Advanced financial accounting - Appunti completi (ENG)

A provision is recognized when the circumstances meet the following criteria (note: all three of them):

1. There is a present obligation that arises from a past event: past event which might cause negative

outcomes in the future;

2. Settlement with company resources will be probably required: IAS 37 specify “more likely than

not to occur so the probability that the event will occur is greater than the probability that it will

not” (50,1% of probabilities);

3. The amount of the liability can be reliably estimated: for example you will ask to your lawyers for

an advice. Whenever there is no reliable estimate, you are not entitled to write a provision (so you

will not write an expense in the statement of income), but you will simply give additional

information in the notes of the financial statement.

To sum up, when relevant (potentially negative for the entity) events have occurred, this becomes a

complex and delicate issue in preparing financial statements. It might impact on expenses (provisions) and

total liabilities (cumulated provisions). It requires to assess levels of uncertainty of future effects of past

events in terms of:

1. Probability;

2. Timing;

3. Amount.

It requires subjective (but not arbitrary) estimates, based on serious analyses (technical, organizational,

legal, contractual, etc.) and adequately documented. It requires an appropriate level of disclosure.

Particular attention by top management, auditors and financial analysts is needed.

Preliminary observations on shareholders’ equity

The use of leverage is wrong? Not really, but it highlights the need for a sound strategic management of

financial leverage. It’s important to distinguish financial liabilities and equity instruments. Issuer’s

classification either as liability or equity shall be based on substance, not on legal form, of the instrument.

Of course, to understand correctly substance, a careful analysis of the instrument is essential, considering

both its contractual terms and economic reasons for its use.

Equity instruments

Equity instrument means any contract that evidences a residual interest in the assets of an entity after

deducting all of its liabilities. Attention that residual does not mean trivial. Some examples are:

• Non-puttable equity shares: if there’s a put option (puttable share, a share including a put option),

you have the possibility to ask your money back (usually when market prices drop);

• Preference/savings shares that don’t pay a fixed rate of dividend and/or do not have a

mandatory redemption feature;

• Some types of puttable shares with put option by the shareholder: if they represent the residual

interest in the net assets of the entity;

• Warrants or written call options: that allow the holder to subscribe or purchase a fixed number of

non-puttable equity shares in the issuing entity in exchange for a fixed amount of cash or of

another financial asset.

Treasury shares originated from purchase of own shares by the entity which has issued them or by other

members of its consolidated group. In the statement of financial position, the cost of existing TS (in stock) is

deducted from equity:

ℎ ( ℎ ℎ ℎℎ) = ℎ − ℎ

Issued shares means the total of shares issued. TS in stock are formerly outstanding shares that have been

purchased and are being held (important) by the issuing company (or by other members of the

consolidated group). Why can this happen? Maybe to stabilize a situation of volatility in the share prices

(manage volatility in a legal way). In practice I’m using my own money to buy myself and money went out

from the company to some shareholders and this is why we subtract them from issued shares (and it’s also

the reason why we have restrictions on this operation). TS resales of TS are equity transactions.

Reflections on treasury shares

For the purchase of treasury shares, cash outflows from the company (or from another entity in the group)

are needed, decreasing equity value. From the sales of treasury shares held, cash inflows are received by

the company (or by another entity in the group), increasing equity value. Therefore:

• In the statement of financial position: the value of treasury shares held at the end of the period

shall be subtracted from equity so it is a negative item of equity;

• In the calculation of EPS: the number of treasury shares held shall be subtracted from the number

of outstanding shares considering the effects of purchases/sales occurred during the period in the

weighted average calculation.

Share buybacks/share repurchases program and share split/share reverse split

Treasury shares shall not be confused with shares buyback (or share repurchases program) operations:

• In buybacks: the shares are repurchased by the issuing company and cancelled after the

repurchase operation. So when we acquire them we reduce cash and equity for the amount of the

purchase (up to this point it’s identical to treasury shares) then we cancel them (and equity will still

be lower because it’s the difference between the original value and the shares repurchased). They

don’t exist anymore so if I want to increase equity I have to make profits or issue new shares;

• Buyback is a way of reducing excess capital and/or an alternative to payment of dividends, etc.

Sometimes the price of a share becomes very high (like for a very profitable company that doesn’t

distribute dividends). An important operation/tool for that is the share split. They are operations that don’t

imply any movement of money/cash. When you do this it is significant for the share market because the

price per share becomes lower giving possibility to smaller investors to buy them. Of course the liquidity of

the shares increases giving benefits also to the company. Let’s see an example of a 10-for-1 split:

SoFP before the split SoFP after the split

Assets 250 Equity 135 Assets 250 Equity 135

Shares 90 Shares 90

Reserves 45 Reserves 45

Liabilities 115 Liabilities 115

9 shares, face value 10 90 newly issued shares, face value 1

Assets and liabilities do not move and also reserves. They’re also called “scrip operations” (scrip means

paper). Is it possible the contrary operation? Yes it is, it’s the reverse split operation. Let’s say that I have 2

shares outstanding, I can withdraw them and giving to the investor 1 share. Of course this reduces the

number of shares (1-for-2 reverse split). They are operated if the stock price is going very down.

Reverse convertible bonds

These are risky financial instruments. Why? Because they include an equity component where the decision

at maturity is in the hands of the issuer, not the investor. If the underlying share price falls below a certain

level, the issuer can repay the bond not in cash, but by delivering depreciated shares. These bonds are

typically issued with a short maturity (2-3 years) and offer a higher coupon than a standard bond.

Shareholders’ (owners’) equity

In consolidated financial statements: ′

ℎℎ

′

= ℎℎ + ℎℎ

Non-controlling interests shareholders formerly were also called minority interest. The group SE is the

equity of the group which is in the hands of the shareholders of the holding company. Non-controlling

interests is the equity in the hands of external shareholders. For instance, imagine that there is an

Indonesian oil drilling company which is owned for 70% by BP and for 30% by the Indonesian government.

This

This 30% is the non-controlling interest in the subsidiary. distinction is fundamental for our analysis on

consolidated profitability because this means that a part of the profit of the subsidiary is attributable to

someone else. Coming back to our example, the profits or the losses of the Indonesian drilling company will

be 70% attributable to BP and 30% attributable to the Indonesian government. Notice that total

consolidated SE is equal to group SE if and only if the parent corporation owns all the shareholdings in its

subsidiaries (the 100% of all of them).

Total shareholders‘ equity calculation

In general: ′

ℎℎ =

+

(−)

+

±

± ℎ ℎ

Earning per share (EPS)

EPS is a widely used performance ratio, mostly for listed companies, because it can be:

• Compared over time for the same entity: or between different entities, but with additional

calculation because every entity has its capital structure;

• Used in calculating Price/Earnings ratio;

• Its denominator can be used in calculating other “per share” ratios;

• It is one of the possible indicators in calculation of performance-oriented variable

compensations.

EPS has a dedicated accounting standard (IAS 33). Apparently, EPS seems easy to calculate:

= ℎ

I can’t take the end of the year number of shares and I need to take a weighted average (as we will see).

Ordinary means that saving shares/preferred shares are excluded (which have particular rules of

remuneration) because the IAS 33 is interested in expressing the profitability for ordinary shareholders with

full powers. Outstanding means the shares in circulation and effectively in the hands of shareholders which

means that treasury shares are excluded. Let’s analyse the technical problems we have.

Numerator and denominator problems

Net profit is influenced by the company’s accounting policies. Nevertheless:

• To a certain extent this is inevitable;

• A correct application of accounting standards: should help to limit major differences and should

give enough public information to allow to treat data properly and consistently (the importance of

auditing and of disclosure of accounting policies).

Remember (important), in any case numerator figures must be coherent/consistent with denominator

calculation (example to cl