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. 6
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Earnings per share %

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

8 42.74 41.71 97.6
9 42.41 41.64 98.2
10 35.85 35.04 97.7
11 34.17 33.86 99.1
12 28.69 28.13 98.0
13 27.50 27.12 98.6
14 25.21 25.11 99.6
15 24.42 23.70 97.1
16 17.33 17.14 98.9
17 15.34 15.27 99.5
18 13.55 12.71 93.8
19 12.77 12.74 99.8
20 10.77 10.55 98.0
21 10.38 10.38 100.0
22 8.72 8.52 97.7
23 8.03 8.03 100.0
24 6.99 6.44 92.1
25 5.43 5.19 95.6
26 3.86 3.83 99.2
27 3.35 2.96 88.4
28 2.64 2.40 90.9
29 (0.98) (1.02) 96.8
30 (11.51) (11.90) 96.6




A further point to consider is that the option price as calculated by the Black-
Scholes model could not, even by stretching the imagination, be deemed to be
a ˜fair value™ price. Given that ˜fair value™ is deemed to be ˜the amount with
which an asset could be exchanged between knowledgeable, willing parties
in an arm™s length transaction™, the first thing to evaluate is who the willing
parties might be. The most likely parties would be whoever wanted to buy the
option and banks, those operating through traders would be the likely sellers.
Now, let it be assumed that despite its flaws. the Black-Scholes model is the
most accurate model available. What this model would tell us would be, in
betting terms, the break-even price; in other words, the price at which neither
party could expect to make a profit. But we know that the sellers always aim

164
Financial reporting and IFRS

to make a profit, so that the option price they would quote would probably be
around 40% plus above the Black-Scholes computation.

It could not be argued otherwise because banks always build in a profit margin
into the financial derivatives they sell, yet they find willing buyers, in the same
way as bookmakers find willing punters despite their profit margin built into
the odds. All these lead to the inescapable conclusion that IFRS 2 is pretty
pointless. In our example (Figure 3.1), the cost of share options is assumed to
be £800 000. Note 2 shows the charge while note 8 demonstrates that the credit
is found in equity.



Intangible assets (notes 1 and 3)
An intangible asset is defined as the one that cannot be seen or touched, but
according to IAS 38 (see note accompanying IFRS vs. UK GAAP summary) it is
defined as ˜an identifiable non-monetary asset without physical substance™. The
key words must be ˜physical substance™ because although computer software
can usually be seen in the form of a disc, what you see cannot be substantial
enough to demonstrate what you get. Accordingly, under IFRS, computer soft-
ware that can be used independently of a particular hardware configuration is
deemed to be an intangible asset, rather than a tangible asset as it was under
UK GAAP.

It could be argued that this decision is somewhat illogical, given the other
types of intangible asset:

• Goodwill, being the difference between the price paid for a business and
the fair value of the net assets in that business.
• Development costs, including the cost of tooling.
• The costs of setting up and maintaining brands, provided these costs are
external to the company.

These intangible assets can only be deemed to be assets and therefore Balance
Sheet items if the expenditure is expected to generate future income streams. In
all these cases, if the expenditure does generate income streams, then they are
likely to continue to do so as long as the company is in business. Accordingly,
these assets are deemed to have indefinite useful lives.

For most companies, the largest intangible asset is usually ˜goodwill™, a type
of asset with an indefinable lifespan, which was therefore deemed indefinite.

165
Accounting and Business Valuation Methods

Under UK GAAP, it was felt prudent to assume that these assets would have a
lifespan of 20 years and accordingly these would be amortised at the rate of 5%
per annum. However, under IFRS, such intangible assets cannot be amortised.
Instead, a judgement has to be made as to the fair value of the intangible
asset. This may be defined as the higher of market value of the asset less costs
associated with selling the assets and the ˜value in use™ of the asset. The ˜value
in use™ takes into account predicted future income streams and discount rates
that reflect the market conditions and the risks involved. All of which must be
judgemental and to some extent subjective.

If the fair value of the intangible asset is less than the amount shown in the
Balance Sheet, then it is ˜impaired™ to bring it back to the correct value. This
impairment is charged to the Income Statement, with the corresponding credit
reducing the value of the intangible asset.

Intangible assets must be tested annually and their fair value adjusted accord-
ingly. If in the following year, the fair value of the intangible asset is greater
than it was, then the impairment is reversed to bring it back to its correct
valuation. This time, the Income Statement would be credited and the asset
debited. However, the value of the intangible asset cannot be greater than its
original cost, so there cannot be overall negative impairment.

Given valuations can go up and down; it again means that the volatility will
result in it being difficult to interpret the Income Statement. As can be seen,
the vast majority of intangible assets will no longer be amortised, but will
instead be impaired as appropriate, and it is this that makes computer software
stand out. Most companies rightly believe that computer software has a finite
life and where it is developed for a particular company cannot have a market
value in the accepted sense of the word. In addition, computer software is
not installed to generate future business, but rather to enable the company
to organise its administration effectively. Accordingly, most company™s write-
off their software over 3 years and accordingly amortise it. On the basis that
software will not work without the associated hardware, it would seem logical
to treat both as a tangible asset.

In our example (Figure 3.1), it is assumed that the fair value of the intangible
asset is the same value as the carrying value and accordingly no impairment
is required. The amount charged under UK GAAP reflected the annual charge
for amortisation. In Figure 3.2, ˜other intangible assets™ is assumed to include
software and development costs.

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Financial reporting and IFRS


Investment property and investment property under
development (Case Study: UNITE Group plc)
This is an area where there has been a significant change from UK GAAP to
IFRS, and this is explained succinctly in UNITE Group plc™s annual accounts
for 2005.
UNITE Group plc is a company based in Bristol, which has a core strat-
egy of building and maintaining student accommodation at universities. The
company™s primary focus is to build modern and safe student accommodation
in a relaxed atmosphere, thereby creating a community environment. Typical
of this vision is ˜The Heights™ complex in Birmingham, a new concept of stu-
dent village that houses 911 students and incorporates a large common room,
a quiet room and a gym. The company is expanding and has property under
development as well as completed property.
UNITE Group plc™s 2005 accounts explain the following.
Investment property and investment property under development
Under IFRS, completed investment property (accounted for under IAS 40) is
held separately from investment property under development (accounted for
under IAS 16).
Completed investment property is carried at fair value under IAS 40, which
equates to the market value previously applied under UK GAAP. There is
therefore no equity impact arising from the change to IFRS in respect of these
properties.
Investment property under development is carried at fair value under IAS 16,
which differs slightly from the directors™ valuations previously applied under
UK GAAP. This has resulted in additional value being recognised in both
opening and closing balance sheets. IFRS fair values for both the above classes
of property have been calculated by the Group™s external valuers.
Under UK GAAP, all revaluations of property were made directly in equity
(unless values fell below cost). Under IFRS, investment properties under devel-
opment continue to be accounted for this way but completed property valuation
movements are recognised in the Income Statement. In addition, when a prop-
erty under development is completed and transferred to investment property,
the difference between its fair value at that date and its previous carrying value
is recognised in the Income Statement. This has resulted in an increase in the
profit of £20.869 million under IFRS (2004).

167
Accounting and Business Valuation Methods

(Source: Reproduced from UNITE Group plc™s 2005 accounts, with kind
permission from the Board of UNITE Group plc.)

UNITE Group plc™s accounts for 2005 showed a revaluation surplus in the
Income Statement of £23.377 million, so that the overall profit of £32.310 for
the year equated to an earnings per share of 28.7 pence. When this calculation
was adjusted by removing valuation gains, movements in ineffective hedges
and movements in deferred tax, brought about by IFRS (as against UK GAAP)
earnings per share, fell to just 3.0 pence (Figures 3.4 and 3.5).

These accounting standards do raise issues that are worthy of debate. Based
on UNITE Group plc™s accounts, it would seem that UK GAAP is more prudent
than IFRS, but far more importantly, in recording a profit before it is earned,
the concept of prudence is thrown out of the window.


Unite Group plc

Consolidated Income Statement for the year ended Notes 31 Dec 2006 31 Dec 2005 31 Dec 2004

£™000 £™000 £™000
Revenue 1 [U2] 110,636 113,799 74,623
Cost of sales 1 [U2] (49,889) (54,864) (24,678)
Administrative expense “ goodwill impairment (2,515)
Administrative expense “ other (19,751) (15,671) (14,284)

Profit/(loss) on disposal of property (5,397) 2,534 23
Net valuation gains on investment property 1 & 2 [U8] 60,817 23,377 20,869

Net operating profit before net financing costs 96,416 69,175 54,038

Loan interest and similar charges 1 [U6] (53,599) (44,212) (38,098)
Changes in fair value of ineffective hedges 1 [U6] 5,014 (4,317) 0
Finance income 1,551 1,541 1,137
Net financing costs 1 [U6] (47,034) (46,988) (36,961)

Share of joint venture profit 1 [U11] 9,180 5,944 30

Profit before tax 58,562 28,131 17,107

Tax credit 1 [U7] 12,921 4,179 233
Profit for the year 71,483 32,310 17,340

Earnings per share “ Basic 1 [U20] 58.4 28.7 15.8
Earnings per share “ Diluted 1 [U20] 57.8 28.3 15.6

Note 1. In Unite Group plc™s accounts various notes explain the above figures. The number in (square brackets) is the note
number in this company™s accounts for 2005, as follows: Figures in (brackets) below indicate corresponding note numbers in 2006.
Note 2 gives segmental analysis for sales and cost of sales;
Note 6 (7) provides details of interest costs, including amounts capitalised
Note 7 (8) demonstrates how the tax charge and deferred tax is calculated, including showing that tax on unrealised gains is deferred;
Note 8 (5) shows how the valuation of investment property and property under development has moved from the prior year (see script);
Note 11 (6) provides full details of subsidiares and joint ventures; and
Note 20 (10) explains that the basic and diluted earnings per share falls to 3.0p (loss 11.6p in 2006) when IFRS type adjustments are
taken out.
Unite Plc™s Income Statements for 2004 to 2006 are reproduced by kind permission of the Unite Group plc Board


Figure 3.4 UNITE Group plc “ Income Statement for 2004 to 2006

168
Financial reporting and IFRS

Unite Group plc

Consolidated Balance Sheet as at 31 Dec 2006 31 Dec 2005 31 Dec 2004

£™000 £™000 £™000
Assets
Investment property 656,969 1,028,747 991,460
Investment property under construction 124,980 80,004 119,732
Property, plant and equipment 9,533 19,303 15,971
Investments in joint ventures 106,287 18,861 817
Intangible assets 5,216 5,465 4,753
Other receivables 4,973 8,618 6,079
Total non-current assets 907,958 1,160,998 1,138,812

Property under development Note 1 12,093 0 0
Inventories 22,982 13,418 13,401
Trade and other receivables 70,165 66,011 26,246
Cash and cash equivalents 55,143 30,297 37,582
Total current assets 160,383 109,726 77,229

Total assets 1,068,341 1,270,724 1,216,041
Liabilitites
Borrowings and financial derivatives (63,563) (124,541) (106,153)
Trade and other payables (78,594) (73,559) (71,675)
Total current liabilities (142,157) (198,100) (177,828)

Borrowings and financial derivatives (403,181) (644,671) (665,925)
Deferred tax liabilities (41,816) (45,255) (50,479)
Total non-current liabilities (444,997) (689,926) (716,404)

Total liabilities (587,154) (888,026) (894,232)

Net Assets 481,187 382,698 321,809

Equity
Issued share capital 30,763 30,435 27,825
Share premium 173,008 169,957 141,324
Merger reserve 40,177 40,177 40,177
Retained earnings 218,035 129,508 96,113
Revaluation reserve 18,053 17,531 16,370
Hedging reserve 1,151 (4,910) 0

Total equity 382,698 321,809
481,187

Note that In Unite Group plc™s Balance Sheets (as reproduced above) there are acompanying notes providing details of each line.

Note 1. In 2006, UNITE Group plc created the a ˜UK Student Accommodation Fund™ in which the company owns a 39% stake
and acts as a property and fund manager. It is likely that this fund will acquire the Groups future developments and
accordingly property under development that will be sold to this fund are classified as current assets. This revised
business model will allow the group to reduce its borrowings.
Unite Plc™s Balance Sheets for 2004 to 2006 are reproduced by kind permission of the Unite Group plc Board


Figure 3.5 UNITE Group plc “ Balance Sheet for 2004 to 2006


The issues here are that the Income Statement should reflect the profit gener-
ated in the period, while the Balance Sheet should show a true and fair valu-
ation for assets and liabilities. Given that judgements are required to calculate
fair value, it will be relatively certain that the figure calculated will turn out to
be incorrect.

169
Accounting and Business Valuation Methods

Anyone who has ever tried to sell a house will know that no two estate agents
or valuers will come up with the same valuation on the property. Establishing
the true market price is not an exact science and coming up with the answer
relies upon educated guesswork. The problem under IFRS is that if traditional
company valuation methods are used; a small error in property valuation will
lead to completely unrealistic company valuations. This can be illustrated
below with UNITE plc™s 2005 accounts:

Average no. of Earnings Net Assets
shares (˜000) (£™000) (£™000)
Properties 1 108 751
Other (726 053)
112 633 32 310 382 698

Earnings per share 28.7 pence Asset value per share 339.8 pence

Price of share at 31 December 2005 = 400 pence
P/E ratio 13.9 Goodwill in share valuation 60.2 pence

Now if the property valuation had overvalued the properties by a mere 2.5%,
then the picture would change:

Average no. of Earnings Net Assets
shares (˜000) (£™000) (£™000)
Properties 1 081 032
Other (726 053)
112 633 4591 354 979

Earnings per share 4.1 pence Asset value per share 315.2 pence
Price of share at 31 December 2005 = 400 pence
Price of share based on P/E ratio of 13.9 = 57 pence
Price of share based on maintaining goodwill = 375 pence

What this shows is that even very minor errors in valuation can have a dra-
matic effect on the Income Statement, and given the uncertainties in valuation,
earnings per share calculated in this way simply cannot have much validity.

Of course, it is not suggested that there are any inaccuracies in the valuation
of UNITE Group plc™s accounts either for 2005 or 2006; the example above

170
Financial reporting and IFRS

is merely to show the dramatic effect that minor variations in valuations can
have on these types of company™s accounts.

In addition, it should be noted that investors would base their valuation of
companies such as UNITE Group plc on asset values, rather than on income.
Nevertheless, this does demonstrate that including unrealised profits in Income
Statements does not help investors to make rational decisions.


Dividends (note 4)
Most companies pay a dividend to their shareholders, usually twice a year.
The interim dividend paid on the first six months is often between a quarter
and one-third of that expected for the year.

At the end of each financial year, the directors meet to decide what the final
dividend will be. In doing so, they take several factors into account:
• What they can afford to pay, given the results.
• The expectation of shareholders.
• How much of the earnings they want to hold back to pay for future
growth.
• If the dividend is cut, how such action would impact the company™s share
price.

If a company is doing well, then the directors™ decision is an easy one; they
simply increase the dividend and explain that this decision reflects the strength
of the company. However, if the company is doing badly, then the directors
face a dilemma. Do they put a brave face on things and pay an increased
dividend saying that this decision is based on their confidence that things will
get better, or do they come clean? Dishonesty will hold up the share price in
short term and will risk a middle- to long-term crash, while honesty usually
leads to a short-term crash, but a very quick recovery.

The shareholders need to know three things from the accounts:
• Whether or not the company is generating sufficient cash to pay the
dividend;
• What the dividend yield is, based on the current share price;
• What the dividend cover is.

From UK GAAP accounts, such information was easily deduced, but under
IFRS, shareholders will have to scramble around the notes and then do their

171
Accounting and Business Valuation Methods

own calculations to elicit the information they require. It has been argued that
those responsible to IFRS must be academics who practice the art of theoretical
abstract in a scholarly way, but who have not deemed the needs of investors as
paramount in their thinking. The decision to drop dividends from the Income
Statement would seem to support this view.

Under the matching concept, the cost of the dividend was included in the Profit
and Loss Account because the cost related to the period in which the income
was taken. But once the matching concept has been abandoned, we are in the
realms of legalistic phenomena. The argument goes like this. If, say, a company
has a year end of 31 December 2006, the accounts will have been prepared
by 28 February 2007. In early March 2007, the directors will meet to agree a
dividend. Having done so, the accounts will be finalised and will go off to the
printers. They will be despatched early April telling shareholders what the rec-
ommended dividend is and telling them that this will be one of the resolutions
that will be put before the annual general meeting to be held in mid-May.

The argument put forward by those determining accounting standards is that
as the dividend was not in public knowledge before April, it could not be a
˜fair value™ liability before that time and certainly when the company closed
its accounts on 31 December 2006, there was no liability. Strictly, of course,
the dividend does not become a liability until the shareholders have voted to
accept the dividend as recommended by the directors, though it has to be said
that it is extremely rare to find shareholders voting to refuse the dividend.

So, if there is no liability at the date of the accounts, then the dividend will not
go into the accounts. This seems rather strange because of the liabilities that
appear in the Balance Sheet; the liability for the final dividend is just about as
accurate as it gets, even though in legal terms there is no liability. But there will
be ˜legal liabilities™ in the Balance Sheet, which are based on judgements that
turn out to be more inaccurate than the dividend liability. This is clearly an
example where IFRS has been designed to hinder investors, even if unwittingly
so, rather than to help them. With regard to note 4 of Figure 3.1, the dividend
is omitted in the IFRS accounts.



Salary-related pension schemes (note 5)
Having whinged about IFRS, this is one area where the new standards get
full marks, despite protests coming from some companies. The concept behind
a salary-related pension scheme is that employees and their employer will

172
Financial reporting and IFRS

contribute a set percentage of the employee™s salary. The money saved this way
would be invested for the long term by the trustees of the scheme.
Under these schemes, employees could, for example, receive a pension that is
equal to the number of year™s service, divided by (say) 80, multiplied by the
best of the last three years™ salary. Pensions are often subject to inflationary
increases year on year, subject to a set formula.
Whether the sums add up in the end is dependent upon a number of factors,
including the following:
• The success or otherwise of the investments
• The longevity of the members receiving a pension
• The number of people leaving the scheme early

At any one time, it is possible to calculate the surpluses or deficits in the scheme
by calculating the value of the investments on the one hand and actuarial
liabilities on the other.
In the 1970s, salary-related pension schemes built up huge surpluses, because
investment returns were good and people left their pension schemes to seek
other jobs. In those days, if an employee had a relatively short number of
year™s service, then that employee would receive only a return of his or her
contributions on leaving the employment. Often, the amount returned was
relatively small.
The most generous pension schemes (other than those for members of parlia-
ment who encourage restraint upon everybody apart from themselves) were for
those employed in the civil service. These were usually non-contributory (i.e.
the employee made no contribution) and inflation-proof. By the early 1980s,
inflation was running riot and it was apparent to the government of the day
that unless drastic action was taken they might have to default on pensions.
So, getting inflation down became a priority and as the dual objective was to
reduce the power of the unions, the method chosen was to deliberately create a
high level of unemployment. This meant that hundreds of thousands of people
lost their jobs and with inflation coming down, many pension schemes saw
their surpluses increase.
Some ˜entrepreneurs™ took advantage of this phenomenon. What they did was
to look for honestly run companies that had built up surpluses in their pen-
sion scheme. They then made audacious takeover bids for these companies
arguing that the current management team was sleepwalking to nowhere.
Once these entrepreneurs had gained control, they had a wholesale culling of

173
Accounting and Business Valuation Methods

employees aged 50 or more, paying allegedly generous redundancy payments.
This increased the surplus in the company™s pension scheme, which was then
transferred to the company. The company™s pension scheme was therefore nei-
ther in surplus nor deficit and the company had a pot of money that was used
to pay a huge dividend. The company was then sold.

The reason they could do this was that there was no way that pension funds
could be ring fenced. The company had a legal duty to pay pensions as they
fell due in accordance with the terms of the scheme. If therefore they had to
make good pension deficits legally, the other side of the coin was that they
could take out surpluses.

The directors with higher scruples nevertheless could not see the point of
having pension schemes with huge surpluses, so they took ˜holidays™. What this
meant was that although the employees continued to contribute, the company
did not. Of course, although the company again made contributions once the
surplus was gone, what many had not thought of was that there were swings
and roundabouts and that sometimes surpluses were required to cover future
deficits.

It is true to say that governments™ refusal to pass legislation to ring-fence pen-
sion schemes is one of the scandals of our time. A small number of companies
have been forced into liquidation because they could not meet their pension
liabilities, leaving pensioners will little or no pension after years of saving
for one.

By the twenty-first century, many companies realised that the combination of
no surpluses to carry forward in their pension scheme, reduced investment
returns and people living longer meant that it was unlikely such schemes would
ever move into surplus. So what they did was to close salary-related schemes to
new employees and instead offer them a money purchase scheme. Under these
schemes, both the employee and the employer make regular contributions,
where neither party take a holiday. The money saved and then invested builds
up a ˜pot™ that is then used to finance the employee™s pension. This time the
pension fund is ring-fenced because there cannot be any surplus or deficit;
the pension is entirely dependent upon the value of the pot at the date of
retirement.

Many companies are now finding that their salary-related pension schemes
are in deficit, but as the company™s pension scheme did not form part of
its accounts, such deficits did not show up under UK GAAP. Under IFRS,

174
Financial reporting and IFRS

companies at each year end must show details of their pension scheme showing
both assets and liabilities.
On the assets side, companies show the amounts held in their pension scheme,
comprising equities, bonds, gilts and cash, together with the expected return
on these financial instruments. The liabilities are shown as the present value
of the scheme™s liabilities, as computed by the company™s actuaries. Where
liabilities exceed assets it means there is a deficit and companies show their
funding plan to meet such deficit.
Companies sometimes address this deficit by making regular payments into
their pension fund. When this happens, the payment will be shown in the
Cash Flow Statement, but not in the Income Statement. There may be some
charge somewhere in the Income Statement relating to pensions and pension
liabilities, but often the disclosures are difficult to interpret. This is yet another
reason why the Income Statement as presented under IFRS is not investor
friendly as far as shareholders are concerned. Investors are primarily interested
in ˜earnings™ defined as the profit available to them and it must be obvious
that the net profit shown in the Income Statement does not belong to them
if a chunk had to be paid out to reduce the deficit in the company™s pension
scheme. However, at least such deficit is shown in the Balance Sheet, so it is
now known. In Figure 3.1, note 5 demonstrates these fundamental changes.


Financial derivatives (note 11)
The companies dealing in financial derivatives can be classified into two cat-
egories: hedgers and gamblers. Many manufacturing and trading companies,
especially if involved in trading, worldwide are subject to three types of risks:
credit risk, currency risk and interest rate risk. These companies will almost
certainly be involved in hedging activities, where the sole aim is to limit risk.
But limiting risk is not costless, so hedging costs money.
The companies taking on the risk, in turn for reward, are banks and institu-
tions. These are the gamblers, but, like bookmakers, banks like the odds in
their favour. Insurance companies, on the other hand, tend to calculate their
premiums to give lower margins, but make up for this by the returns they
achieve on their investments built up over the years.
However, the activities of banks and insurance companies with regard to finan-
cial derivatives are very complex and not within the scope of this book. We
are concerned solely with hedging activities.

175
Accounting and Business Valuation Methods

Credit risk
Credit risk is to do with a bank holding the company™s liquid assets defaulting
and/or the company™s debtors being unable to pay for a variety of reasons. The
probability of a major bank defaulting is extremely low, but nevertheless this
risk is managed by having accounts with more than one bank. Large companies
with many customers can stand the odd one defaulting, so they will take no
action to limit this risk. Smaller companies who rely on a relatively small
numbers of customers will take out insurance to cover both their UK and
foreign customers.


Currency risk
Imagine a company has contracted to buy a quantity of a particular raw material
costing $1 million in total, for delivery and payment in 6 months time. The
material is to be used to manufacture 1000 tonnes of a chemical with a selling
price of £900 per tonne. Other raw materials used to manufacture the chemical
are paid in sterling and amount to £107 per tonne. At the time the order for
the main material was placed, the exchange rate was $1.95 to £1.00, so that the
total raw material cost is £620 per tonne, giving a margin of £280 per tonne.
The company might take the currency risk and do nothing and there could be
three possible outcomes:
• The pound weakens so there are less dollars to the pound, in which case
the raw material price increases, which could put the company into a
loss-making situation.
• The exchange rate does not change much, so the margin is roughly main-
tained.
• The pound strengthens the dollar again, thereby reducing the material
cost per tonne and increasing the company™s profitability.
However, the company is a chemical manufacturer, not a currency trader, and
therefore will not want to take risks. Accordingly, imagine it has two options:
• To buy $1 000 000 forward at a fixed rate of $1.891 to £1.00 in 6 months
from the date of the contract; or
• Buy an option to buy $1 000 000 at the spot rate of $1.950 anytime
between the date of the contract and 6 months later at a cost of £24 000.
If the company opts for the forward contract, the raw material cost will increase
by £16 per tonne, reducing the overall margin to £264 per tonne, but this would

176
Financial reporting and IFRS

be guaranteed. On the other hand, if the company chose to buy the option,
then the worse case scenario is that the raw material cost would increase by
£24 per tonne. The risk of taking the option, rather than the forward contract,
would be £8000, a gamble that would pay off if the spot rate went to $1.981 to
£1.00, or higher.

Now let us imagine that at the company™s year end, three months from the
date of the contract, the spot rate was $2.00 to £1.00 and the company had
bought the option. The trend is that the dollar is weakening and the Finance
Director believes that it will continue to do so; accordingly, he does not want
to exercise the option at the company™s year end. The question is: what goes
into the accounts?

There can be several views as to how these events might be treated:

• As the spot rate at the date of the contract was $1.95 to £1.00 and margins
were worked out on this basis, then the £24 000 cost of the option should
be written off to administrative expenses. This is the most prudent view.
• As the company does not take risks, the margins to be taken in the
following year should take account of the forward rate (fixed rate) of
$1.891 to £1.00. Therefore, only £8000 should be charged to administra-
tive expenses, this being the difference between the worst possible and
contracting at the forward rate.

The difficulty here is that different companies could not be relied upon to come
up with the same interpretation, so the IASB felt it necessary to be prescriptive
for the sake of consistency. They determined that financial derivatives should
be valued at ˜fair value™. In our example, the ˜fair value™ of our financial deriva-
tive would be £12 821, being the difference of $1 000 000 at the strike price of
$1.95 to £1.00 and the closing price of $2.00 to £1.00.



Interest rate risk
Companies often borrow money at a fixed number of percentage points over
base rate, which means they have a variable rate of interest as the base rate can
change. Guessing what the base rate might be in future is, of course, a gamble.
Companies can hedge this risk by swapping their variable rate borrowings for
a fixed rate loan. Obviously, at the time the deal is struck, there will be a cost
to the company, which will be equal to the bank™s (the one agreeing the swap)
valuation of the risks involved, together with their profit margin. Again under

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Accounting and Business Valuation Methods

IFRS, all these derivatives must be assessed at the year end and valued at their
perceived ˜fair value™.
In Figure 3.2, the figure shown as ˜financial instruments™ represents a liability
in connection with foreign currency hedging, not recognised under UK GAAP.


Leases
Leases are another area that has been open to a high level of judgement in
the past. These financial instruments are particularly interesting because their
popularity really took off because of stealth taxes introduced in the early 1980s.
In the Labour era of the late 1970s, corporation tax was at an extremely high
level, primarily because the then Labour government wanted to encourage
growth by regeneration. They wanted to encourage companies to invest in
new capital equipment and to encourage increased productivity through better
training. As such, companies received 100% capital allowances against capital
expenditure and were paid training grants, all of which went to offset their
corporation tax bill.
Politics never seems to be honest and Margaret Thatcher focussed on the rate
of corporation tax, promising to slash it and free the companies to spend their
money as they saw fit. At the time, companies drooled over the thought of
a vastly reduced rate of corporation tax. What they forgot was that freedom
meant that training allowances were to be abolished and capital allowed were
to be reduced to 25% reducing balance. The companies that were investing
heavily for the future suddenly found that they were paying more corporation
tax than they would have done when a higher rate was applied.
So what was to be done? The answer was to lease capital equipment, rather
than buy it. Obviously, leasing was more expensive as the company leasing
the equipment had to make a profit, but as the cost of lease payments were
deductible for corporation tax purposes, net of tax leasing was cheaper than
buying.
Quite naturally, the government of the day got very cross over this, as they
always do when clever accountants come up with a legal tax avoidance scheme,
as against an illegal tax evasion scheme. So this loophole was closed. Now the
determining factor is whether or not under the terms of the lease the lessee
effectively owns the asset, where owning means taking on all the risks and
rewards associated with it. If the lessee does effectively own the asset, then it
is a finance lease. If it is a finance lease, then under IFRS, it must be capitalised

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Financial reporting and IFRS

at the lower of ˜fair value™ or the present value of the lease payments, having
separated the capital element from the interest to be charged over the term of
the lease. It will then be depreciated in the normal way in accordance with a
particular company™s accounting policy. So the asset leased in this way will
appear as an asset in non-current assets and the corresponding liability will
be included in non-current liabilities. Finance leases are treated as capital
expenditure for tax purposes, meaning that neither the fair value of the asset
nor depreciation is tax deductible. Instead, the normal capital allowances are
applied.

If the lessee does not effectively own the asset, then it is deemed to be an
operating lease. In such cases, the monthly rental is charged to the Income
Statement. Under IFRS, lease incentives such as payment holidays must be
spread over the whole term of the lease.



Minor adjustments
In addition to the above, there are minor changes in the way IFRS accounts are
prepared, compared to UK GAAP. In respect of Figure 3.2, many of the changes
referred above will have an impact on the deferred tax calculation. In addition,
as stated earlier, under IFRS, deferred tax assets and deferred tax liabilities
are not netted off (notes 3 and 6). Another minor change is the valuation of
investments (note 10). As discussed in Chapter 2, two prices are given for
quoted stocks and shares: the bid price at which the broker will buy your share
and the ask price at which he will sell you the share. The difference between
these two prices is known as the spread and the centre point of the spread is
the mid price. Under UK GAAP, investments were valued at the mid price, but
under IFRS, they are valued at the (more prudent) bid price. The reduction in
value of the investments under IFRS, as note 10, reflects this change.



IFRS vs. UK GAAP summary
To date (March 2007), there have been eight IFRS issued:

IFRS 1. This covers the arrangement for migrating from UK GAAP to IFRS. In
effect, companies must show two complete years in which they account
both ways and explain the differences between the two.
IFRS 2. Share based payments. This standard has been discussed in detail
earlier in this chapter.

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Accounting and Business Valuation Methods

IFRS 3. Business combinations. This standard states that when one entity
takes over another, the transaction must be accounted for using the pur-
chase method. All the assets and liabilities of the acquired business must
be valued at fair value at the date of the transaction and goodwill calcu-
lated on this basis.
IFRS 4. Insurance contracts. This standard aims to ensure that the accounts
for insurance companies make it clear that at the date of the company™s
year end, insurance contracts in place could result in significant claims
in future that the insurer is currently unaware of. In other words, the
published accounts must make shareholders aware of the risks involved.
However, insurance companies are specifically prohibited from making
provisions against possible future catastrophes that do not relate to exist-
ing contracts.
IFRS 5. Non-current assets held for sale and discontinued operations. Where
appropriate, profits/losses relating to discontinued operations must be
shown separately on the Income Statement. If an asset is being held for
sale and it is available for sale at the company™s year end, then it must
be valued at the lower of its carrying amount and fair value less costs
to sell. This is exactly the same as the traditional valuation of stock that
is the lower of cost and net realisable value, with net realisable value
being defined as selling price, less the cost of getting the product to the
customer.
IFRS 6. Exploration for and evaluation of mineral resources. This standard
allows companies to capitalise the cost of searching for minerals, oil,
natural gas and other non-regenerative resources as an asset, but insists
that at each accounting period, these assets are tested for fair value and
are impaired as necessary.
IFRS 7. Financial instrument: disclosures. This standard makes companies
to disclose their financial instruments and their associated risks and state
how the management manages such risks.
IFRS 8. Operating segments. Most companies produce internal management
accounts that enable the management to make key decisions. On this
basis, each company must decide what its operating segments are and
must produce separate Income Statements for each operating statement
and a separate Balance Sheet, as appropriate.

(Source: Technical Summaries prepared by IASC Foundation Staff.) Details of
the eight IFRS™s, as above, are summaries of a much larger extracts produced by
IASC Foundation Staff, which have not been approved by the IASB. This also

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Financial reporting and IFRS

applies to the description of IAS 38. It must be noted that this chapter is written
with the objective of providing an overview from an investor™s perspective.
Readers with responsibility for implementing IFRS should refer to the full
International Financial Reporting Standards.
The Income Statement under IFRS is helpful in separating profit/loss between
continuing and discontinued operations, but overall it is a disappointment
as it cluttered up the non-monetary adjustments that make it, in isolation,
difficult to interpret. The decision to omit the proposed dividend also hinders
investors.
Apart from investments, where a more prudent position is taken, an IFRS Bal-
ance Sheet will show assets at a higher asset value than a UK GAAP Balance
Sheet, because assets and liabilities are shown at fair value. However, the dif-
ferences, overall, should not be that great and in any event the IFRS Balance
Sheet should project the more accurate picture, as well as providing more
detailed information.
The IFRS Cash Flow Statement will balance to the same numbers as the UK
GAAP Cash Flow Statement (except the former includes ˜cash equivalents™).
In addition, the IFRS format is easier to understand.


Corporate governance
Within the limitations of human error and human nature, most published
accounts give a reasonable approximation to profitability, assets, liabilities and
cash flow. Assuming accounts have been put together honestly, the Cash Flow
Statement should be the most accurate statement, the reason being that it is
reconciled to something tangible, being cash and cash equivalents held by the
company.
However, corporate governance is not about the accuracy of the accounts, but
rather how the directors conduct themselves. In particular, shareholders need
to be confident that they will get their fair share of the company™s profits and
not see the directors take the lion™s share for themselves.
In the past, there have been a number of concerns, all based on the ˜old pals™
act, where the pals were the executive directors, non-executive directors and
auditors, all of whom might be said to have a conflict of interest.
For example, the directors might suggest to the auditors that they accept the
numbers put before them, reminding them that the company has paid several

181
Accounting and Business Valuation Methods

thousands of pounds in consultancy fees, on top of the audit fee, all of which
might be lost to them in future. So, in this example, we clearly have a conflict
of interest.

Of course, in the majority of cases there was no conflict of interest because the
accountancy firm™s consultancy arm acted independently of its auditing arm.
But the problem was, how could this be proved, even if it is true? Did not both
arms meet up at the local hostelry for lunch?

Then there was the problem of non-executive directors not really doing their
job. The Managing Director of a company might suggest to his non-executive
directors that executive salaries should increase by 25%, adding, ˜of course, we
would not object to your fees going up by the same percentage™.

To alleviate these problems, the regularity authorities introduced the ˜Com-
bined Code™ setting out what is good governance and best practice. The follow-
ing is what one might see in a Corporate Governance Report.



Duties of the Board of Directors
Duties listed might include:

• Approval of Board Appointments
• The roles of Chairman and Chief Executive and how their duties have
been segregated, together with the roles of other executive directors
• Details of non-executive directors, together with a statement showing
how the executive directors can confirm that the non-executive directors
are truly independent
• The induction and training offered to new non-executive directors to
ensure that they know sufficient about the company to make informed
decisions
• Establishment of various committees, such as the Audit Committee and
Remuneration Committee, setting out their constitution
• Strategy and corporate objectives
• Business plans, forecasting procedures and variance analysis
• Performance monitoring of the board and senior management
• Setting approval limits for employees, in terms of what each senior
employee can commit the company to with regard to revenue and capital
expenditure
• Approval of major contracts, outside the approval limits set for employees

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Financial reporting and IFRS

• Approval of internal control and accounting procedures and the publica-
tion of annual accounts
• Risk identification and evaluation
• Health and safety
• Environmental sustainability
• Dialogue with institutional shareholders on a meeting basis and keeping
smaller private investors in touch by updating the company™s website


The Audit Committee
The Audit Committee will usually comprise solely non-executive directors
and if this is not the case the ˜Corporate Governance™ Report will usually
state the reasons. The Audit Committee is responsible for recommending the
appointment of the external auditors and for ensuring that the appointee will
not be granted consultancy work, unless such consultancy can be seen to be
directly linked to the audit. For example, a company might ask their auditors
to advise on tax matters and the implementation of IFRS and such consultancy
could not conflict with the audit or compromise the auditors in any way.


The Remuneration Committee
Like the Audit Committee, the Remuneration Committee should be made up on
non-executive directors. Their role is to determine remuneration policy with
regard to the executive board and will make recommendations with regard
to salary, conditions of employment, the award of share options and other
benefits.


The Nominations Committee
Non-executive directors usually outnumber executive directors in the Nomi-
nations Committee. If a company has such a committee, it will meet up at least
once a year to consider the size, structure and composition of the Board. It
will also oversee retirements from the Board and recommend changes or new
appointments, as necessary.


Board and Committee membership
The Corporate Governance Report will list the members of the full board and
the constitution of each committee. Some reports indicate how often each met
and also details of attendance records.

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Accounting and Business Valuation Methods


The Report of the Directors
The Report of the Directors is a statutory report, in which the following infor-
mation are provided:

• Principal activity
• Results and dividends
• Business Review (brief, often referring to fuller report found elsewhere)
• Share capital “ a list of all shareholders holding 3% or more of the
company™s shares
• Directors™ interest “ a list showing how many shares each director holds
• Suppliers payment policy (usually says that payment is made to agreed
terms, but this does not quite seem believable in every case)
• Amount that has been paid out for charitable and political purposes, if
at all, with full disclosure required for the latter
• Directors™ responsibilities (if not included under ˜corporate governance™)
• The recommendation to reappoint the current auditors or (rarely) to
change auditors
• Notice of the Annual General Meeting, specifying date, place and time
• If there is any doubt whatsoever, confirming that business is assumed to
be a ˜going concern™

If the company in question is an investment trust, then further information are
provided:

• Details of tax and investment company status
• Regulation, indicating, for example, that the company is regulated by the
FSA.
• Management arrangements “ cover such matters as to how management
fees and ˜carried interest™ are charged.

Probably, the most interesting aspect of the legal requirements for disclosures in
the ˜Report of the Directors™ is the requirement to specify the ˜principal activity™.
This requirement goes back to many decades and is rumoured to originate
when limited liability companies were first legalised. In the early days, there
was no requirement to state what the principal activity of the company was,
and it is rumoured that some companies were set up as a front to prostitution.
Apparently, it all came to a head when the Church of England inadvertently
found itself investing in and profiting from prostitution. So something had to
be done .

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Financial reporting and IFRS


The Directors™ Remuneration Report
Some people moan about the remuneration some directors reward themselves,
but it is certainly transparent as the ˜Directors™ Remuneration Report™ is a legal
requirement.

The following information are usually found in this report:

• Details of the ˜Remuneration Committee™ (or reference to its constitution
as shown under ˜corporate governance™)
• The company™s remuneration policy
• Details of annual incentive plans and long-term incentive plans
• Company policy on directors™ contracts of employment
• Company policy with regard to share options
• List of directors, each one showing their salary/fees, benefits (company
car, BUPA, etc.) bonuses and total remuneration
• Disclosure details of directors™ pensions schemes
• List of directors, each one showing details of share options

Share options are shown in detail and the following will be shown for each
director (as applicable):

• Date of grant
• Option price
• Date from which exercisable
• Expiry date
• Number of share options held at beginning of accounting period
• Number of share options exercised during the year
• Number of share options granted during the year
• Number of share options held at the end of the accounting period



Optional (non-statutory) reports
The Chairman, Chief Executive, Finance Director or indeed any other director
may choose to write a report for the benefit of the shareholders. In addi-
tion, most companies include in their Annual Report ˜promotional™ pieces that
are designed to encourage shareholders to appreciate the company they have
invested in.

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Accounting and Business Valuation Methods


Annual Report “ Summary
A few years ago an ˜Annual Report™ would be a relatively thin document com-
prising simply a little promotional material, annual accounts and the ˜Report of
the Directors™, but ever increasing regulation has meant that these documents
have become thicker and thicker. Of course, it is the shareholders who end up
paying for all the regulation and there must come a point where it becomes
self-defeating from a cost benefit point of view.

Of course, it is totally reasonable to expect highly paid directors to act in a
manner consistent with their remuneration, but do we need to cut down so
many forests to provide every shareholder all the details? Surely the following
statement in the Report of the Directors would suffice:

We the directors do hereby declare that we have adhered to all the appropriate
rules and regulations, including all matters relating to corporate governance,
and have made the appropriate decisions with regard to business and risk in a
professional, competent and honest manner. Details of our salaries/fees, benefits,
bonuses and share options are shown below.

But it could have been worse. At one time, the ASB was pursuing the concept
of introducing a report that would enable shareholders to assess the strategies
adopted by the company and the potential of such strategies to succeed. This
report was to be called an ˜Operating and Financial Review™ (OFR) and should
(according to the proposal published by the ASB):
• have a forward-looking orientation;
• complement as well as supplement the financial statements;
• be comprehensive and understandable
• be balanced and neutral; and
• be comparable over time.

The OFR should include key elements of the disclosure framework that should
cover:
• the nature, objectives and strategies of the business;
• the development and performance of the business, both in the period
under review and in future;
• the resources, risks and uncertainties and relationships that may affect
the entity™s long-term value; and
• the position of the business including a description of the capital struc-
ture, treasury policies and objectives and liquidity of the entity, both in
the period under review and in future.

186
Financial reporting and IFRS

The ASB recognised that if the proposal became a standard, then some guidance
would be useful to directors. The ASB also recognised that the preparation of
an OFR would require a fair amount of judgement on the part of the directors.

One had to wonder how many shareholders would have the ability to judge
from an OFR whether a company™s strategy was likely to be successful or not
and to some it appeared that directors would soon be unable to do their jobs
properly as they were slowly becoming submerged in red tape. No doubt, the
latter people were relieved to learn that the concept of an OFR never became a
legally enforceable standard. However, across the pond, they were not so lucky.



The Sarbanes-Oxley Act
There is no doubt that the collapse of Enron in the United States was so
calamitous that we did not witness a financial wave, but a tsunami. Here we had
a company that according to Gary Hamel was revolutionary and extraordinarily
entrepreneurial. He wrote:

Since 1984, when it was formed out of a merger between two sleepy natural gas
pipeline companies, Enron has invented a handful of radical new business con-
cepts. In so doing the company has reinvented itself several times over. By the mid
1990™s, Enron had transformed the wholesale natural gas business from an ineffi-
cient and highly regulated bureaucracy into an extraordinarily efficient market. It
had changed electric power grids from stodgy old-boys™ clubs into flexible energy
markets that meet the ever-changing needs of energy-hungry customers. It had
revolutionised international power plant development, creating entrepreneurial
solutions to some of the most perplexing energy problems in the third world.

(Source: ˜Leading the Revolution™ Gary Hamel, Harvard Business School Press
(first edition, 2000), p. 211.)

Unfortunately, one of the radical new business concepts developed by some
of the senior Enron executives was to hide its liabilities off Balance Sheet.
Whenever phenomenal growth in revenue and profitability is not accompanied
by a mountain of cash, there is the risk that something is wrong somewhere.
In Enron™s case, what was wrong was that the whole thing was a sham.

If one counts the number of limited liability companies in the United States and
United Kingdom, it has to be said that scandals such as Enron are extremely
rare and can happen only where directors are acting dishonestly. In any event,
the legal system in the United States was robust enough to ensure that the
main perpetrators of the Enron scandal received long prison sentences. On this

187
Accounting and Business Valuation Methods

basis, it might have been concluded that the law was strong enough to act as
a deterrent to dissuade directors of other companies to follow suit.

However, it was concluded that the law had to be strengthened; so on 30 July
2002 the Sarbanes-Oxley Act was signed into law. The concept behind this
Act was no doubt admirable as the objective was to ensure that the highest
standards of corporate governance are being maintained. However, the Act
could be described as onerous and like ˜taking a sledgehammer to crack a nut™.

In all, there are 11 ˜titles™ being major sections and each ˜title™ has an average
of seven sections. This gives approximately 80 sections, most of which require
some action by the company.

Anybody wanting to get to grips with the Sarbanes-Oxley Act should read the
book by Michael F. Holt with that title (Elsevier, CIMA Publishing, 2006).
In this book, Mr Holt lists the action needed to be taken by companies.
The examples below give a mere flavour of the tasks involved (all taken from
Mr Holt™s book):

• Section 102: Obtain written confirmation that the company™s auditors are
registered.
• Section 103: Obtain written confirmation that the company™s auditors comply
with the quality control and ethics rules of the Board.
• Section 105: If the company has a non-US accounting firm and is listed in
the US, ensure by written confirmation that the auditing firm does and will
conform to the requirements of the Act.
• Section 203: Retain records on an annual basis of the participants in the audits
for the company and check that this requirement is observed (audit partner
rotation).
• Section 406: Generate a suitable Code of Ethics and insert it in the Policies
and Procedures Manual. Ensure that the CEO and other financial officers are
aware of it, sign it, and agree to abide by it.


On pages 111“113 of his book, Mr Holt provides a checklist for things that
management need to do to comply with the Act. In all he lists 32 sections, some
of which require more than one action and as can be seen from the example
above, some actions require a considerable amount of time and expertise.

The most expensive part of the Act as far as the companies will be concerned
is section 302, which covers corporate responsibility for financial reports, and
section 404, which covers management assessment of internal controls. Com-
panies must therefore set up complicated internal control systems to comply

188
Financial reporting and IFRS

with this legislation. Mr Holt defines ˜internal control™ within the context of
the Act as:

A process, effected by an entity™s board of directors, management and other per-
sonnel, designed to provide reasonable assurance regarding the achievement of
objectives in the following categories.

(a) Effectiveness and efficiency of operations (Operations)
(b) Reliability of financial reporting (Financial Reporting)
(c) Compliance with applicable laws and regulations (Compliance)

The three categories have five components:

(1) Control environment
(2) Risk assessment
(3) Control activities
(4) Information and communication
(5) Monitoring

One of the key problems faced by companies is that some of the components
are contrary to each other. For example, a risk assessment might believe that
there is a risk of fraud and theft if the company™s accountant and his staff are
responsible for both producing the accounts and controlling the company™s
liquid resources. So the decision is made to separate the accounting and trea-
sury functions. This can be further complicated where the treasury function is
centralised to make the most of the cash resources available to the group as a
whole. Now, instead of a cash book, each company accountant will have only
details of intracompany transactions. This means that a key control function
is lost, namely reconciling the accounts with cash movements and explaining
the appropriate difference.

Another problem is that it is extremely difficult to have a control system
that is so brilliant that it prevents serious fraudsters, acting in unison, from
discovery in the short term. This is especially the case where the accounting
function and treasury function are separated. How directors can be held totally
responsible in such circumstances is difficult to envisage. It could be argued
that companies would get better results if they prioritised recruitment and the
motivation of staff.

It costs companies millions of dollars to comply with the Sarbanes-Oxley Act
and some smaller companies simply cannot afford to do it and are delisted
from the US stock markets. It has to be said that the overall cost to corporate
investors (large pension funds and the like) of companies having to comply

189
Accounting and Business Valuation Methods

with this Act will likely be far more than the savings made by avoiding another
˜Enron™, given that something as bad as this calamity is extremely rare.


Shareholders™ power
Although it might appear that directors are all powerful, the real power lies
with shareholders. It is the shareholders who must pass ordinary (50% or more
of the vote required) and special (75% or more of the vote required) resolutions
at the Annual General Meeting. Shareholders must sanction the appointment of
directors and auditors. That said, the real power lies with institutional investors
as they have the voting power; in reality, the private shareholder is impotent.
From information gleaned from an Annual Report, the private investor has just
two choices, hold or sell his or her shares.

Given the power of institutional investors, many directors have developed poli-
cies in the area of what they define as ˜investor relations™. Institutional investors
can find themselves being wined and dined and given the hard sell. Whether
this clouds their judgement or not is open to speculation, but the actions result-
ing from such meetings can be dramatic. If the institutional investor has been
persuaded that a particular company is going forward, then he might buy some
more of that company™s shares pushing up the price. On the other hand, if
he or she is disillusioned and feels the only way forward is regime change,
then selling a wad of shares might be considered. Either way, such events can
provide private investors with a headache, given they are solely reliant upon
the information put out by the company, which, for obvious reasons, must
be factual and cannot prejudge the current mood of institutional investors.
Accordingly, it is even more important for private investors to assess correctly
the information available to them.




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Financial reporting and IFRS


Discussion Questions
1. The Auditor™s Report will give ˜reasonable assurance that accounts are
free from material misstatement.™ In this context define what ˜reason-
able™ and ˜material™ means.

2. Give two examples of where IFRS has abandoned the ˜matching
concept™.

3. Under IFRS, what is the definition of ˜fair value™?

4. What is meant by ˜merging cash and value-based items™?

5. What is ˜stocks™, ˜debtors™ and ˜creditors™ known as under IFRS?

6. What is the difference between a deferred tax asset and a deferred tax
liability under UK GAAP compared with IFRS?

7. Where would you find computer software in UK GAAP accounts and
IFRS accounts?

8. How are ˜research and development™ costs treated under IFRS?

9. What major liability was often hidden in UK GAAP accounts, but must
be shown in IFRS accounts?

10. Explain how investments are treated differently under UK GAAP and
IFRS.

11. In an IFRS Cash Flow Statement, if you wanted to find the equiva-
lent of what would have been shown as ˜net cash inflow from operat-
ing activities™ in a UK GAAP Cash Flow Statement, where would you
find it?

12. An IFRS Cash Flow Statement reconciles to ˜cash and cash equivalents™
whereas a UK GAAP Cash Flow Statement reconciles to ˜cash™ only.
What is the definition of ˜cash equivalent™?

13. In what way is ˜investment property™ and ˜investment property
under construction™ treated (a) the same and (b) differently in IFRS
accounts?

14. Name three types of risks faced by most companies with regard to
˜financial instruments™.

15. Explain the difference between an ˜operating lease™ and a ˜finance lease™.

191
Accounting and Business Valuation Methods

16. To maintain good corporate governance, name three sub-committees
that a board of directors usually set up and explain what is important
about their constitution.

17. In the ˜Report of the Directors™, all shareholders are listed if they hold
a particular percentage (or higher) of the equity of the company. What
is this minimum percentage?

18. In a set of published accounts, apart from the accounts themselves,
name four statutory reports that you would always find and two non-
statutory reports that you might find.
19. What major US legislation came about because of the Enron scandal?

20. At a company™s Annual General Meeting, shareholders vote for both
ordinary and specials resolutions. What is the minimum percentage in
favour of such resolutions to enable them to be carried?




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4
Assessing risk and valuing
companies
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Assessing risk and valuing companies

In Chapter 4, Amanda sells her business and collects £1 million, net of tax,
making 25 times her original investment. This chapter illustrates how Amanda
might invest some of her £1 million, through understanding risk, how to inter-
pret published accounts and how to apply different valuation techniques. The
points made are backed up by four case studies, using real companies as
examples.

The topics covered are the following:


• The acquisition of Amanda™s company
• Risk (in general)
• Portfolio theory
• The experiment
• Risks associated with taking on unique risk
• Assessing company performance
• Basic checks
• Valuation techniques (earnings multiple, net asset valuation, discoun-
ted cash flow (DCF) and industry benchmarks)
• The BVCA Code of Conduct
• Final review
• Investment companies “ case study “ HgCapital Trust plc
• Why the market sometimes get it wrong
• Restructuring “ case study “ Topps Tiles plc
• Profit warnings? “ case study “ Paddy Power plc
• Take-over bids “ case study “ Morrison (William) Supermarkets plc



Amanda “ Case Study “ The acquisition
of her company
With the help of her advisers, both internally and externally, Amanda™s busi-
ness progressed fairly steadily. One day the Chairman advised Amanda that he
had been approached by a competitor who was considering to make an offer
for the entire share capital of her company.

Following consultation with their external advisers, Amanda and her Chairman
agreed that the business would be put up for sale with the objective of attracting
other bidders, thereby creating a bidding war. Eventually a bid was received
that was deemed acceptable and Amanda™s solicitor explained the procedures

195
Accounting and Business Valuation Methods

that had to be followed. She was told that she would be asked questions about
her business and that while she must answer truthfully, she must not disclose
any information without first discussing it with her solicitor. She followed her
instructions to the letter and eventually the deal went through netting Amanda
£1 million. However, a clause in the contract meant that she had to stay in the
business for 12 months from the date of the contract to ensure that the new
owners of the business were fully acquainted with it.



Choice of investments
Imagine that you have been left £16 000 in a will and have this amount of
money to spend. You want to buy a new car costing £16 000, but your existing
car is still serving you well, so why not save the money? Do nothing by hiding
the money in the house and a year later the car you want to buy might cost
£16 400. So you need to do something with the money to stay ahead of inflation.

So where do you invest your money? You could buy a government bond or a
fixed interest bond in a building society and assuming an interest rate of 4%
your £16 000 would be worth £16 640 by the end of the year. But now you
would have to pay tax and assuming the standard rate on savings of 20%, tax
of £128 will put your net interest down to £512. But as due to inflation, the
car you want to buy has increased to £16 400, the true interest gained (interest
less inflation) is a mere £112, or 0.7%.

The investment described above will be relatively risk-free and it is unlikely
that the £16 000 capital will be lost, but the true return is minuscule. So we
must look for a method of investment that will give a higher return.

We could buy 16 000 £1 tickets on the following week™s national lottery, and
if we hit the jackpot, we might win £2 million or more, but as the odds for
achieving this are approximately 14 million to 1, the chances are we will lose
our money. So we need to understand the concept of risk.



Risk
According to Ross Westerfield and Jaffe, ˜Corporate Finance™ (4th edition) Irwin
(1996) there is no universally agreed-upon definition of risk and that being
the case risk means different things to different people. In this book, ˜risk™ is
defined as the probability of losing all or part of an investment.

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Assessing risk and valuing companies

In financial theory, investors are deemed to be risk-averse. In this context, a
risk-averse investor would prefer to avoid fair value gambles, where fair value
gamble is one with a zero expected return. An example of a zero expected return
is betting on the spin of a perfectly balanced coin where the stake and potential
winnings are equal. A positive expected return is one where the gambler would
expect to win in the long term, while a negative expected return is where the
gambler would expect to lose in the long term. Betting on horse racing would
have a small negative expected value, while betting on the National Lottery
would have a large negative expected value. The difference between betting on
horse racing and lotteries is that while it could be argued there is a skill to the
former, there is no skill in the latter as the numbers are drawn at random.

If a gambler betting on horse racing believed that his skill was such that the
number of winners he could select were 10% greater than the number he would
expect to select at random and that by betting on the exchanges there was only
a 2.5% spread, then it could be argued that he would have a positive expected
value, even after paying commission.

In the long term, betting in stocks and shares has, in the past, produced a
positive expected value, but we must consider the skill element in this activity.
If you believe there is no skill in selecting stocks and shares, you must follow
˜portfolio theory™ (detailed below), but if you believe there is a skill to it, then
there is no point in simply buying on an unstructured basis.

The key word, as always, is long term, because in the short term, stock markets
can be very volatile, as the figures below illustrate:


Year (1st January) FTSE 100 index Year (% change) Cumulative
(% change)

1997 4129.0
1998 5202.5 26.0 26.0
1999 5878.9 13.0 42.4
2000 6930.2 17.9 67.8
2001 6222.5 (10.2) 50.7
2002 5217.4 (16.2) 26.4
2003 3940.4 (24.5) (4.6)
2004 4476.9 13.6 8.4
2005 4814.3 7.5 16.6
2006 5618.8 16.7 36.1
2007 6220.8 10.7 50.7


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Accounting and Business Valuation Methods

The above table tells you that anyone having a portfolio of shares matching the
FTSE 100 index would have achieved a compound capital growth of 3.125%
per annum on top of the dividend income they received over the years. This
table also tells you the importance of timing when making investments, for as
can be seen, anyone starting their portfolio in 2000 would still be suffering.

According to financial theory, a risk-averse investor would invest in stocks
and shares because they offer a positive expected value in the long term, but
they would not take unnecessary risks. Ross et al. (1996) state that risk can be
measured by volatility. The spread or dispersion of a distribution is a measure
of how much a particular return can deviate from the mean return. If the
distribution is very spread out, the returns that will occur are very uncertain.
By contrast, a distribution whose returns are all within a few percentage points
of each other is tight and the returns are less uncertain. Volatility is measured
by calculating the variance and its square root, the standard deviation.

As can be deduced from the above table, investing in the FTSE 100 index
would be considered very uncertain, given a mean return of 4.9% with returns
varying from +26.0% to ’24.5%.


Portfolio theory
Such volatility is compounded when we consider that individual stocks within
the portfolio of the FTSE 100 will themselves vary, sometimes quite dramati-
cally. So investors investing in stocks and shares are taking considerable risks
and can be expected to do so only if the overall return they receive is greater
than the risk-free rate. The difference between the expected return and the
risk-free rate is known as the risk premium.

The risk associated with shares is divided into two distinct categories:
• Portfolio risk, market risk or systematic risk
• Diversifiable risk, unique risk or unsystematic risk

Portfolio risk, market risk or systematic risk is the risk associated with the
market as a whole, as demonstrated by the volatility of the FTSE index. Diversi-
fiable, unique or unsystematic risk relates to the potential volatility associated
with an individual share. Now it is accepted following the publication of the
paper ˜How Many Stocks Make A Diversified Portfolio™ (Journal of Financial
and Quantitative Analysis, September) by Meir Statman in 1987 that it is pos-
sible to diversify away diversifiable, unique or unsystematic risk. The concept

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Assessing risk and valuing companies

is that by diversifying into different sectors and different stocks, you will be
able to eliminate such risk, leaving you with only the risk of portfolio, mar-
ket or systematic risk. ˜Drury (Management and Cost Accounting, 6th edition,
Thomson)™ gives an example of how diversification works, by suggesting that
if you wanted to invest in a company manufacturing ice cream, you could
also invest in a raincoat manufacturer. If bad weather impacted upon the ice
cream manufacturer, then the raincoat manufacturer would do well, to com-
pensate. If there were a long hot dry summer, then the ice cream manufacturer
should have a bonanza, while the raincoat manufacturer might suffer. Either
way, it would be unlikely that both stocks would suffer. The number of stocks
required to diversify away unsystematic risk is debatable, as different authors
offer varying opinions, but between 15 and 30 seems to be the range.

However, there are two significant problems with portfolio theory, the first
being like all theories it is often more difficult in practice. It is doubtful whether
it is possible to select 15 or even 30 stocks to exactly match the market as
a whole, but of course, it may be possible to get relatively close to this goal.
But the greater problem with portfolio theory can be disclosed by a question.
Why would any rational investor want to diversify away unique risk? For
example, rather than investing in an ice cream manufacturer and a raincoat
manufacturer, why not instead invest in a water company whose revenue will
stay roughly the same regardless of whether it rains or not.

In terms of risk, which is the greater, market risk or unique risk? The answer is
that market risk will usually be the greater risk. When the market falls, nearly
all of the portfolios go with it; we have to be very unlucky if the majority of our
portfolio is in poor-performing companies. To appreciate this, it is necessary to

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