that the company™s share price fell
22% from 613.5 pence to 476.5 pence. The key question is whether or not this
disaster could have been predicted from the accounts. The answer is, of course,
nothing could be predicted with certainty, but when such events happen the
accounts usually throw up the same clue, which is that ˜cash inflow/(outflow)
from operations™ is lower than ˜operating profit™, when it should be the other
way around (see Chapter 2).

The last published accounts of McAlpine (Alfred) plc stated:

6 months to 6 months to 12 months to
30 June 2006 30 June 2005 31 December 2005
£™m £™m £™m
Profit before interest 17.4 17.3 41.9
and tax
Cash inflow/(outflow) (10.9) 7.6 27.9
from operations

However, as stated in Chapter 2, accounting inaccuracies are usually the result
of flawed judgements, rather than fraudulent activity. Either way, it will be
the duty of directors of the company to ensure that their accounting records
meet the required standards, which means that they give a true and fair view
of the start of affairs of their company. Their financial statements must comply
with the appropriate Companies Acts, European legislation of stock exchange

In preparing such financial statements, the directors are required to:

• select suitable accounting policies and apply them consistently;
• make judgements and estimates that are reasonable and prudent;
• state whether applicable accounting standards have been followed, sub-
ject to any material departures disclosed and explained in the financial
• prepare the financial statements on the going concern basis unless it is
inappropriate to presume that the company will continue in business.

Accounting and Business Valuation Methods

The directors also have a general responsibility for taking such steps that are
reasonably open to them to safeguard the assets of the company and to prevent
and detect fraud and other irregularities.

At the end of the financial year, the directors will have gathered in all the
information available to them, including details of minor indiscretions if there
are any and if they have come to light, and will then be faced with a series of
judgements, including:

• the carrying value of intangible assets;
• stock;
• debtors;
• contingent liabilities.

The carrying value of intangible assets. When a company buys another for a
price greater than the tangible assets acquired, this gives rise to ˜goodwill™. This
is shown as an asset in the Balance Sheet, but its inclusion in the Balance
Sheet is dependent upon the goodwill having a genuine value. This means
that the ˜goodwill™ must generate future income streams, otherwise it will have
to be impaired, meaning that it will have to be partially or wholly written
off, as the case may be. As we cannot predict the future accurately, we are
relying on judgements made by the directors. To argue with directors™ judge-
ment, the auditor would have to be able to prove that the directors were being
unreasonable or imprudent.

Stock. At each year end, an ˜age™ analysis of stock will reveal slow moving stock,
or stock that is out of specification, even in a small way. Will this stock be sold
in the following year? Who knows? A cautious director might want to write
off the bulk of this stock, while another, taking a more imprudent approach,
might take the view that somehow the company will find a buyer for it. What
actually happens will likely be different from either view.

Debtors. At the year end, an established customer owes a large amount and is
60 days overdue. The concern is that this customer has a good record of paying
on time. The optimistic view would be that as the customer has always paid in
the past, he will do so in future, while the pessimist will believe that there has
to be something wrong. Who is correct? The directors cannot tell for certain,
either way; it comes down to being a matter of judgement.

Contingent liabilities. A debtor will not pay your invoice for £100 000 and is
suing you for £900 000 on the basis that your product, allegedly being faulty

Financial reporting and IFRS

and out of specification, has damaged many batches of his production. Your
legal team, having seen only your evidence, believes that you have a 60%
chance of winning, but advises you to write off the debt and offer an equal
amount in compensation. They advise you that in their view there is a 90%
probability that the debtor would accept this compromise, but the 10% down-
side risk is that he will use your offer to demonstrate your guilt. Beyond that,
they cannot advise you and have told you that the recommendation they have
made does create a risk profile, for which they cannot be responsible. It is your
decision. So what do you do and how much do you reserve in the accounts?
Again it is a matter of judgement.

The judgements detailed above were simply required to meet the ˜prudence
concept™ that neither profits nor assets should be overstated and liabilities
should be not be understated. However, under IFRS as all costs and assets
must be stated at ˜fair value™, the directors are required to make even more

The Auditors™ Report and their responsibilities
Under company law, independent auditors have to review the annual report
and accounts and give their opinion as to whether the financial statements
give a true and fair view of the state of affairs of the company and have been
properly prepared in accordance with the Companies Act 1985 and Article 4
of the IAS Regulation.

They check whether the company has kept proper accounting records and
report if they have not received all the information and explanations required
for their audit. They ensure that the Directors™ Report is consistent with
the accounts and that the Corporate Governance Statement reflects compliance
with the nine provisions of the 2003 FRC Combined Code specified by the
Listing Rules of the Financial Services Authority (FSA). However, the auditors
cannot be in the position to confirm that corporate governance procedures cover
all risks. They do, however, have the responsibility to give reasonable assur-
ance that the accounts are free from material misstatement, whether caused by
fraud or other irregularity or error.

Auditors conduct their audit in accordance with International Standards of
Auditing issued by the Auditing Practices Board. An audit includes an exami-
nation, on a test basis, of evidence presented to them by the company. It also
includes an assessment of the significant estimates and judgements made by

Accounting and Business Valuation Methods

the Directors in the preparation of the financial statements, and of whether the
accounting policies are appropriate to the company™s circumstances, consis-
tently applied and adequately disclosed.

By law, auditors have a responsibility only to the company and its members,
the shareholders. Their report is made solely to the company™s members, as a
body, in accordance with section 235 of the Companies Act 1985. This means
that if a member of the public, not being a member of a particular company at
the time, bought shares in that company on the strength of a recently published
Annual Report, he or she would not have a claim against the Auditors, even
if the accounts that formed part of the Annual Report turned out to be wholly

The limitations of the Independent Auditors™ Report
Auditors have a duty to review only the mandatory parts of an annual report
and while they will look at optional reports they only have to ensure that these
do not contain apparent misstatements or material inconsistencies. In other
words, they get involved only if they believe a particular report is grossly
misleading. What this means is that it is perfectly acceptable in a Chairman™s
Report to write two pages of glowing prose while limiting the downside to two
lines, provided this downside does not contain anything untruthful.

What the key words in the Independent Auditors™ Report actually mean

So, we know that directors and auditors are primarily responsible for the
accounts and mandatory disclosures, but we need to examine some of the key
words. These are the ones shown above in italics, as discussed below.

Opinion. The auditors are not saying that the audited accounts are accurate. Put
simply, nobody knows what ˜accurate™ is, as the accounts have been compiled
after making a number of judgements. What they are saying is that they are
simply stating an opinion. The value of an opinion must be much less than a
statement of fact.

True and fair view. It is difficult to know what this exactly means. How do you
know what the ˜truth™ is and whether it is ˜fair™, given that the accounts are
based on judgements and estimates.

Reasonable (or ˜reasonably™). The dictionary definition of ˜reasonable™ is ˜having
sound judgement; moderate; ready to listen to reason; not absurd; within the

Financial reporting and IFRS

limits of reason; not greatly less or more than might be expected™. The difficulty
here is that we are going round in circles, as we are back to ˜judgement™.
Material. This is a key word. It means ˜significant™ in accounting terms. The
test is whether the error or omission is material or not. Company A has omitted
a batch of invoices of value £80 000 that has been counted as stock. The error
has come to light only as the year-end accounts are being signed off. The profit
declared in these accounts was £100 000. In such a case, the error is clearly
material and the accounts would have to be corrected. Company B has made
the mistake in the same circumstances, but has declared profits of £8.9 million.
Company B™s accounts have been printed. In this case, the error would not be
deemed to be material, the accounts would be unaltered and the adjustment
made in the following year.
On a test basis. This means that the auditors, by virtue of cost and time limi-
tations, cannot test everything and they have to make a judgement as to what
they are going to test. If they get unlucky and miss something significant, or
relatively significant, then the get-out clause in their report is the statement
that ˜an audit includes an examination, on a test basis, .™ However, over time
the potential for missing something will reduce as eventually all areas will be
tested. The point the auditors are making is that while they will make every
effort to test everything that needs testing, it is impossible to check everything
in a single audit.
Significant. See ˜material™.
Estimates and judgements. The auditors will often make it clear that they are
reliant upon the judgements made by the directors (see above).
Adequately. The dictionary definition of ˜adequate™ is ˜sufficient or barely suffi-
cient; satisfactory (often with the implication of being barely so); proportionate.™
Apparent. This means that any misstatement must be obvious. The auditors
cannot be held responsible for minor errors and for statements that are open
to different interpretations.
It must be appreciated that the auditors are doing a very difficult job, and
while they might be expected to unearth a major fraud, minor mistakes will
sometimes be made and will remain unnoticed. Auditors to some extent have
to rely on the honesty of the directors and will obviously continue to believe
unless one of their tests proves otherwise. The vast majority of companies are
honestly run and where management and auditors differ will usually be over
matters of judgement.

Accounting and Business Valuation Methods

What happens when directors and auditors
cannot agree
If auditors make recommendations to the directors in respect of the annual
report or accounts and the directors choose to ignore them, then the auditors
are faced with a dilemma. The only sanction they have is to ˜qualify™ the
accounts, which means that they state their concerns in their report. Such an
action is the nuclear option; the company™s share price would collapse and the
directors would recommend to the shareholders that the company change their

So, if the directors are determined, for example, to inflate the profit in a small
way, then it comes down to negotiation. How far can the directors go before
the auditors draw the line and qualify the accounts? Who will blink first?

More often than not, in these cases it comes down to compromise. For example,
the directors are adamant that the carrying value of the goodwill is justified,
but the auditors are not convinced. As a compromise, what they might say
is that in return for agreeing this year™s accounts, the directors must agree
to write-off ˜x™ amount next year, if sales in the particular sector do not
reach ˜y™.

In the final analysis, the ˜accuracy™ (if there is such a thing) of all accounts
come down the judgement of directors and auditors and if these two parties
cannot agree to, it will come down to negotiation. Accordingly, published
accounts can vary from being ultra-cautious to excessively optimistic, but, of
course, the vast majority are somewhere in the middle. But at the extreme
end of the middle band, you will find variations between the cautious and the

It has to be said that examples where the accounts of companies in Europe have
been either totally imprudent or fraudulent are extremely rare. Nevertheless,
it was recognised that European counties and the companies within them
have varying interpretations on how accounts should be put together not only
from a judgemental point of view, but also in the way they were presented.
Accordingly, it was felt that it was difficult for investors to compare different
companies, especially if they were based in different countries. To correct
this situation, the International Accounting Standards Board (IASB) developed
international accounting standards (IAS) and IFRS. Such standards impacted
financial reporting in the United Kingdom on 1 January 2005.

Financial reporting and IFRS

International Financial Reporting Standards
Accounts prepared under the historical cost convention had two pillars of
integrity, the matching concept and the prudence concept. The matching con-
cept applied the principle that in a given period, sales and the costs associated
with those sales must match, giving rise to accruals and prepayments. The
prudence concept was unequivocal; profits could not be taken before they were
earned and companies had to create a provision to account for any potential
liability. These two concepts ensured that provided accounts were honestly
prepared, the ˜profit and loss™ account would show a profit or loss that was
prudent. What ˜prudent™ in this context meant was that taking into account
that the profit or loss was struck after making a series of judgements, it was
very unlikely that the profit was overstated or loss understated.

The historical cost convention, therefore, produced a Profit and Loss account
that could usually be relied upon and using this document to calculate earnings
per share allowed investors to assess the trend over time. However, the down-
side of the historical cost convention was that if the accounting standards were
applied literally, key liabilities (usually long-term liabilities), namely pension
liabilities and liabilities relating to financial derivatives, could be missed off
the Balance Sheet.

As discussed in the following chapter, companies can be valued by assessing
future potential income streams and the asset value of the company. Investors
found that they could make valid investment judgements from the Profit and
Loss Account only to be caught out by not knowing the true liabilities of
the company. The Cash Flow Statement helped in that if assets were over-
stated, the company would not be generating the cash their operating profit
suggested should be. But there was no way of assessing what the missing lia-
bilities might be as they would only come to light at the time they had to be

The ASB concluded that the way to resolve this problem of missing liabilities
was to move from historical costing (assets and costs are recorded at their
transactional values) to ˜fair value™ accounting.

All companies who are members of either Le Capital Investissement, the
British Venture Capital Association or the European Private Equity & Venture
Capital Association have agreed to value their investments using fair value
principles. These organisations have produced a booklet ˜International Private

Accounting and Business Valuation Methods

Equity And Venture Capital Valuation Guidelines™, which defines the concept
of ˜fair value™:

Fair Value is the amount for which an asset could be exchanged between knowl-
edgeable, willing parties in an arm™s length transaction.

The estimation of Fair Value does not assume that the Underlying Business is
saleable at the reporting date or that its current shareholders have an intention to
sell their holdings in the near future.

The objective is to estimate the exchange price at which hypothetical Market
Participants would agree to transact.

Fair Value is not the amount that an entity would receive or pay in a forced
transaction, involuntary liquidation or distressed sale.

Although transfers of shares in private businesses are often subject to restrictions,
rights of pre-emption and other barriers, it should still be possible to estimate
what amount a willing buyer would pay to take ownership of the investment.

These organisations own assets in the form of investments that they plan to
dispose of in the medium to longer term. Accordingly, as a matter of course,
they will seek to establish ˜fair value™ on an ongoing basis to enable them to
make the key decision of staying with a particular investment or disposing it
of. Do nothing in the long term is not an option. In other words, if there was
no market for a particular investment, because for example there would never
be a willing buyer, then that investment would have to have a ˜nil™ valuation.
So investment companies should be able to establish ˜fair value™ because they
hold assets that they intend to sell and would not have bought them in the first
place if they knew there was no market for their assets.

However, the concept of ˜fair value™ under IFRS goes further and insists that
a ˜fair value™ calculation be made even where there is no market for the asset.
Some academics argue that this is perfectly valid and that estimating fair values
will become a culture. Dimitris N. Chorafas writes:

Fair value: This will, in all likelihood, be the most significant impact of IFRS.
Fair value of assets and liabilities that have not been traded will become a cul-
ture, uncertainty over its measurement when no market exists for certain issues

(Source: IRFS, Fair Values and Corporate Governance (2006), p. 59, Dimitris
N. Chorafas, Elsevier)

Financial reporting and IFRS

However, the contrary view is that calculating fair values where there is no
discernable market could lead to assets being overstated and that in such cir-
cumstances it would be more prudent to use historical cost values. In addition,
it could be argued that in applying fair value this way the safeguards inher-
ent in historical cost accounting have been abandoned, in that the matching
concept and the prudence concept no longer apply. For example, bookmakers
often take bets ante-post for events that take place after the company™s year end.
Under UK GAAP, these were treated as payments in advance (creditors in the
Balance Sheet) and had no impact on the Profit and Loss Account. Under IFRS,
such payments in advance are treated as financial instruments and accordingly
must be valued a ˜fair value™. But it is absolutely impossible to estimate this, as
the results of the events betted on cannot be reliably predicted. All the book-
makers can do is make an assessment taking into account the ante-post bets
already lost through already declared non-runners and the overall betting mar-
gin usually achieved. This means that the bookmaking company will be forced
to take a profit before it is earned, something that can hardly be described as
being prudent.

A further difficulty is that there is no longer a distinction between a real liability
and the one that could be described as imaginary. A ˜real liability™ is one where
the liability will eventually have to be settled and an ˜imaginary liability™ is
one that is never settled in the books of the company for which accounts are
to be prepared.

At the beginning of 2007 a brief questionnaire was sent to the Finance Director
of 100 FTSE 350 companies. Two of the questions were:

• From an investor point of view, do you believe that IFRS provides better
information than UK GAAP?
• In the last complete financial year, how much extra have you spent
complying with IFRS than you would have spent producing accounts
under UK GAAP (if any)?

There were eighteen respondents (18% of sample) and while such a low res-
ponse rate might not be statistically sufficient to form a judgement, only three
(17%) voted in favour of IFRS. They gave the cost of implementing IFRS in
the range of zero (we have used internal resources and have not quantified the
cost) to £2 million. The average was £384 000.

Accounting and Business Valuation Methods

Some respondents volunteered opinions and the three given below were
representative of the overall view:

In favour: ˜I think it very important that we have International Standards so
that companies in different companies can be compared.™

Against: ˜I do not believe that IFRS provides any better information but at least
there is a greater consistency between all European companies. The Investors
have struggled to understand the impact of IFRS upon companies and spend
even more time reviewing cash flows.™

Against: ˜Not quite the contrary, IFRS has resulted in considerable pollution of
reporting. A point which it seems the IASB is now starting to recognise since
it has observed that the merging of cash and value based items is not helpful.
We have maintained our split of “Trading” and “Other Items” in our Income
Statement “ an approach which is non-compliant with IFRS but which it is
possible the standards will change to!!™

The point made by the respondent about merging of cash and value-based
items is the same as the point about a real liability (cash) and an imaginary
liability (value-based). An example of an ˜imaginary liability™ is ˜share-based
payments™, where the ˜fair value™ of share options must be charged to the
Income Statement, with the credit going to ˜equity™ in the Balance Sheet. But
if no entry was made for share-based payments, then although the ˜retained
earnings™ would be higher, the figure for ˜equity™ would be the same. The effect
of this ˜share-based payments™ entry, therefore, is that it is a one-sided entry
(debit) only. Even worse, as companies continue to show ˜diluted earnings per
share™, it means that this calculation has been subject to a double hit for the
same thing, firstly the cost of the option and secondly the dilution.

Apart from imaginary liabilities, the worst aspect of IFRS is the abandonment
of the prudence concept, as under this current standard, profits are taken into
the Income Statement before they are earned. Such imaginary profits are then
taxed. The accounts for the ˜Big Yellow Group plc™ demonstrate this absurdity;
having to comply with IFRS, their Consolidated Income Statement for 31 March
2006 showed profits of £118.547 million and taxation of £35.112 million, giving
earnings per share of 82.10 pence. However, ˜to give a clearer understanding
of the Group™s underlying trading performance™, a note in the accounts shows
˜an “adjusted” earnings per share of 8.91 pence™ In his ˜Financial Review™, the
Finance Director points out ˜the group™s actual cash tax liability for the year is,
however, nil, as .™

Financial reporting and IFRS

So we are left in the position that IFRS has improved matters by forcing compa-
nies to provide a Balance Sheet that includes all known liabilities, but has made
matters worse by changing a Profit and Loss Account from a document where
earnings per share could be extracted to establish a trend over the years to an
Income Statement that is subject to so much volatility that it becomes potentially
meaningless. However, the good news is that the ˜Cash Flow Statement™ can be
adjusted to assess what the earnings per share should really be and this combined
with a better Balance Sheet means that investors have, overall, improved tools to
work with. How ˜earnings per share™ can be validated is illustrated in Chapter 4.

In Chapter 2, Figures 2.3 and 2.4 showed the Profit and Loss Account, Balance
Sheet and Cash Flow Statement for ˜A Food Manufacturing Company™ using
a UK GAAP format. Figures 3.1“3.3 show the same accounts for 2006 as they
would appear under IFRS. Note that as the format is different, the numbers are
also different. The format differences are explained below:
A Food Manufacturing Company

Income Profit & Loss
Statement Account

31 Dec 06
31 Dec 06 31 Dec 06
£™000 £™000

Revenue 128,500 128,500 Turnover 0

Cost of sales Note 1 96,200 96,700 Cost of sales

Gross profit 32,300 31,800 Gross profit 500

Distribution and Administration Note 2 25,768 24,968 Distribution and Administration

Profit from Operations 6,532 6,832 Operating profit/(loss) before amortisation

0 (1,750)
Other operating costs Note 3 1,750 Amortisation/impairment/exceptional

Operating profit/(loss) 6,532 5,082

Finance costs (net) 2,503 2,503 Interest payable/(receivable) 0

Profit before taxation 4,029 2,579 Profit before taxation

Taxation 875 875 Taxation 0

Profit for period 3,154 1,704 Earnings

Note 4 200 Dividends
1,504 Retained profit for year

Net asset
Statement of
Income &

Profit for period 3,154 Net assets reported under UK GAAP 33,680

Actuarial loss on defined benefit pension scheme Note 5 (1,230) Dividends 173
Deferred tax on actuarial loss Note 5 369 Note 6 Unwinding of deferred tax discounting (255)
Note 7
Note 3 Goodwill amortisation 1,787
Total recognised income for the period 2,293 Note 5 Retirement benefits (5,229)

Add back: share based payments Note 8 800

Profit & loss account at beginning of period 6,470

Profit & loss account at end of period 9,563 Revised net assets as restated under IFRS 30,156

Figure 3.1 A Food Manufacturing Co. “ Pro¬t and Loss Account (IFRS vs. UK GAAP)

Accounting and Business Valuation Methods

A Food Manufacturing Company

Balance Balance
Sheet Sheet

IFRS UK GAAP Difference
(UK GAAP Balance Sheet is in IFRS Format)
31 Dec 06
31 Dec 06 31 Dec 06
£™000 £™000
Non-current assets
Goodwill Note 3 35,743 32,206 Goodwill 3,537
Other intangible assets Note 1/9 1,700 0 Other intangible assets 1,700
Property, plant and equipment Note 9 59,260 60,460 Tangible assets (1,200)
Deferred tax asset Note 3 2,610 0 2,610
Investments Note 10 1,100 1,200 Investments (100)
100,413 93,866 6,547

Current assets
Inventories 9,720 9,720 Stock 0
Trade and other receivables 21,417 21,417 Debtors 0
Cash and cash equivalents 4,456 4,456 Cash 0
35,593 35,593 0

Total assets 136,006 129,459 Total assets 6,547

Current liabilities
Trade and other payables Note 4 28,867 29,240 Trade creditors (373)
Current tax liabilities 3,635 3,635 Other creditors 0
Borrowings 4,200 4,200 Bank overdraft and loans 0
36,702 37,075 (373)

Non-current liabilities
Long term borrowings 50,000 50,000 Long term debt 0
Financial instruments Note 11 103 103
Retirement benefit obligations Note 5 8,700 8,700
Deferred tax liabilities Note 6 255 255
Other provisions for liabilities & charges 7,200 7,200 Other long term liabilities 0
66,258 57,200 9,058

Total liabilities 102,960 Total liabilities 8,685

Net assets (2,138)
Net assets 33,046 35,184

Share capital
Called up share capital 3,632 3,632 0
Share premium account 18,024 18,024 Share premium account 0
Revaluation reserve 0
Other reserves 1,827 2,030 Capital reserves (203)
Retained earnings (as fig. 3.1) 9,563 11,498 Retained earnings (1,935)

Total shareholders™ equity 33,046 35,184 Total shareholders™ equity (2,138)

Figure 3.2 A Food Manufacturing Co. “ Balance Sheet (IFRS vs. UK GAAP)

The Income Statement
The Income Statement replaces the Profit and Loss Account; the only real for-
mat difference between the two being that the former does not show dividends,
so that the bottom line is ˜profit after tax™. In the Profit and Loss Account, ˜profit
after tax™ was the same as ˜earnings™ and represented the profit that belonged
to shareholders, which, in theory at least, could be distributed to sharehold-
ers. This is no longer the case because as non-monetary adjustments are now
appearing in the Income Statement, profit after tax does not necessarily repre-
sent earnings that could be described as distributable. Figure 3.1 illustrates the
differences between the Profit and Loss Account (UK GAAP) and the Income
Statement (IFRS).

Financial reporting and IFRS

IFRS Style

31 Dec 06
Cash Flow Statement for
A Food Manufacturing company

Reconciliation of profit to net
cash inflow from operating activities

Profit after taxation 3,154

Taxation 875
Interest 2,503

Operating profit 6,532

Depreciation of tangible assets 5,740
Share based payments 800

(Increase)/decrease in stocks 380
(Increase)/decrease in debtors 8,697
Increase/(decrease) in creditors 1,199

Cash generated from operations 23,348

Interest paid (2,503)
Tax paid (467)

Net cash inflow from operating activities 20,378

Investment in development costs (500)

Net cash outflow from investing activities (500)

Repayment of bank loans (15,000)
Dividends paid to shareholders (173)

Net cash outflow from financing activities (15,173)

Net increase in cash and cash equivalents 4,705

Reconciliation of cash flow with
movements in cash and cash equivalents

Opening cash and cash equivalents (4,449)
Closing cash and cash equivalents 256

Movement in cash and cash equivalents 4,705

Figure 3.3 A Food Manufacturing Co. “ Cash Flow Statement (IFRS vs. UK GAAP)

Accounting and Business Valuation Methods

The Balance Sheet
The Balance Sheet under UK GAAP style and IFRS style changes both in
format and terminology. In essence, IFRS uses American terminology. The
differences are:


Current assets manufactured for sale or Stock Inventory
bought for resale
People who owe the business money Debtors Receivables
People the business owe money to Creditors Payables

The UK GAAP Balance Sheet was designed to show the ˜total capital employed™,
and after deducting long-term debt this agreed with ˜shareholders™ funds™, so
the format was:
Fixed assets at cost less cumulative depreciation = Net fixed assets
Current assets less current liabilities = Working capital
Net fixed assets plus working capital = Total capital employed.
Total capital employed less long-term debt = Net assets.
Share capital plus share premium plus capital reserves plus cumulative
Profit and Loss Account = Shareholders™ funds.
Net Assets = Shareholders™ funds.

The IFRS Balance Sheet is much more informative, with the following informa-
tion available on the face of the Balance Sheet, rather than in the notes under
• Goodwill is separated from ˜other intangible assets™.
• The deferred tax asset is not netted off with the deferred tax liability.
• Investments are shown separately.
• Current tax liabilities and borrowings are shown separately and not sim-
ply lumped together with ˜trade and other payables™.
• Provisions have to be evaluated so that they are shown correctly as current
or non-current (formerly known as ˜fixed™ under UK GAAP) liabilities.
• Retirement benefit obligations are included in non-current liabilities.

The format under IFRS also changes:

Non-current assets plus current assets = Total assets
Current liabilities plus non-current liabilities = Total liabilities

Financial reporting and IFRS

Total assets less total liabilities = Net assets
Net assets = Total shareholders™ equity.

Figure 3.2 illustrates the differences between the Balance Sheet under UK
GAAP and the Balance Sheet under IFRS.

The Cash Flow Statement
The Cash Flow Statement is much clearer under IFRS than it was under UK
GAAP and is easier to follow. The main difference between the two statements
is that under UK GAAP, ˜operating profit™ (profit before interest and tax) is
reconciled to ˜net cash inflow from operating activities™, whereas under IFRS,
˜profit after tax™ is reconciled with ˜net cash inflow from operating activities.™

Under IFRS, the starting figure is ˜profit after taxation™, to which interest and
tax (as shown in the Income Statement) are added to get to ˜operating profit™.
From this figure, non-cash charges such as depreciation and share-based pay-
ments are added and then movement in working capital is either added or
deducted, as the case may be, to arrive at ˜cash generated from operations™.
This figure represents what ˜cash inflow from operating activities™ was under
UK GAAP. Finally, the actual interest and the tax paid are deduced from ˜cash
generated from operations™ to arrive at ˜cash inflow from operating activities™
under IFRS style.

This is simpler than it was under UK GAAP, because we now have just three

Net cash inflow/(outflow) from operating activities
Net cash inflow/(outflow) from investing activities
Net cash inflow/(outflow) from financing activities

The sum of these three sections is the same as the increase/(decrease) in cash
and cash equivalents.

With regard to the Cash Flow Statement, the only other difference between
UK GAAP and IFRS is that the former reconciles to ˜cash™, whereas the latter
reconciles to ˜cash and cash equivalent™. A ˜cash equivalent™ is a financial
instrument where the value is known and secure and can be converted to cash
within 3 months of the Balance Sheet date.

Figure 3.3 illustrates the differences in Cash Flow Statement under UK GAAP
and IFRS. In our ˜Food Manufacturing Company™ illustration, there are no ˜cash

Accounting and Business Valuation Methods

equivalents™ and accordingly unlike the Income Statement and the Balance
Sheet, the numbers between the two systems match. This is because all the
changes made by IFRS are book entries that have no impact on cash.
These differences in the Income Statement and the Balance Sheet are explained
below and match with the ˜note numbers™ shown in the accounts.

Revenue recognition
There are two aspects of revenue recognition, what it is and when you recognise
it. In normal circumstances, revenue is recognised when the goods or service
has been supplied and the customer, subject to the agreed credit terms, legally
has to pay . But there can be complications. An engineering company might
be working on a large project where the terms are (say) 20% deposit on order,
interim payment of 30% when half complete, 40% on delivery and 10% when
fully commissioned, meaning that the equipment is working satisfactorily on
the customer™s site. Revenue and expenses would be recognised in proportion
to the stage completed on a contract, but in such circumstances, when to
declare the revenue will be a matter of judgement.
Another example could be a manufacturer developing software for a huge
organisation that could take several years to complete. In such cases, stage
payments are usually negotiated, but again when to take the revenue takes a
considerable amount of judgement and over the years some computer compa-
nies have either collapsed or seen their share price fall when it was admitted
that revenue had been taken early.
Of course, in all cases where revenue is taken early, the giveaway is ever
expanding debtor days. To reiterate what has been stated earlier, debtor days
being too high, taking into account the particular industry and competition,
means that either sales have been taken early or credit control is poor. Either
way, investing in companies with such a profile is risky, although some do
For banks, revenue becomes ˜income™ where income is defined as interest
receivable less interest payable, plus other income where applicable such as
income from trading activities, fees, commissions and insurance premiums.
For insurance companies, revenue becomes net premiums earned plus net
investment return and other operating income.
For bookmaking companies, revenue under UK GAAP was the amount wagered
by bettors. Cost of sales was the amount returned to bettors for winning

Financial reporting and IFRS

bets, leaving ˜gross win™ from which the costs associated with these bets were
deducted to arrive at the gross profit. The costs associated with betting include
such things as costs associated with running betting shops, betting taxes, soft-
ware supplier costs and data rights.

Under IRFS, what used to be ˜gross win™ is now defined as revenue and to
assess bookmaking companies for investment purposes we are reliant upon
them giving their gross take figure (what used to be ˜revenue™ under UK GAAP)
as well. The reason for this is that the percentage returned to bettors will vary
from one accounting period to another, depending upon the results. In the long
term, the gross win figure will settle down to that expected based on in-built
margins (in the same way the number of ˜heads™ or ˜tails™ will get closer to 50%
of the total, the more times a coin is spun), but any 6-month period could be
some way off the mean. For this reason, when judging trends in bookmaking
companies, UK GAAP revenue is more important than IFRS revenue.

Research and development (notes 1 and 9)
How to deal with expenditure on research and development is one of those
areas where a considerable amount of judgement is called for. It could be
argued that from a prudent point of view, such expenditure should be written
off to the Income Statement, while others might argue that as the expenditure
will generate future income streams, it should be capitalised. IFRS attempts
to clarify the position by declaring that research costs (cost associated with
developing an unknown product) should be written off while development
costs should be capitalised as an intangible asset. Development costs are those
associated with bringing a new product from the research stage to getting it to
a state where it is ready to be sold. In our example, £500 000 of development
costs that would have been written off, following a judgemental decision, have
been capitalised.

Share-based payments (notes 2 and 8)
If we examine ˜share-based payments™, we find that the concept is flawed from
practically every aspect examined. Under historical cost accounting, what was
charged into the accounts was the exact value of the transaction. If a director
or manager a got an exceptionally good deal on a commodity purchase, then
the accounts reflected the achievement. On the other hand, if a poor manager
paid too much for an item, again the accounts reflected what had actually

Accounting and Business Valuation Methods

happened. Anyone with a knowledge of the type of transactions entered into
could assess whether the management of a particular company was up to the
job or not.
Now, under IFRS, we have moved from recording the actual cost of transaction
to recording transactions at ˜fair value™, the main difficulty being how you
assess the fair value. It is all rather subjective.
Probably, the most subjective of all the IFRS rules is the concept of charging
the Income Statement (and crediting ˜equity™) with the ˜fair value™ of share
options, where directors and other senior employees are granted such options.
Traditionally, directors and in some cases senior employees have been granted
share options giving them the option of purchasing the company™s shares at
price prevailing at the date of the grant some time in future. Often the future is
any time between (say) 5 years hence and 10 years from the date of the grant.
Share options are designed both to provide an incentive for the employee to
perform well and to protect the company from having the employee headhunted
and poached by another. This is achieved by having a clause to the effect that
if the employee leaves the company prior to the first exercise date, then all
share options held would lapse.
The beauty of share options is that it is a classic win“win play. If, in future, the
company™s share price has increased, then the director or the employee holding
the option will exercise it. In response, the company will issue more shares,
and as the entry for this will be debit ˜cash received™, credit ˜share capital™ and
credit ˜share premium™, rather that costing the company, it will strengthen its
Balance Sheet. The only losers will be the other shareholders who will have
their shareholding diluted, but they will not be unhappy as it would have
simply taken the edge off the gains they must have made. In addition to this,
shareholders will have realised that if the directors and other senior employees
had not been given the incentive in the first place, then there might not have
been any gains. Clearly, 95% plus of gain is better than 100% of no gain at all.
This is illustrated below.
A company™s latest accounts for their year ended 31 December 2006 show a
share capital comprising 105 000 000 ordinary shares of 0.1 pence each that
have been issued for 25 pence each. On 31 December 2003, the directors were
granted options to buy 4 250 000 0.1-pence ordinary shares for £1 per share
anytime between 31 December 2009 and 31 December 2012, provided they
remain an employee of the company on 31 December 2007 and provided that
the company™s earnings per share (as a percentage of the issue price to get a

Financial reporting and IFRS

like for like calculation) is more than 10% higher than the sector averages in
each of the five years 2003“2007.

The company declared earnings of £36 million, shareholders™ equity was valued
at £175 million and the company™s ordinary shares were quoted at 540 pence
at their year end. At this stage there is no guarantee that the share options will
have any value because the hurdle set for 2007 cannot have been achieved. So
shareholders can reasonably assume that either the share price will go higher
and the directors will be able to exercise their options or if things do not work
out as per plan, then they will not become diluted.

If shareholders assume the best, then it is a simple matter to calculate the effect
of potential dilution:

Without dilution With dilution
Number of shares 105.000 million 109.250 million
Market price of share 540 pence
Market price of company £567.000 million £567.000 million
Add: issue of shares £4.250 million
Value of company £567.000 million £571.250 million
Market price of share 540 pence 523 pence

Note that the above calculation assumes that the goodwill built into the share
price, being the difference between the market price and the asset value per
share (shareholders™ funds divided by the number of ordinary shares), remains
the same after dilution.

Another way of calculating dilution is to calculate the diluted earnings per

Without dilution With dilution
Number of shares 105.000 million 109.250 million
Earnings £36.000 million £36.000 million
Earnings per share (pence) 34.3 33.0

If the difference between the basic and the diluted earnings per share (1.3 pence)
is multiplied by the basic P/E ratio of 15.74, we get a valuation of 20.5 pence.
This compares with the difference of 17 pence, based on market values. This
difference (3.5 pence) is the effect of the directors subscribing £4.25 million for
shares. So whichever way it is looked at, the effect of dilution on shareholders
is between 17 pence and 20.5 pence. Nothing to get really exited about!

Accounting and Business Valuation Methods

Published accounts show the potential diluted effect of share options and all
seemed well. But along comes the ASB that determines that the hypothetical
cost of share options must be recognised in the accounts, the problem being,
of course, the impossibility of calculating the ˜fair value™ of such transactions.

In most cases, companies use either Monte Carlo option pricing model or the
Black-Scholes option pricing model (sometimes both), with the latter model
being used in the majority of cases. Now while the use of the Black-Scholes
option pricing model might appeal to some academics, from investors™ point of
view the model has significant flaws.

The book by Lowenstein ˜When Genius Failed “ The Rise and Fall of Long Term
Capital Management™ (Harper Collins, 2001) describes how the model is based
on the assumption that a stock price will follow a random walk in continuous
time (p. 66) but as random events such as the flip of a coin are independent of
each other, markets have memories (pp. 72 and 73).

He writes:

Early in 1998, Long Term began to short large amounts of equity volatility (equity
vol) . and it set the fund ineluctably on the road to disaster. Equity vol comes
straight from the Black-Scholes model. It is based on the assumption that the
volatility of stocks is, over time, consistent.

The professors running Long-Term Capital Management calculated that, using
the Black-Scholes model, the options market was pricing in volatility of around
20% when in fact actual volatility was only about 15%. Now, being followers
of the efficient market hypothesis, they believed that markets had got it wrong
and that accordingly option prices would fall. What they had not understood
was that investors can act in a way they believe is perfectly rational, which to
academics trained in mathematics and financial economics appear completely

What had happened was that investors were panicking because they believed
equity prices were about to fall back sharply. The market was capitalising on
such panic by selling products at a price, of course, that protected investors
against the downside risk of share prices falling back. The salesman™s patter
might have read ˜invest in our fund; if the market goes up we will pay you
75% of the increase in the index (the index the fund was being linked to), but
if it goes down you lose nothing. The worst that can happen is you get your
money back.™

Financial reporting and IFRS

If the market went down, then institutions selling these products would not
make any profit, so they bought options to protect themselves. Demand for such
options accordingly increased, pushing up the price. The difference between
the actual option prices and the prices determined by the Black-Scholes model
was simply the cost of panic in the market. Now, the efficient market hypoth-
esis believes that an efficient market will quickly correct irrational factors
such as panic, but it does not. Human beings, once in panic mode, stay pan-
icking long after it is rational to do so and certainly even after the options

The point in the above example is that the vital constituent of the Black-Scholes
model that future volatility can be assumed from historical records is not
necessarily realistic. Mathematical models that assume that future results will
always fit inside a normal bell curve are bound to fail in the long term, because
the future is always about the unexpected. After all, the future is the spice of
life and what makes the requirement of judgement (as against ˜mathematical
certainty™) a consistent feature.

The effect of volatility on the Black-Scholes model can be seen from the table
below. In each case, the share is currently priced at 692 pence and the strike
price (the price at which the option holder can buy the share) is 692 pence.
The option has an expected life of 5 years or 8.5 years, the risk-free rate is
assumed to be 4.3% and the dividend yield is expected to be 2.0%.

Assumed volatility (%) Black-Scholes option price (pence)

5-year term 8.5-year term

0.1 66.1 101.0
10.0 92.3 124.9
20.0 141.3 179.3
22.0 151.3 190.5
27.0 176.2 218.5
30.0 191.1 235.1
35.0 215.5 262.2
40.0 239.5 288.4
45.0 263.0 313.7
50.0 285.8 337.8

Accounting and Business Valuation Methods

In effect, the Black-Scholes model assumes two things, neither of which
holds true:
• Markets are perfect, every investor is equally knowledgeable and will act
• The historical volatility of a share is a good predictor of future volatility
as it is constant.
However, the key point is that you can never mathematically model human
behaviour, because with human beings you are dealing with uncertainty, rather
than risk.
Nevertheless, companies have been forced to charge their Income Statement
with the theoretical cost of share options, based on the rules laid down by
IFRS 2, even though from investors™ point of view the amounts involved are
not material and will lead to an unnecessary volatility in earnings.
For the purpose of share-based payments, there are three key dates: grant date,
vesting date and exercise date. The grant date is the date at which the share
options were granted (31 December 2003 in the above example); the vesting
date is that date at which the employees are unconditionally entitled to the
share options (31 December 2007 in the above example) and the exercise date
is the earliest date at which the options can be exercised (31 December 2009
in the above example).
For IFRS 2, the key date is the vesting date for this is the date at which the
value of the share option becomes fixed and charged to the Income Statement
on a permanent basis. In the meantime, for share options granted on or after
7 November 2002, companies have to accrue for the cost of the share option
from the grant date to the vesting date. In our example, this would mean the
• At 31 December 2004, calculate theoretical option cost for 4.25 million
shares and divide by 4.
• At 31 December 2005, calculate same option (using latest data) and divide
by 2. From this, take away the 2004 accrual to arrive at the 2005 accrual.
• At 31 December 2006, calculate same option (again using latest data) and
divide by three-quarters. From this, take away the 2005 accrual to arrive
at the 2006 accrual.
• At 31 December 2007, calculate same option (using latest information
available). From this take, away the 2006 accrual. This charge in the
Income Statement will now become permanent and will not be changed.

Financial reporting and IFRS

Now if in 2009, disaster struck the company and the share price fell to (say)
90 pence, then the share options could not be exercised. Clearly in such cases,
there is no cost to the company, yet the charge to the Income Statement would
stand. This has to be irrational, but the argument the ASB use is that share
options have been granted for services provided. Again, it could be argued
that such reasoning is illogical. The Directors are paid a salary for services
rendered and receive share options along with other incentives to achieve an
above-average performance. If, for example, a director™s contract stated that he
would receive a bonus of 1% of basic salary for every one percentage point the
company™s share price beat the FTSE 100 index and if the company™s closing
share price fell below that index, then there would be no bonus paid.

There is a basic rule in management accounting that states that the benefit of
a particular report must exceed the cost of producing it; otherwise, there is
no point in preparing it in the first place. Investors might reasonably question
whether the benefit of IFRS 2 to them is greater than the costs involved in
getting together the necessary data, especially because the charge has minimal
impact on earnings per share.

The accounts of 30 companies, with accounting year ends of 31 January 2006
or later, were examined. These companies were selected at random, slightly
adjusted to ensure that a full range based on size was included. The capital
employed by these companies ranged from £34 million to £713 162 million.
The cost of share options charged to their Income Statement was added to their
stated earnings, from which an ˜earnings per share™ excluding share options
was calculated and compared to the actual earnings per share.

The results are as below:

Earnings per share %

Excluding share options (pence) Actual (as accounts) (pence)

1 169.63 168.27 99.2
2 148.59 147.23 99.1
3 113.47 113.26 99.8
4 71.94 70.46 97.9
5 55.53 51.77 93.2
6 46.62 42.72 91.6
7 45.04 44.21 98.2

Accounting and Business Valuation Methods


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