applying ifrs in equity analysis and valuation

Applying IFRS in Equity Analysis and Valuation

Dennis JullensUBS Valuation & Accounting ResearchTel: +31 20 551 0117

This document has been prepared by UBS Limited

ANALYST CERTIFICATION AND REQUIRED DISCLOSURES BEGIN ON SLIDE 89UBS does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.

Brussels – June 2012

UBS Investment Research

Accounting/Accounting/Presentations /Seminar_ABAF_Brussels_June 2012_Jullens

2


3


Refresher on equity analysis and valuation

Challenges with IFRS

Impact of IFRS changes

Concluding remarks

SECTION 1

Refresher on equity valuation

5

Use of Financial Statement Information

Ex-ante or valuation role of accounting information– Evaluate the return potential of investment opportunities

Ex-post or stewardship role of accounting information– Monitor the use of capital once committed

Our focus is on the valuation role of accounting information

6

Overview: Valuation methodologies

Discounted Cash Flow

Equity value

Enterprise Value

Residual Income Model

Dividend Discount Model

PE, Price to Book Value

Enterprise

Free Cash Flow

EV/EBITDA,

EV/OpFCF

Valuation Multiples

Invested Capital + PV of net income –

cost of equity

Invested Capital + PV of NOPAT - cost of invested

capital

7

Debate on valuation methodologies

DCF is superior when it comes to equity valuation

But multiples are so much easier and used by everyone

8

“It may be objected that no one can possibly look with certainty so far into the future as the new methods require and that the new methods of appraisal must therefore be inferior to the old. But do the new methods really require any more foresight than the old? How could anyone using the old methods explain the market price of a stock except by recourse to some long-range forecast that implied either the continuation of present dividends or earnings, or an increase or decrease therein.

Clearly the old methods required just as much foresight as the new”.

1938, John Burr Williams, The Theory of Investment Value

All techniques are really the same

9

All methodologies are really the same

For a given set of assumptions all valuation techniques should give the same answer

Residual Income Model Valuation Multiples

Discounted Cash Flow

A target equity or enterprise value

10

Value drivers matter for valuation

Analysts and investors need financial statements to gauge value drivers for equity analysis and valuation

EarningsInvested capital

GrowthDiscount

rateTaxation

SECTION 2

Challenges with IFRS in equity valuation

12

Founded in 1973 as International Accounting Standards Committee (IASC)

In 2001, restructured and renamed to IASB

A breakthrough was the adoption of IFRS in 2005 in Europe

A success story with IFRS now used in 100 countries

International Accounting Standards Board and IFRS

Chairman:Hans Hoogervorst

IFRS is the accounting language for equity analysis and valuation

13

IFRS objective of financial reporting

‘Provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity’

Those decisions involve buying, selling or holding equity and debt instruments, and providing or settling loans or other forms of credit

Source: IASB

14

Contribution of IFRS to equity analysis and valuation

Principle based nature makes accounting better reflect underlying economics

Single set of accounting standards enhances comparability in Europe

Material improvements in key areas such as M&A, pensions and stock options

Major steps on the road to convergence with the US

15

Challenges with IFRS in equity analysis and valuation

Key performance metrics such EBITDA are not well defined

Balance sheet does not reflects ‘all’ assets and liabilities

No clear definition of financing and operating items

Inconsistent treatment of similar transactions across companies

16

Key performance metrics are not well defined

IFRS is a principle based accounting system

Limited guidance on the presentation of the income statement

IFRS only requires presentation of six items in the income statement

IFRS does NOT provide definitions of EBIT and EBITDA

17

Which EBITDA to use? Deutsche Telekom (€billion)

Source: Company annual reports

0.0

5.0

10.0

15.0

20.0

25.0

2004 2005 2006 2007 2008 2009 2010 2011

EBITDA EBITDA (Adjusted for special factors)

18

What earnings to use in valuation models?

Permanent versus transitory earnings

Core versus non-core earnings

Operating versus financing income

Adjusted versus reported earnings

What earnings number to use in valuation models?

19

Earnings at Anheuser Busch Inbev (€m)

2008 2009 2010 2011

Revenues 23,507 36,758 36,297 39,046

Cost of sales -10,336 -17,198 -16,151 -16,634

Gross profit 13,171 19,560 20,146 22,412

Distribution expenses -2,725 -2,671 -2,913 -3,313

Sales and marketing expenses -3,510 -4,992 -4,712 -5,143

Administrative expenses -1,478 -2,310 -1,960 -2,043

Other operating income/expenses 440 661 604 694Profit from operations before non recurring items 5,898 10,248 11,165 12,607

Non-recurring items -558 1,321 -268 -278

Profit from operations 5,340 11,569 10,897 12,329


20

Earnings at Anheuser Busch Inbev (€m)


2008 2009 2010 2011

Profit from operations before non recurring items 5,898 10,248 11,165 12,607

Restructuring (including impairment losses) -457 -153 -252 -351

Fair value adjustments -43 -67 0 0

Business disposal -38 1,541 -16 78

Disputes -20 0 0 0

Acquisition costs 0 0 0 -5

Non-recurring items -558 1,321 -268 -278

Profit from operations 5,340 11,569 10,897 12,329

21

Other Operating Income/Expense at Anheuser Busch Inbev (€m)

Source: Anheuser Busch Inbev (€m)

Other operating income/expenses 2008 2009 2010 2011

Government grants 142 155 243 418

Licence income 40 84 96 98

(Additions to)/reversals of provisions 159 -4 23

Net gain on disposal of PPE and intangibles 87 123 119 45

Net rental and other income 171 140 150 110

Total 440 661 604 694Total as a % of EBIT before non recurring items 7.5% 6.5% 5.4% 5.5%

22

Identifying key performance metrics under IFRS

IFRS does not provide definitions of key analytical metrics

Companies increasingly present alternative performance metrics

Analysts and investors’ judgment is needed to determine key earnings metrics

Earnings are a crucial input into returns; the key value driver

23

The key value driver is return on capital

Existing profitability can be expressed as return on invested capital

The profit a company earns from existing operations

Most straight-forward formula: ROIC =Invested Capital

NOPAT

Challenge with IFRS is determining the appropriate results (numerator) and invested capital (denominator)

24

Identifying drivers of Return on Invested Capital

Profit margin: the extent to which sales are profitable– Depends on price and competition

– Cost base

Capital turnover: the amount of sales that can be generated– Utilization of assets

– Sector-specific (e.g. high versus low investment industries)

Sales

NOPAT

Invested Capital

SalesROIC = *

25

Drivers of returns – European brewers (2012e, m)

Source: UBS

Anheuser-Busch InBev

Carlsberg A/S Heineken SABMiller

Reporting currency (m) USD DKK EUR USD

Revenues 40,956 65,462 18,060 17,001

EBIT 13,595 10,226 2,271 4,076

EBIT margin 33.2% 15.6% 12.6% 24.0%

Asset turnover 0.6 0.7 1.1 0.7

ROIC (pre-tax) 18.6% 10.6% 14.3% 15.8%

Tax rate 21.7% 25.0% 19.6% 35.5%

ROIC (post-tax) 14.6% 8.0% 11.5% 10.2%

Gearing factor 1.7 1.4 1.6 1.1

Interest burden 0.7 0.7 0.8 1.0

ROE 16.8% 8.3% 14.3% 12.1%

26

Drivers of returns at European brewers (2012e)

Anheuser-Busch InBev

Carlsberg A/S

Heineken

SABMiller

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

0.0 0.2 0.4 0.6 0.8 1.0 1.2

Capital Turnover

NO

PAT

mar

gin

Source: UBS

27

Balance sheet does not reflect ‘all’ assets and liabilities

Most expenditure that creates intangible assets is charged against profits:– Advertising and Marketing

IFRS only allows recognition of intangibles when they are certain to generate future income– Part of corporate development expenditure

IFRS, however, does require these intangibles to be recognized on the balance sheet as part of acquisitions– These will be captured as intangibles with finite or indefinite live

Different accounting treatment of expenditure on intangibles impairs calculation and comparability of returns

28

Interpreting returns at European pharmaceuticals (%, 2002-2012)

0%

10%

20%

30%

40%

50%

60%

70%

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011E 2012E

Astra Zeneca Glax o Smithkline Nov artis

Nov o Nordisk Roche Sanofi-Av entis

Source: UBS, Company Statements

29

Analyzing NOPAT Margin at European pharmaceuticals (%, 2002-2012)

0%

5%

10%

15%

20%

25%

30%

35%

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011E 2012E

Astra Zeneca Glax o Smithkline Nov artis Nov o Nordisk Roche Sanofi-Av entis


30

Analyzing capital turnover at European pharmaceuticals (2002-2012)

0.0

0.5

1.0

1.5

2.0

2.5

3.0

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011E 2012E

Astra Zeneca Glax o Smithkline Nov artis Nov o Nordisk Roche Sanofi-Av entis


31

Intangibles as a part of invested capital (%)

0%

20%

40%

60%

80%

100%

120%

140%

Astra Zeneca Glax o

Smithkline

Nov artis Nov o Nordisk Roche Sanofi-Av entis

2004 2012E


32

Intangibles impact return differentials in Euro Pharma (2012e)


Astra Zeneca

Glax o Smithkline

Nov artis

Nov o Nordisk

Roche

Sanofi-Av entis

0%

10%

20%

30%

40%

50%

60%

70%

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

Intangible assets as % of total assets

RO

IC

33

Dealing with (absent) intangibles

Gauge incremental returns rather than aggregate returns

Adjust and attempt to include all intangibles in – Identify expenditure charge against profit that is creating intangibles

(future value)

– Research and development costs

– Advertising

– Capitalise and amortise over an estimated useful life

Focus on tangible assets– Exclude all capitalised intangibles from all return on capital measures

Judgment on the appropriate return metric in valuation models

34

Using enterprise value versus equity value metrics

Equity value

Value of the equity shareholders’ stake in the business

Represented by market capitalisation or share price

Enterprise value

Value of the whole business

Price which would have to be paid to acquire all enterprise profit or cash flow

Sum of the market values of the various claims on the business

35

Enterprise value multiples for European brewers

EV/EBITDA EV/EBIT EV/NOPAT

2011 2012E 2011 2012E 2011 2012E

Anheuser-Busch InBev 8.1 8.6 9.8 10.5 11.7 13.1

Carlsberg A/S 7.6 7.4 10.5 10.5 14.0 13.9

Heineken 8.8 8.4 13.2 12.0 16.0 17.0

SABMiller 6.6 7.2 8.8 9.6 14.1 14.8


36

Limited guidance on split between financing and operating

The majority of the valuation work is done on an enterprise value basis

Analysts derive enterprise value and then deduct non-equity financing claims

There is no guidance in IFRS on distinction between financing and operating

Limited guidance impairs comparability of enterprise value metrics

37

Common claims in enterprise value

Sum of the values of claims on enterprise profit or cash flow equals ...

Market capitalisatio

nNet debt

Minority interests

Debt deemed

provisions

Other claims

Total enterprise

value

Core enterprise value

Non-core assets

38

Enterprise value at European brewers (2012e, %)

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Anheuser-Busch InBev Carlsberg A/S Heineken SABMiller

Market cap Net debt (cash) Minority interest Other debt deemed liabilities

Source: UBS

39

Distinguishing between operating and financing items

Operating assets and liabilities arise in the ordinary course of business

These operating assets and liabilities combined generate operating earnings

Financing assets and liabilities generate financing income / (expenses)

We label liabilities as financing when they meet the following criteria– Long term in nature

– Measured on a present value basis

– Accrue interest

Distinction between operating and financing impacts all aspects of valuation

40

Consistency in enterprise value

Weighting factor * Cost WACC

Market value of debt * Post tax cost of debt Wd*COD

Market value of pension deficit * Post tax cost of debt Wp*COD

Market value of equity * Cost of equity We*COE

Market value of minority interest * Cost of equity Wm*COE

WACC

Enterprise Free Cash Flow at WACC = Target Enterprise Value

(Market value of debt)

(Market value of pension deficit)(Market value of minority

interest)

Target Equity Value

41

The cost of equity based on CAPM

))(()( FmiFi RREβRRE

Risk Free Rate– The rate at which government can lend or borrow

Equity Risk Premium– Expected excess return of equities over the risk free rate

Equity Beta – The systematic risk of the specific equity investment

Deriving values for CAPM metrics is more art than science

Deriving values for CAPM metrics is more art than science

42

Equity beta: the practitioner’s view

Equity betas combine financial and operating risk

Operational risk is reflected in the asset beta

Financial gearing increases equity risk

E

DTcAE )1(1*

Understanding constituents of beta is keyUnderstanding constituents of beta is key

43

Enterprise value and cost of capital: European Brewers

Anheuser-Busch InBev Carlsberg A/S Heineken SABMiller

Asset beta 0.8 0.8 0.8 0.8

Corporate Tax Rate 16% 25% 20% 36%

Equity weighting 83% 95% 74% 86%

Debt weighting 17% 5% 26% 14%

Debt/Equity factor 0.21 0.06 0.35 0.17

Equity beta 0.9 0.8 1.0 0.9

Risk free rate 4.0% 4.0% 4.0% 4.0%

Equity risk premium 4.5% 4.5% 4.5% 4.5%

Cost of equity 8.2% 7.8% 8.6% 8.0%

Risk Free Rate 4.0% 4.0% 4.0% 4.0%

Credit spread 0.2% 0.3% 0.3% 0.2%

Cost of debt (pre-tax) 4.2% 4.3% 4.3% 4.2%

Cost of debt (post tax) 3.5% 3.2% 3.5% 2.7%

WACC 7.4% 7.5% 7.3% 7.2%

Source: UBS

44

Challenges with IFRS in equity analysis and valuation

As a principle based system, IFRS is more subjective

This leaves more financial reporting discretion for management

IFRS is also less prescriptive increasing the need for judgment by users

SECTION 3

Impact of IFRS changes

46

Impact of IFRS changes on equity analysis and valuation

New standards – 1 January 2013– Pensions

– Joint arrangements

Short term projects – 1 January 2015– Financial instruments

– Leasing

– Revenue recognition

47

Refresher on funded defined benefit plans

Pension liability is the present value of future pension payments– Discount rate, inflation and longevity drive pension liability

Pension assets are at market value in the balance sheet– Conditions on financial markets determine pension asset values

Defined benefit pensions in equity valuation are poorly understood– Both the relevance of pension for earnings and valuation

Conditions on financial markets have triggered more queries on pension funding

48

Pensions at Philips (€m, %)

2008 2009 2010 2011

Projected benefit obligations 16,846 17,720 20,166 22,413

Fair value of plan assets 17,899 18,470 20,080 21,249

(Deficit)/surplus 1,053 750 -86 -1,164

Funded status 106% 104% 100% 95%

Current market cap 16,911 19,088 21,264 15,591

Pension liability as a percentage of market cap 100% 93% 95% 144%

Pension (deficit)/surplus as a percentage of market cap 6% 4% 0% -7%

Source: UBS, Philips

49

Proposed changes to pensions in income statement

Companies currently present key items in the income statement– Service costs

– Interest cost on the pension liability

– Expected return on plan assets

Net pension financing income is the difference between the expected return on plan assets and the interest cost on the pension liability

The IASB proposes to replace the expected return on plan assets with pension income based on the discount rate for the pension liability

Replacing the expected return on plan assets should reduce earnings for companies with significant pension schemes

50

Impact of net pension financing on profit: Philips (€m, %)


2008 2009 2010 2011

Expected return on pension assets 1,161 1,101 1,087 1,102

Interest cost on pension liabilities -922 -927 -939 -961

Net pension financing income 239 174 148 141

Pre-tax profit 108 448 1,943 1,374

Net pension finance income as a % of pre-tax profits 220.7% 38.8% 7.6% 10.3%

51

Impact of pension change on profit: Philips (€m, %)


2008 2009 2010 2011

Pension Assets (beginning of year) 20,200 17,899 18,470 20,080

Discount rate 4.9% 5.5% 5.3% 4.8%

Interest income on Pension Assets 997 985 979 957

Interest Cost on Pension Liability -922 -927 -939 -961

Net Pension Financing Income/(Expense) 75 58 40 -4

52

Impact on earnings at Philips (€m,%)


2008 2009 2010 2011

Reported Pre Tax Profit 108 448 1,943 1,374

Impact of accounting change -164 -116 -108 -145

Adjusted Pre Tax Profit -56 332 1,835 1,229

Impact of accounting change on pre tax profit (%) -151% -26% -6% -11%

53

Employee benefits: Actuarial gains and losses

IFRS currently permits three options for so-called actuarial gains and losses– Directly charged to income

– Directly charged to Other Comprehensive Income

– Deferred recognition in income statement (‘corridor approach’)

‘Corridor approach’ means economic position differs from accounting number

IASB proposes amendment that will require all actuarial items to be in OCI

About 60% of European companies currently apply the corridor method for actuarial gains and losses

54

Pension schemes at RD Shell (US$ m)

Source: RD Shell

Pension Benefits Other benefits Total Benefits

Projected benefit obligations -69,962 -4,386 -74,348

Fair value of plan assets 63,637 0 63,637

(Deficit)/surplus -6,325 -4,386 -10,711

Funded status 91% 0% 86%

Market capitalization 235,557

Pension obligation as a % of market cap 32%

Pension (deficit)/surplus as a % of market cap 5%

55

Impact on shareholders equity at RD Shell (€m,%)

Source: UBS, PostNL

2011Deficit - pension benefits -6,325Deficit - other benefits -4,386Deficit - total -10,711

Unrecognised actuarial (gains) / losses 15,757Unrecognised past service cost / (credit) 44Total unrecognized amounts 15,801Net amount recognised in the balance sheet 5,090

Total equity 171,003Unrecognized amounts as a % of equity 9%

56

Corridor method: Pensions at RD Shell (2011, US$m)

Source: RD Shell

-12,000

-10,000

-8,000

-6,000

-4,000

-2,000

0

2,000

4,000

6,000

Economic position Accounting recognition

57

Changes to pension accounting

Bottom line earnings can benefit from pension income

Presentation of pension items impacts key performance metrics

IASB proposal improves reflection of pensions in financial statements:– Actuarial gains and losses through OCI bring economic position on balance

sheet

– Replacing return on assets gives sensible net pension financing charge/income

Change will be implemented as of 1 January 2013

58

Changes to joint venture accounting

The IASB has published a new standard IFRS 11 Joint Arrangements

In joint arrangements, two or more parties have joint control– The contractual agreed sharing of control where the unanimous consent of all

relevant parties sharing control is required to make decisions

The standard distinguishes between two types of joint arrangement

In a joint operation, the parties having joint control have rights to the assets, and obligations for the liabilities of the arrangement– A party to the joint operation having joint control recognizes its share of the assets

and liabilities held jointly and share of output from sale by the joint operation

In a joint venture, the parties having joint control have rights to the net assets of the arrangement– A party to a joint venture having joint control recognizes its interest in the joint

venture as an investment using the equity method, as per IAS 28 Investments in Associates

59

Changes to joint venture accounting

Jointly controlled operations

(gross accounting)

Jointly controlled assets

(gross accounting)

Jointly controlled entities

(prop cons or equity method)

Joint operations

(gross accounting)

Joint ventures

(equity method)

Joint ventures: joint control

Joint arrangements: joint control

Source: IASB

60

Impact of accounting change for joint ventures: BASF

Proportionate cons Adjustment

Equity method Change

Net Sales 63,873 -4,602 59,271 -7%Operating result 7,761 -383 7,378 -5%

Income from joint ventures 0 363 363Income before taxes and minorities 7,373 -408 6,965 -6%Impact on taxes and minorities 0 -45 -45Net Income 4,557 0 4,557 0%

Balance sheet itemsProportionate

cons AdjustmentEquity

method ChangeNon current assets 34,532 -1,533 32,999 -4%Current assets 24,861 -1,262 23,599 -5%

Investment in Associates 0 1,385 1,385Total assets 59,393 -1,410 57,983 -2%Equity 22,657 0 22,657 0%Non current liabilities 21,168 -426 20,742 -2%Current liabilities 15,568 -984 14,584 -6%Total equity and liabilities 59,393 -1,410 57,983 -2%

Source: UBS, BASF

61

Impact of accounting change on key ratios at BASF

Ratios Proportionate cons Equity method

Debt to Equity 1.62 1.56

EBIT margin 12.2% 12.4%

Net profit margin 7.1% 7.7%

Return on Equity 20.1% 20.1%

Return on Assets 7.7% 7.9%

Abandoning proportionate consolidation has been very controversial among companies and investors

62

Financial Instruments

Classification and measurement

Impairments

Offsetting

Hedge accounting

Crucial projects together with the US standard setter

63

Introducing hedge accounting

Companies use financial instruments to hedge risks such as foreign exchange risk, interest rate risk and commodity price risk

Changes in the value of hedged items (sales or purchase) are not always recognized in the same accounting period as gains/losses on hedge instrument (derivatives)

Hedge accounting is an accounting choice that causes the gains and losses to be recognized in the same accounting period

The entity may choose to apply hedge accounting to show the effect of managing those risks in the financial statements

Ideally, financial statements should reflect risk management

64

IAS 39 allows for hedge accounting

Companies can qualify for hedge accounting under IAS 39

Changes in underlying item are offset by changes in hedge instrument

IAS 39 allows for three forms of hedge accounting.

Fair value hedge– Examples are foreign currency payable, foreign currency receivable or

inventory

Cash flow hedge– Examples are forecast sales or purchases in foreign currency

Hedge of net investment– Example is foreign currency exposure of net investment abroad

65

Qualify for hedge accounting is not easy

IAS 39 requires hedge effectiveness to be assessed both prospectively and retrospectively

One on one relationship between derivative and hedged item

The hedge must be effective to qualify for hedge accounting– Prospective test: 95–105%

– Retrospective test: 80-125%

All hedge ineffectiveness is recognised immediately in profit or loss (including ineffectiveness within the 80% to 125% window)

Method must be documented and followed consistently

Some companies cannot be bothered…..

66

The economic dog does not always move?

Nestle – Some derivatives, while complying with the Group’s financial risk management policies of managing the risks of the volatility of financial markets, do not qualify for hedge accounting and are classified as trading.

Holcim - Certain derivative transactions, while fitting into the general risk management approach do not qualify for hedge accounting under the specific rules of IAS 39

Siemens - Company manages its risks primarily through a company-wide portfolio approach. Such a strategy does not qualify for hedge accounting treatment under IAS 39

Telefonica - The hedges with economic sense in the Telefonica Group’s opinion do not always fulfil criteria to be treated as hedges in the financial statement

67

Challenges with hedge accounting under IAS 39

Rule based standard versus principle based nature of IFRS

Qualifying for hedge accounting is very challenging

Use of hedge accounting varies among companies

Poor disclosure of risk management and hedge accounting

The challenge is financial statements do not always reflect underlying economics

68

Revamping hedge accounting

Risk components such as credit risk on a loan can be hedged

Combinations of exposures and derivatives can be hedged

Hedging of groups and net positions will be possible

Criteria for hedge effectiveness are relaxed and quantitative criteria are removed

Financial statements should better reflect risk management going forward

69

Sir David Tweedie on flying

One of my great ambitions before I die is to fly in an aircraft that is on an airline’s balance sheet. Why does this not occur?

Because most aircraft are leased and the standards divide leasing into two types: operating leases and capital/finance leases in which (broadly speaking) the asset is owned for

almost its entire life

70

The disappearing aircraft

Manufacturer

Lease Company(Lessor)

Airlines(Lessee)

Sale

Finance Lease Operating Lease

The aircraft has disappeared…

Account Receivables

SPV

Removed…

71

An aircraft lease transaction…

Manufacturer – Sells the aircraft to the leasing company

– Record a sale and remove the aircraft from its balance sheet

– Does not recognize the potential repurchase

Airlines (lessee)– Leases the aircraft from the lease company

– Treat the lease as operating and pay ‘receivables’ to the lease company

– Does not recognize ‘fixed assets’ and ‘liabilities’ on its balance sheet

Lease company (lessor)– Leases the aircraft to the airline

– Treat the lease as financing and recognize ‘receivables’, but not ‘fixed assets’

– Securitize the ‘receivables’ and the aircraft is gone…

72

All leases move on the balance sheet

Criticisms:Current accounting

Solution:Proposed accounting

Operating leases - assets & liabilities off B/S.

Impacts reported leverage and capital employed

All assets & liabilities on B/S

Can structure to achieve accounting outcome (finance vs. operating lease)

All assets & liabilities on B/S, so improving comparability

Standard should be applied as of 1 January 2015 at the earliest

73

Lessees will apply the rights of use approach

Lessees recognize a right of use assets and an obligation to pay rentals

The lease asset and obligation are derived by discounting future payments

Key considerations in estimating lease asset and liability: – Amounts

– Lease life

– Discount rate

Proposal will also impact the income statement– Operating lease charge will be replaced by amortization and interest charge

This will cause material changes to leverage and enterprise value for companies active as lessees

74

Leases in enterprise value

Enterprise value requires the inclusion of the operating lease liability

These are calculated by applying multiple or using present value technique

To get consistent EBITDAR, we need to reverse operating lease charge

This should give more comparable enterprise value multiples

Capitalizing operating leases will make enterprise value calculations more robust

75

Adjusting EV multiples for Airlines (2011)

0.0

2.0

4.0

6.0

8.0

10.0

12.0

Air France KLM Lufthansa Easy jet Ry anair International Airlines Group

EV / EBITDA EV / EBITDAR (Adjusted for operating leases)

Source: Company statements, UBS

76

Changes to lease accounting and returns

Current accounting distinguishes between finance and operating lease

Companies that use operating lease report higher returns as assets and liabilities are kept off balance sheet

The IASB considers bringing all leases on the balance sheet

This will impact returns on invested capital at the Food retailers

77

Leasing and NOPAT: European Food Retail (2010, %, local currency m)

Company NOPAT

Operating lease adjustment

Adjusted NOPAT NOPAT margin

Adjusted NOPAT margin

Ahold 1,033 205 1,238 3.5% 4.2%

Carrefour 2,050 557 2,607 2.3% 2.9%

Casino 886 247 1,133 3.0% 3.9%

Colruyt 326 13 339 4.8% 5.0%

Delhaize 690 127 817 3.3% 3.9%

Metro 1,496 670 2,166 2.2% 3.2%

Morrison 625 13 638 5.5% 5.6%Sainsbury 537 129 667 2.7% 3.3%

Tesco 2,739 222 2,961 4.8% 5.2%


78

CompanyInvested Capital

Operating leases capitalised

Adjusted Invested Capital

% change in invested capital

Ahold 5,518 3,750 9,268 68%

Carrefour 16,828 4,226 21,055 25%

Casino 10,032 1,022 11,054 10%

Colruyt 1,041 39 1,080 4%

Delhaize 6,428 1,264 7,692 20%

Metro 11,394 6,868 18,262 60%

Morrison 6,602 280 6,882 4%

Sainsbury 6,676 2,304 8,980 35%

Tesco 22,043 5,058 27,100 23%

Leasing and invested capital: European Food Retail (2010, %, local currency m)


79

Leasing and returns: European Food Retail (2010, %)

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

35.0%

Ahold Carrefour Casino Colruy t Delhaize Metro Morrison Sainsbury Tesco

ROIC ROIC Adjusted


80

Current accounting for revenue recognition

Revenue is one of the most important components of the income statement

Accounting for revenue recognition is one of weakest areas in IFRS

IFRS currently has two standards on revenue recognition– IAS 18 Revenue

– IAS 11 Construction contracts

US GAAP has many standards and pronouncements on revenue recognition

The IASB and FASB have published an amended exposure draft on revenue recognition

81

Proposal on Revenue Recognition

Steps to apply the core principle

Core principle

1. Identify the

Contract (s) with

the customer

2. Identify the

Separate

performance

obligations

3. Determine the

transaction price

4. Allocate the

transaction price

5. Recognise revenue

when a performance

obligation is

satisfied

Recognize revenue to depict the transfer of goods or services in an amount that reflects the consideration the entity expects to be entitled in exchange for those goods or services

82

SEC analysis of application of IFRS

The Staff noted a a number of differences in the accounting for the sale of handsets in the Telecommunications industry– The loss on the handset was recognized immediately through cost of sales because

the sale of the handset at a loss was considered to be a revenue transaction

– The loss on the handset was considered a subscriber acquisition costs, similar to a commission paid, that met the definition of an intangible asset. Under this view, the intangible asset was amortized over its useful life.

– The handset and the service contract were two separate deliverables. However, the handset consisted of two components: revenue was recognized to the extent of the proceeds from the sale of the handset and the loss was considered an asset (subscriber acquisition costs) that was amortized over its useful life.

– The loss on the handset was recognized immediately and classified as part of selling and marketing expenses in the income statement.

Differences in accounting practices impairs comparability in the Telecommunication sector

83

Implications of revenue recognition proposal -Telecom

Identification of separate performance obligations for distinct goods or services

Company would be required to account for all goods or services that can be labeled as separate performance obligations

Under the proposal, some revenue will be attributed to goods or services that are now incidental to the contract

Telecom companies for mobile phone contracts with free phone

84

Telecom offering handset and subscription

Monthly charge for bundled service (handset, voice, sms etc) 30

Contract term (in years) 3

Contract term (in months) 36

Market price of standalone handset 150

Cost of handset 120

Source: UBS Valuation & Accounting Footnotes

85

Comparing accounting for revenue recognition

Exposure draft Current practice

Year 1 Year 2 Year 3 Year 1 Year 2 Year 3

Service revenue 310 310 310 360 360 360

Handset revenue 150 0 0 0 0 0

Total revenue 460 310 310 360 360 360

Cost of sales -120 -120Profit before other expenses 340 310 310 240 360 360


86

Comparing profitability for Telecom

0

50

100

150

200

250

300

350

400

Year 1 Year 2 Year 3

Current accounting Proposed accounting


87

Conclusions on accounting for revenue recognition

Identification of separate performance obligations for distinct goods or services

Revenue recognized only from the transfer of goods or services to a customer

SECTION 4

Concluding remarks

89

Any questions?

90

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