Measuring and Liabilities Investment Professionals’ Views

February 2007 “This research is an important contribution to the debate and will be examined with interest by the IASB.”

Sir David Tweedie, Chairman, International Standards Board Measuring Assets and Liabilities - Investment Professionals’ Views

Introduction

In July 2006, the FASB and IASB One of the key points to be The outcome of this measurement jointly issued a discussion paper debated as part of the proposed debate will impact not just the entitled “Preliminary Views on an revisions to the Conceptual amounts represented on the improved Conceptual Framework Framework is the purpose of the ; it will also have for Financial Reporting”. This balance sheet and its interaction direct consequences for the other paper, the first of a series, is a with the other primary financial primary statements. For instance, major step in the evolution of statements. What information do when assets are measured at fair financial reporting. It challenges users expect to derive from the value, how should the change key stakeholders to debate the balance sheet as they assess a in fair value be recognised in the objective of financial statements. company’s financial performance ? Whose needs should standard and, accordingly, how should Given the scope and importance setters serve? Does stewardship assets and liabilities be measured of these questions, input from have a role in the reporting model? in this statement? To date, the professional investors is a What are the qualitative attributes Conceptual Framework does necessary part of the solution. that determine whether information not articulate a comprehensive is decision-useful? The answers to set of criteria for determining the these questions will have profound appropriate measurement bases for consequences for financial assets and liabilities. reporting for years to come.

3 PricewaterhouseCoopers LLP  Measuring Assets and Liabilities - Investment Professionals’ Views

Talking with Investors

PricewaterhouseCoopers met in The balance of the participants The following themes and late 2006 with over 50 buy-side and provided insights from the observations regarding the use of sell-side investment professionals in perspective of their industry variations of either Boston, London, and New York, as speciality, including those covering or current value measures are well as a small number of investors the automotive, financial services, specifically focused on their use based in San Francisco, Frankfurt, retail, software, and infocomm for illiquid assets and liabilities (for and Toronto. The two objectives sectors. The results should not be example, PP&E, intangible assets, of the interviews were to discuss considered to be statistically valid. etc.). Generally, interviewees their use of the balance sheet in However, the consistency of views agreed with the use of current their analysis of performance and, expressed provides valuable insight value measures for liquid financial secondly, the measurement bases into both the role of the balance instruments, except long-term debt, for assets and liabilities that best suit sheet in the investment process and as discussed below. Participants their needs. Approximately a quarter the measurement bases that best were encouraged to avoid using the of respondents to this survey were meet these users’ needs. generic terms historical cost, fair “generalists”, either accounting and value, or current value, and were finance specialists or senior portfolio invited instead to focus on more managers. granular terms such as entry price, exit price, original cost, replacement cost, etc.

 PricewaterhouseCoopers LLP Measuring Assets and Liabilities - Investment Professionals’ Views

Forecasting Balance Sheets

These investors generally did not of performance, which is consistent believe a fundamental re-evaluation with the fact that only 17 percent of measurement bases used in of respondents actually elect to accounting for assets and liabilities forecast the balance sheet as part to be a high priority. Instead, of their analytical process. However, the participants want a more this focus does not mean that they transparent view into the underlying ignore all items in the balance sheet. operating performance of a They focus on specific numbers that business – that is, greater clarity as help them assess, for example: to the investment returns generated • Return on invested capital by management as they convert the inputs of production into . • flow The respondents generally placed • Indebtedness. more emphasis upon the income statement in their assessment

PricewaterhouseCoopers LLP  Measuring Assets and Liabilities - Investment Professionals’ Views

Moving to Current Value Measurement Bases

Respondents are satisfied with • Many participants found it If a current value measure is to be the use of current value measures unsettling that by measuring provided, participants want: for highly liquid financial assets. liabilities using current value, • Key assumptions/drivers to be However, there are pervasive a deterioration in credit rating disclosed in order to compare concerns about the adoption of any results in a gain to the company across companies and evaluate form of current value measurement and an increase in shareholders’ sensitivity and reasonableness. for illiquid assets and many wealth. liabilities: • Gains and losses on • Interviewees are concerned remeasurement of current • Whilst respondents generally about the potential cost of value to be excluded from welcome a current value for implementing current value the operating performance liquid financial assets and for measures: Might management’s of the business, that is, most those assets deemed to be time be better spent? interviewees want to see current “investments” or “available • Respondents view the task of measures reported through for sale”, they question the estimating the current value incremental disclosure rather relevance of current value of the enterprise as theirs, not than recorded in the primary measures for a number of assets the role of management and/or statements. that are “operational” in nature. . • Ranges of outcomes, provided • Interviewees are concerned through additional disclosure, about managements’ ability to rather than point estimates. provide reliable estimates of current value and the potential • Benchmarking against industry for changes in current value norms. estimates to mask operating performance, given the current presentation of the income statement.

 PricewaterhouseCoopers LLP Key Findings

In the Review of Findings we offer line-by-line analysis of the findings. However, some high-level observations can be made:

• Some respondents are interested in • Ninety-six percent of respondents wish the disclosure of the replacement cost of property accounting for provisions* to reflect only so that they might better understand the probable events on the balance sheet. adequacy of capital expenditure rates and However, many interviewees comment that whether management is utilising the assets additional disclosure of other improbable but efficiently. Few wish to see replacement cost potentially material events would be useful on the face of the primary financial statements. information. • Fixed income respondents wish to see • Eighty-six percent of interviewees want debt to disclosure in the notes of a “best possible use” be measured at par value in the balance sheet sale price for key assets which might be used rather than current value. to repay outstanding liabilities. • Within the group of participants for whom • None of the respondents uses balance sheet operating leases are important, there is a information on acquired intangible assets near-unanimous desire for such leases to be – for example, customer lists or brands. The capitalised on the face of the balance sheet. majority of interviewees believe that the current • The reporting of taxes is universally deemed to allocation of purchase price, required under be highly complex. For this reason, deferred both IFRS and US GAAP, does not provide tax information is typically ignored. Participants useful information. recognise the importance of taxes, but have • A few in technology-dependent industries significant difficulty in identifying cash taxes think that research and development (R&D) versus deferred taxes and what they should should be capitalised. However, they are in the expect future cash taxes to be. minority; most express the desire to see R&D • Participants are unanimous in their desire to expensed in the income statement. There is see the underlying economics of pension plans near-unanimity that disclosure of the total cash clearly reflected in the financials. There is little spend on R&D would be helpful. unanimity, however, in the solutions proposed • Inventory, receivables, and payables are by the respondents. generally considered to be adequately reported, although many call for improved disclosure of changes and trends. (Note: The survey did not extend to analysts in industries where inventory is typically held for prolonged periods.)

* Provisions is defined for purposes of this report as all liabilities of the organisation excluding long-term debt and deferred tax liabilities. Therefore it would include, for example, , pension liabilities and contingencies. 7 Measuring Assets and Liabilities - Investment Professionals’ Views

Review of Findings

What is the balance sheet The most common use for a “I don’t know if for? balance sheet is as an input to a model. In this regard, performance is best This is an important question that it is the individual line items that described as the many respondents had difficulty are useful rather than the balance difference between answering. Generally, their focus sheet as a whole. Very few of our is on either cash flows or earnings two balance sheets, respondents (17 percent) therefore or both, and the balance sheet but I think it’s helpful choose to forecast whole balance provides relevant information in sheets. A further 17 percent as there’s always a these regards, but none of the forecast whole balance sheets only lot going on. That’s respondents treats the balance because they are required to do why all of the primary sheet as a primary focus. so by their investment houses or Performance is not viewed by statements are so because this is a necessary input these professional investors as the important to look at to their modelling systems. Twenty- difference between two balance eight percent forecast specific line together.” sheets. items, but the largest number of The use to which balance sheet respondents (38 percent) state information is put varies, as shown that they do not forecast balance in Figure 1. sheets.

Figure 1: How do you use balance sheet data?

 PricewaterhouseCoopers LLP Measuring Assets and Liabilities - Investment Professionals’ Views

The responses on individual PP&E line items are discussed below. “If we lost sight of the The majority of survey respondents Generally speaking, there is little actual cost base, that do not explicitly include the balance appetite for greater use of current sheet amount for PP&E in their would be the biggest value in the primary statements, investment analysis. Thirty percent loss to investors.” although enhanced disclosure of respondents describe PP&E as would seem to be welcome. “very useful” and 57 percent as “not “I really do think market In the sections that follow, we useful”. As one might expect, PP&E values, fair values, summarise the survey results with is considered to be useful in the have their place – but respect to certain balance sheet line more -intensive businesses, selectively.” items, namely: such as automotive (83 percent) • PP&E and retail (100 percent). Conversely, “Investors do not want every respondent in the financial the accountants valuing • services sector describes PP&E as companies for them. • Other intangibles “not useful”. That’s what investors • Working capital Where PP&E is considered useful, the reasons vary. Most commonly do.” • Provisions (43 percent), the relationship • Debt. between capital expenditure and is an input to cash flow modelling.

Figure 2: How useful is PP&E data?

PricewaterhouseCoopers LLP  Measuring Assets and Liabilities - Investment Professionals’ Views

Review of Findings

As regards measurement in There is also an appetite for “We wouldn’t value the financial statements, most greater disclosure around capital what they have in terms respondents (74 percent) are expenditures, which is consistent of PP&E. It’s more a satisfied with the status quo (that is, with the cash flow objective case of how much did it historical cost less depreciation and described above. impairment). cost? How much more Goodwill are they going to spend There is very little appetite in the primary statements for a Most respondents do not consider on it?” measurement basis other than goodwill balances in their analyses. amortised historical cost. However, In our sample, 70 percent describe disclosure is another matter, with goodwill as “not useful”. 52 percent seeking information Where any use is made of goodwill, “I would love to see about replacement cost and 37 a footnote on capital it is considered helpful in assessing percent favouring a sales price or the success of past acquisitions. expenditures, breaking similar measure of exit price. As one these things out into might expect, most (70 percent) With so little interest in the goodwill number, respondents are more detail in terms of those favouring sales price are fixed income analysts who are ambivalent about its measurement. of maintenance and generally more concerned about Only 38 percent express an investment capex and debt coverage and potential break- opinion and most of those favour where it has gone.” up values. measurement at historical cost less impairment.

Figure 3: How useful is goodwill data? “Goodwill is relevant from a sentiment point of view – what has the company been doing over the last few years? It tells you the history. But in terms of valuing a company, it is irrelevant.”

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Other intangibles in recognising such amounts in the model whereby some expenditure is balance sheet. capitalised and some expensed. Many of the respondents view intangible assets much as they view Some strong views were expressed Concern was also expressed about goodwill, with 74 percent describing about research and development the reliability of data related to the item as “not useful”. and the requirement to capitalise intangible assets. development expenditure either Participants are interested in the It is hard to draw firm conclusions after certain criteria are satisfied or nature and amount of a company’s from this result, although there is when it is acquired in a business intangible assets. However, the clear evidence that respondents are combination. Many respondents interviewees are not interested more interested in the nature of and describe as confusing the current expenditure on intangible assets Figure 4: How useful is data about other intangibles? than in the treatment of intangible assets in the primary statements.

“Separating goodwill into different components is a complete waste of time.” “These things are incredibly hard to value. If you look at most businesses, much of the value is actually in the Figure 5: How should other intangibles be reflected into primaries? intangibles. But valuing them is impossible.”

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Review of Findings

Working capital The financial services sector seems Equity analysts use working capital to be the outlier; in all other sectors, information in a variety of ways, Overall, 55 percent of respondents working capital can at least be but fixed income respondents consider working capital to be described as more useful than not. participating in the survey all use “very useful”, whereas 28 percent This result could reflect the fact that working capital data as an input to a consider it to be “not useful”. the concept of working capital has cash flow model. However, the industry analysis less meaning in the financial sector. indicates that the usefulness of A small number (10 percent) of information about working capital Where working capital information is respondents, scattered across varies from industry to industry. considered useful, it provides input industry sectors, consider that For example, all respondents from to cash flow models (51 percent) or working capital should be measured the retail sector consider working gives evidence of business trends on a current value measure. The capital to be “very useful” while 100 (42 percent). Only a handful of remainder favour a version of percent of respondents from the respondents use working capital historical cost. financial services sector consider it information in any other way. “not useful”.

Figure 6: How useful is working capital data?

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Provisions Regarding the measurement of provisions, almost all respondents Provisions* are considered to be a (96 percent) prefer a model based “very useful” source of information on probability-adjusted discounted by 51 percent of our respondents cash flows. There is little support and “not useful” by 28 percent. for the current proposal that non- There is no significant variation by financial liabilities be measured at industry sector. current value regardless of whether Where provisions are considered the event is deemed probable. useful, the majority (86 percent) However, there is significant support use the information as an input for greater disclosure, which might to a cash flow model. This is not include a probability-adjusted surprising because provisions and discounted cash flow analysis the related disclosures can give an without the recognition hurdle, or important insight into the sensitivity some other current value measure. of future cash flow projections. One particular type of provision Most of the respondents (86 that causes much concern is the “Smoothing percent) support the current model accounting for defined-benefit mechanisms make whereby a liability is only recognised pension plans. pension accounting when an outflow is likely. completely impenetrable for most people.” Figure 7: How useful is provisions data?

* for the definition of ‘provisions’, please refer to page 7 PricewaterhouseCoopers LLP 13 Measuring Assets and Liabilities - Investment Professionals’ Views

Review of Findings

Debt In almost all cases (86 percent), “If I really want to the measurement basis preferred Debt information is almost know the market value by respondents is the settlement universally (74 percent) considered amount rather than a current value. of the debt, it’s on to be “very useful” except in the Nevertheless, many respondents Bloomberg.” financial services sector, where 56 acknowledge that the current value percent of respondents consider of debt is an important measure “I don’t need you to put debt to be “not useful”. the market value of debt for calculating enterprise value. The debt balance satisfies a number However, they prefer to develop on the balance sheet.” of information objectives, as shown their own measures. in Figure 9 below.

Figure 8: How useful is debt data?

Figure 9: How is debt data useful?

14 PricewaterhouseCoopers LLP Measuring Assets and Liabilities - Investment Professionals’ Views

Taxation “Somebody has to While taxation was not a survey figure out a way to topic, a number of respondents raised concerns about the current make deferred tax more accounting model. Accounting for understandable.” deferred taxation, in particular, was frequently cited as an area where “For things like deferred disclosures could be improved. tax assets or liabilities, we tend just to say to ourselves, we really don’t know what’s going on here.”

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Addendum: Keeping Abreast of Accounting Developments

Few of the investment professionals Participants might also wish to An up-to-date project timetable can we interviewed describe themselves consider joining the debates that be found at www.IASB.org or www. as “engaged in the standard- are proving their value in investor FASB.org. setting or regulatory process”. This forums such as the Corporate observation, based on surveys Reporting Users’ Forum (www.cruf. conducted by PwC firms in the US com). and Canada in 2006, was reinforced Key dates for some of the more by the interviews conducted in this significant IASB/FASB projects are survey. set out below: PwC is committed to facilitating greater engagement by all Topic Document Standard Publication stakeholders in the financial Setter date reporting process. We encourage Fair value Discussion Paper IASB Q4 2006 investment professionals to offer measurements* comments on the due process Income taxes Exposure Draft IASB Q1 2007 documents that will be published by standards for Invitation to FASB Q1 2007 the FASB and IASB in the coming financial reporting* Comment years or indeed to participate in the Consolidations Discussion Paper Joint Q2 2007 standard setters’ established user Discussion Paper Joint Q2 2007 groups. presentation* We recognise that, owing to time Post-retirement benefits Discussion Paper Joint Q3 2007 constraints, some investors may Business combinations* Standard Joint Q3 2007 not be able to engage with the Discussion Paper Joint Q4 2007 standard setters directly on all of Leases Discussion Paper Joint H2 2008 the standard-setting activities. Phase 2 of the fair value Discussion Paper FASB TBD Therefore, we commit to canvass option project* opinion on critical topics. * These projects will have a material impact on measurement and the presentation of remeasurement gains and losses

16 PricewaterhouseCoopers LLP Contact Details

For further details about this survey please contact:

John Horan t: +1 (973) 236 4997 e: [email protected]

Alison Thomas t: +44 (0)20 7212 2438 e: [email protected]

© 2006 PricewaterhouseCoopers LLP. All rights reserved. ‘PricewaterhouseCoopers’ refers to PricewaterhouseCoopers LLP (a limited liability partnership in the United Kingdom) or, as the context requires, other member firms of PricewaterhouseCoopers International Limited, each of which is a separate and independent legal entity. Design 0700112ass(vcl)